Tuesday, November 4, 2008

Keep Track of Your Customer's Sentiment

It is easy for management teams, boards and venture capitalists to get caught up in the headlines. The risk of doing that, of course, is missing out on a subtle but important change that indicates a new trend.

After the Internet/Telecom bubble burst, I noticed a certain business practice that helped some companies survive. The better management teams developed systems for tracking the planned spending patterns of their customers. They created weekly charts using various relevant metrcis for following the changing sentiment of their customer base. For instance, were customers talking about shifting to lower cost products, were they starting to defer certain expenses, ect? The upshot was that during board meetings we had information rather than one off anecdotes. And by tracking customer changes week by week, we acquired a better feel for the direction our market was headed. The most striking example of this was in tracking Internet adverstising. Most peopole (VCs included) would have assumed that the post bubble Internet adverstising spend was down 50%, maybe even 75%. In reality, by tracking the numbers, Clearstone's consumer Internet companies saw that the spending decline was a relatively modest 15% to 20%. Pretty bad but not terrible. That gave our managment teams more confidence when it came to making decisions about growing their businesses.

Sunday, October 26, 2008

Hard to Avoid Higher Taxes

I have a reflexive reaction to higher taxes, particularly on the most productive members of society. I always think “will congress/state legislatures deploy the tax revenue more productively than society at large?”. Generally speaking, I think not. There is also the issue of tribute paid to members of congress to curry favor with various interest groups. When an entity has the power to redistribute wealth via tax policy, it has a corrupting influence on everyone involved.

Given the fiscal problems in our Federal and State houses, I don’t see how we will avoid higher taxes. I also believe the “top 5%” targeted by Obama today will become the top 50% in 12 months. Unless we make major changes to the way our federal and state governments are run, the politicians will need to raise taxes by a large amount to fund the myriad programs. It is going to be ugly. Keep in mind that a major tax increase will occur in 2011 regardless of who is in office because the 2002tax cuts are set to expire. One thing I would really like to see is an expiration date on tax increases.

Thursday, October 23, 2008

Gather Market Intelligence in Q4

Quick comment on something I have been suggesting to my companies since the financial crisis unfolded. Q4 2008 may be one of of the most uncertain time periods, in terms of customer demand forecasting, that I have experienced since Q4 2001. So how should management teams cope with this really unpleasant fact? My advice is to institute a data gathering process immediately. Start polling customers (existing and potential) and rigorously rolling up and evaluating your findings. The office of the CFO or Marketing Department is probably the right group within the company to be aggregating this information. Look at this information every week. Be sure to track how expected customer spending patterns are changing from week to week. As far as 2009 goes, I would recommend building your sales (and spending forecasts) on a quarter by quarter basis. Q1 2009 (and possibly Q2) could be a particulary selling environment. 2009 operating plans will be finalized in November and December. Most of those budgets will restrict all discretionaly capital spending until later in the year.

Ready, Aim, Aim, Aim, Fire

Companies should always be careful about how they spend their money, but the reality is, they sometimes get lazy. In these very challenging times where fund raising has become difficult, it is critical to spend cash wisely. I bring this up today because I am thinking about all of the companies that raised money in the past 1 or 2years. One thing I would bet on: most (if not all) of these management teams wish they could rewind the clock on how they spent their venture funding. As a venture capitalist, one of toughest choices I have to make is when to encourage a company to ramp headcount and ultimately spending. It feels good to grow headcount, move to a bigger office, take on more projects and vertical markets. But in times like these, it is worth remembering how important it is to wait until your business really understands the market (and customer adoption rate of your technology or service) before ramping spending. One of my partners uses the phrase "ready, aim, aim, aim fire" to describe the process for growing your business. Resist the urge to grow your business headcount (and related expenses) until you have HIGH confidence that you have the right product and the customer base is ready to buy. It is so much easier to grow your busines than it is to shrink it.
Some factoids I heard on CNBC today were pretty shocking.

- 750,000 foreclosures in Q3.
- In 2004, 2005, 2006, Americans took out between $500B and $800 billion per year in home equity loans. What the heck were these people doing with that money.
- On the other hand 80% of all homeowners have sufficient equity to weather the current crisis. It gets ugly, however, if home prices drop another 20%. Then a lot more people may walk away.

Thursday, October 9, 2008

Remaining Objective When Fear is in the Air

It is hard to believe that just 8 years ago, venture capitalists were facing what we all thought would be the ‘great crash’ of our lifetimes. Meaning the one and only significant crash we would see before we retired. After all, even with two world wars, a cold war, and an unprecedented energy shock in the 1970’s, the 20th century only had one Great Depression. The Dow dropped 90% from its high during the Great Depression. NASDAQ dropped 80% from its high after the tech bubble burst. Market collapses of that order are only supposed to happen once in a lifetime. But now, due to the financial crisis of 2008, the consensus opinion among wall street and venture investors is that we are at the beginning of another great crash and long term economic malaise (note Sequoia’s amazing comment about a 15 year secular bear market).

If this were my first bubble bursting experience, I might buy into that dire consensus view. But it isn’t and I don’t. The figure that stays with me more than any other during these trying times is the performance of the Internet and hospitality sectors from 2002 to 2007. In the dark days of 2002, two years after the tech bubble collapsed and a year after the terrorist attacks, the hospitality sector was crushed (who wanted to fly) and many Internet stocks were trading near their cash balances. What happened? Over the next 5 years, Internet and hospitality stocks, which you could barely give away in 2002, were the #2 and #3 best performing sectors out of 75 tracked by Wilshire Associates. The only better performing sector was coal - due to unprecedented growth in emerging market energy consumption.

When the tech bubble burst, lead by collapse of the Internet and telecom sectors, there was widespread believe that these were not ‘real businesses’. It was easy to see why people felt that way. Few Internet or telco executives were talking about cash flow and profits. Of course, the reason for this was that the public markets were not rewarding those things. Five years after the dot com crash, investors came to realize that in fact Internet and telco centric business models (think Google, RIMM) were among the most profitable businesses of our era. This lesson is now well known. What does that mean? I believe this time around the entire tech sector will not be abandoned. If anything, there will be more conviction around the best businesses and business ideas. This very same phenomenon is happening now in the banking sector. In the middle of the panic phase of the financial crisis, investors speak highly of BofA, JP Morgan, US Bankcorp.

We can’t deny that people are worried, even scared, about what is happening on Wall Street. Venture capitalists read the headlines and assume the worst. I believe the root cause of the deep anxiety being felt about the stock market and economy is the speed and severity with which it has taken hold. People have only so much capacity for dramatic change, especially when that change is negative. The pace of mortgage defaults and bank failures this year has been too much for most of us to keep up with. Images of a banana republic come to mind. But consider this point. Over half of all subprime mortgages originated in the trouble years of 2005-2007 have already been written off – to zero. Many of the remaining troubled loans are being worked out. The upshot? There is a historical wealth transfer taking place between global financial institutions and US home owners. Housing debt ratios for consumers will be cut by 40% when the write-offs and loan adjustments are complete. Consumer leverage will be close to what it was in 2001, at the beginning of the housing bubble. While unsettling, the speed at which financial institutions and governments are disposing of problem assets and injecting liquidity into the economy will accelerate economic recovery by 2010, perhaps beginning in the second half of 2009.

And what of those shaky financial institutions that triggered the crash of 2008? The consensus view, reflected by their stock prices, is that more banks will disappear and most will be permanently impaired. Now look at the numbers. The book value of global financial firms was $4 trillion in 2007. Today, it stands at $4.2 trillion. This takes into account the $300B of asset write-downs (net of tax effect) offset by $300B of equity infusions and $400B of newly retained earnings. The stock prices don’t reflect it yet, but the bulk of financial firms have addressed their problems, either by taking massive write downs or merging with stronger partners. So why does it feel so awful? Because these corrective actions have place at a speed we have never seen before. The 1980’s S&L crisis was 5 years in the making and took another 5 to fix. 2000 banks failed during that period. This time feels worse because we are taking all of the bad news at once. In just a few months, US banks have written off more of their troubled loans than the Japanese banks did with their problem loans in 15 years. Have faith in this: once the bad loans have been charged off, a process that might take another 6 months, US banks will have confidence in their own - and each other’s - balance sheets. At that point, reasonable lending practices will return. That is what always happens.

Aside from the painful – but ultimately positive- massive deleveraging by consumers, the scourge of inflation is being wiped out. Headline inflation (which includes food and energy costs) has been running 5% per annum over the past 5 years. It is now projected be near zero for the next 2 years. Reductions in housing, energy and basic consumer staples are the primary reasons for the decline. That means growth in real wages.

Goldman Sach’s recently proclaimed that a deep recession was likely. In their estimates, the US economy could contract by 7% in the next 12 months. We must keep in perspective, however, that just a few weeks ago Goldman was rumored to be on the road to collapse. I can’t help but assume that their deeply pessimistic institutional views have been colored by their proximity to the financial epicenter. But even if we assume that Goldman’s 7% economic contraction estimate is correct, that means that 93% of business and consumer spending continues. Certain sectors like automotive, housing and hospitality will undoubtedly be hard hit. On the other hand, affordable entertainment and productivity enhancing purchases, like investments in business technology, should fare much better.

In summary, this is not a normal economic cycle. The problems in our economy were created by irresponsible home borrowers and lenders, not the typical recessionary forces triggered by excess industrial capacity The blast radius of this crisis has threatened to engulf the whole economy because banks uniquely touch every aspect of commerce. They provide the liquidity for borrowing and lending. There is reason for optimism. With the measures being taken by banks and our government, we are working our way out of this mess. We understand the problems and are addressing them. When we get to a period where 90 days go by without a major financial institution failing, I believe the frayed investor nerves will start to heal. Until then, we must have the discipline to remain informed and objective.

Friday, August 22, 2008

The Next Big Thing is?

Giant secular change. That is what Wall Street pays strict attention to, particulary when it comes to evaluating IPO candidates. In my investment career, I have seen a few of these. The eras of biotechnology, Internet, alternative fuels, commodity inflation are some of the big ones. I mention this because I routinely am presented with business plans for perfectly good companies. And yet, my firm, Clearstone Venture Partners, regularly passes on these 'perfectly good' businesses? Why? Because we are looking for the kind of businesses that are tapping into a giant secular trend that will provide substantial growth and earnnings power.

These opportunities don't come along very often. And when they do, it is easy to miss them. I have been a VC for a long time, and I can tell you that the fantastic business ideas do not come with a bright ribbon on them saying "Please open, this is the next Google, Microsoft, Paypal, ect". To see the hidden value of a business, particulary an early stage one, an investor must have a view of the mega trends unfolding in the world. How is the business under consideration positioned to take advantage of whatever large trend it is playing to? Entrepreneurs would do well to think through this concept before meeting with investors.

Web Marketing for Tech Businesses...

I recently began examining corporate web marketing practices. I was curious at how things have evolved in the past few years, particulary among supposedly web savy technology companies. What a surprise. The sophistication of B2B web marketing techniques falls considerably behind what is happening on the consumer web.

What is equally surprising is the disparity among companies in the same industry. In the enterprise networking space, for example, F5 and Riverbed are quite sophisticated in their web lead gen practices. Riverbed, as a benchmark, generates close to 100% of its sales leads from web based marketing. Imagine what that does for its sales and marketing expense line. For most companies, however, the web is little more than an online product brochure. A huge missed opportunity.

I don't believe this condition will last forever. But on the web, there is a big advantage to being first. In the end, those companies that begin taking their web sites seriously as sales tool will show superior operating margins to their off- line focused rivals.

So here is some advice to technology company executives in the B2B world. Ask your marketing staff how many leads come from the web today? If it is less than 10%, you probably have little or no web marketing direction. A good goal to shoot for is 25%. Keep in mind: the higher that figure goes, the lower your cost of sales. Also consider that most corporte purchase decisions are well researched. The web is the starting point. Your business should be the first place potential buyers go to get informed and ultimately make a purchase.

Next up: The Bail Out of Detriot

I just read that Representative John Dingell of Michigan has proposed a $25 billion federal bail out for the Big 3 auto manufacturers located in his home state. Hard to believe it has come to this. Though not suprising. After the bail out of the airlines in 2001, followed by the bail out of the major wall street invesment banks, home builders and now Freddie and Fannie in 2008, it was bound to happen. In fact, it is hard to make a principled argument against Dingell's proposal based on recent precedent. How do you tell an American auto executive that he is less worthy of charity than the coalition of agribusinesses that benefited so handsomely from this years Farming Bill.

Which makes me wonder: Why didn't the tech industry request federal funds after the dot com and telecom bubbles burst in 2000? In hindsight, it seems like a grave mistake. The tech industry employs a large number of middle class voters. For some reason, there was no cry for help as this important industry shed millions of jobs from 2001 through 2004. Perhaps this is a reflection of the way we in this industry think. We are more open to the good and bad of market forces. Start-ups are risky and routinely fail. We don't expect people to feel sorry for us or to provide us a hand out when poor management or bad luck works against us. What is surprising to me is that I thought this was a strongly held American belief. The last few years have changed my outlook.

The most troubling implication of this recent massive federal intervention is the precedent we have now set for federal hand outs. The bar is quite low. When the next American industry experiences hard times, how do we stand up and say "you got yourselves into this mess, you need to solve the problem yourselves"?

Sunday, June 22, 2008

Enterprise 2.0 Makes Me Excited....

Good news. I am seeing a growing number of Web 2.0 and social software companies successfully selling into enterprise customers. After years of incremental investment in corporate IT, I believe we are moving into a new cap ex phase in the enterprise. Web 2.0 is driving much of this new dynamism. As much as we have all grown tired of the consumer led social networking phenomenon, the enterprise is finally embraching these emergying tools.

I am truly surprised at the level of interest in social software among enterprise customers. Even better, IT departments, typically the gatekeepers of new technologies, are pushing these new collaboration tools with the same degree of excitement as the employees demanding them. Another positive trend, the support for these new technologies is often coming from the executive suite. Among the CEOs I regularly work with, enhancing employee collaboration via Web 2.0 technologies is a priority.

This is an area where Clearstone is quite interested. We believe their are many new opportunities for start-ups in the social software sector. After a long drought in enterprise spending, it is nice to see a growing trend that we can participate in.

No VC Backed IPOs in Q2 2008

During my VC career, there has never been a quarter where no venture backed companies went public. According to the NVCA, the lobbying group of the venture capital industry, this situation has not occured as long as it has been around either. What a remarkable turn around from a decade ago. I don't think any VC would have predicated this situation then. Should we - VCs and entrepreneurs - care about this? What are the causes? I will take a stab at these two important questions.

First, VCs and entrepreneurs should very much care about the drought of venture backed IPOs. Think of the venture capital industry as a system. The input side of the system is capital. This capital comes from limited partners who expect superior returns as compensation for having their money tied up for 10 years (typical length of a venture capital fund). The output, of course, is investment returns. And generally speaking, no bigger returns exist for entrepreneurs, VCs and their limited partners than an IPO. With the IPO window closed, fresh capital - via returns - is not available to invest back into the venture industry. Over a prolonger period, this problem in the IPO market could lead to a reduction in available venture capital. Anyone who experienced the aftermath of the dot com/telecom bubble knows how bad that can be.

Now on to the second question, why has the IPO window closed? Like all complicated things in life, there are a host of reasons we find ourselves in this situation. The biggest contributors? The risk averse mentality on Wall Street brought about by the credit crisis and the unintended consequences of Sarbanes Oxley legislation.

Until the major capital market investors get more visibilty and comfort with the extent of the credit crisis on corporate balance sheets, I don't foresee a big appetite returning for VC backed IPOs. Will that be in 12 months, 18 months? Hard to say, but that is my guess at the approximate time frame. There will be venture backed IPOs in the interim to be sure, but those will be companies with particularly attractive near term prospects. Companies hoping to tap the public markets to pursue business opportunities with a longer term payoff are out of luck.

I believe we are now seeing the enormously negative consequences of Sarbanes Oxley play out in the IPO market. From my own portfolio company experiences, IPOs are looked upon with far more trepidation than they were previously. Aside from the added costs created by SarBox, there are fewer qualified CFOs willing to be involved in public companies. Experienced CFOs have become among the most difficult positions to fill in pre-IPO companies. I understand their reluctance. Prosecutorial overreaching has turned bad business decisions - recognized in hindsight - into criminal cases. I have never seen a piece of congressional legislation that was quickly signed into law work very well. That is certainly the case with SarBox. Congress - in its self interested desire to appeal to the populist anger over a few bad actors, signed into law a piece of legislation that has permanently stymied the IPO process.

Why have the tech IPOs stopped this year….



Why Do People Work At Your Start-Up?

The only sustainable advantage that a start-up has over other players in its industry is its company culture. This might seem a strange statement from a technology focused venture capitalist, but I really think it is the case. Consider some of the best known and most respected companies you know. How many of these have a culture that is well known and lauded? I would guess probably all of them. What you will probably also find is that each of these successful companies has a certain corporate personality. In these companies, prospective employees can typically gauge whether they will "fit in" even before they have their first interview. This was certainly the case at my previous employer, The Walt Disney Company. It is not so important that the culture be of a particular type - though there are some similarities among the best companies - but rather that the culture and the hiring practices are well matched.

I am often asked "what is the most important variable in the success of a start-up". My response is the culture created by the foundinig team. It is challenging to identify and hire the best people. The top performers can work most anywhere. They will not stay at your start-up if they are miserable. When I examime turnover patterns at the companies I invest in, I am always on the look out for a poor culture that may be limiting the potential of the business.

The title of this blog is "why do people work at your start-up". Curiously, many founders don't give this question much attention. I believe the culture of the company plays a greater part in attracting and retaining high performers than any other factor - yes, including compensation.

Here is a bit of advice that I give to entrepreneurs. Consider all of the factors that kept you working for your former employers. Then ask yourself: why do people come to work at my start-up and what makes them want to stay: I bet these things will fall into one or more of the categories listed below:

What is Attractive About Your Start-Up:

- The company's mission?
- The opportunity to innovate?
- The reputation of management?
- The prestige of working for a respected company?
- Career learning opportunities?
- Cash compensation?
- Stock options?
- Sense of job security?
- Camraderie?
- Lifestyle perks?

Now ask yourself: how many of the items listed above does my start-up provide to its high quality employees? Also important, does your company filter candidates to match their career priorities - say great opportunities to innovate and camaderie - with what the company can provide?

There is a process I like to go through with my portfolio companies each year as part of my compensation committee responsibilities. I like to lay out - explicitly - what opportunities our company can provide to its employess and compare that to the career desires of our high performers. Where is there good overlap - and where are there holes in what our employees need to stay excited and engaged and what our company can provide over the coming year? This can be a valuable exercise. It often helps identify those key employees who may be at risk of burning out and leaving. I encourage those of you who are responsible for building winning start up teams to consider how you can make your work environment the most desirable one in your industry.

What Start-Ups Should Do About the Recession

As a venture capitalist, I am dealing with this question continuously with all of my active portfolio companies. At board meetings, the conversations inevitably center around whether to reduce spending, and deal with the commensurate slowdown in business growth, or whether to stick with an aggressive growth plan while others are hunkering down. Truth is, as tough as a recession can be on an established company, it can be fatal to an early stage company. One of the things board members get paid for, of course, is making the tough calls. So, in the last 60 days, I have been giving the following advice to my portfolio companies.Secure FinancingThis is pretty straight forward. If your company will need capital in the next 12 months, I would recommend obtaining capital now. Yes, the extra cash could wind up being unnecessary. On the other hand, if the economy gets worse, it might be difficult to find capital when you need it.Hire a CFOThis is one of my pet peeves as a VC. Too many start ups, and even some investors, don't appreciate the value a competent finance professional can provide. This is not the time to skimp on financial oversight.Re-Evaluate Your Sales TeamIs your VP of Sales up to the task? Too many CEOs delay making a change in the sales role until it is too late. My advice: establish firm targets for the quarter and this time don't accept excuses!Bring on a Top Notch Independent Board MemberThis is a great way to expand your network of potential customers and capital providers. In addition, a board member who has been through tough times can be a valuable asset in 2008.

Value of Certain Angel Investors

Most of the companies Clearstone invests in have angel money. In the past few years, angels have become much more active than they were following the tech crash of 2000. As a VC, I divide angel investors into two buckets. The first group includes angel investors who know the space they are investing in. Perhaps they previously started a company in the same industry or were part of a successful company targeting the same market. These investors can spot a new idea with potential from a me-to copy cat with limited prospects. When a company comes to Clearstone with some money in the bank from smart in-the-know angels, we get interested quickly. As it happens, angel investors in this category usually know the VCs who invest in their space and can be a great help in introducing a start up to smart venture capital investors. Better still, these angels typically know the going terms for a start up in their market. Accordingly, they can help the entrepreneur get the best deal warranted given the progress of the business.The second bucket of angel investors are those who have some spare cash to invest but don't have any familiarity with the target market. These investors are generally not known by VCs active in the specific market the start up is pursuing. In most cases, they can't help with follow on fund raising. Because they don't know what the going VC terms are, they often set terms for their investment that make it harder to raise money in the next round. So, here is my advice to entrepreneurs when it comes to raising angel money. First, it can help a great deal if you raise angel money from a prominent person in the space you are targeting. This prominent person could be affiliated with a large potential customer or could be a brilliant technical person who lends street cred to the technical platform being built. Seek out the well known people in the industry you are involved in! Their money means something. VCs can't know everything about an industry. So how do they get comfortable with a new business? They rely on smart people who are accomplished and well connected in that industry. If someone of that caliber happens to already be an angel in your business, raising venture capital just got a lot easier.

Are VCs All Hardware Haters

What a strange 12 months its been in the enterprise equipment space. Last summer, a crop of relatively young but fast growing public equipment companies were being aggressively valued in the public markets. Riverbed, Aruba Networks, Acme Packet, F5 and Isilon and were all trading at multiples of 5 to 15 times sales. VCs took note. Most of these companies had recently gone public. Many VCs, myself included, thought the public markets were once again embracing the enterprise IT investment theme.There were lots of reasons to believe the valuations of these small cap businesses would maintain their attractive levels - at least for a while. All were growing revenues at 25% to 100% annually. Gross margins were 50% to 70%. Most importantly, the enterprise IT market seemed like a relatively safe bet for the next 2 to 3 years. Following the tech recession of the early 2000's, business IT investment shrank significantly. But after 5 years of belt tightening, it seemed a new investment cycle for IT was due. Sadly, the past few months have shown otherwise.With fears of recession and certain high IT spending verticals, like financial services and retail being hard hit, growth in enterprise IT spending in 2008 is now in doubt. This cloud of uncertainty has leveled the market caps of the enteprise equipment sector. Many of these small cap companies have seen their valuations cut by 50% to 75%.So what do VCs think about all of this? Theoretically, VCs are not to supposed to care about the day to day price gyrations of the stock market. Practically speaking, however, the retrenching of the enterprise equipment sector will have an adverse effect on venture funding. With many of these companies needing $100 million or more to reach breakeven, a dip in the public market comparables makes it harder to justify an initial investment.So what should entrepreneurs - or CEOs of existing equipment companies - do about all of this? More on that topic in my next blog post.....

The One Thing I Love To Hear in a Pitch

In a lot of ways, venture capitalists are like any everybody else when it comes to the listening to presentations. Keep in mind that they listen to lots of them - maybe 100's - in a given year. They get distracted. They get bored. They wonder (and hope!) that the speaker will say something thought provoking. Want a sure fire way to gain their attention? Make a prediction!The best presentations I have heard over the years have been ones where the CEO or founder takes a position on where a market is headed over the next 2 to 5 years and then intelligently walks through where the opportunity will arise from that. Why 2 to 5 years? Because that is a time frame managble for a start-up. Guessing what will happen 'eventually' is a lot easier than putting a time stamp on it.Let me provide a few more details on what I like to see when it comes to predictions. Start with a discussion of where your market is today. Who are the incumbents, who are the relevant new comers and what does each contribute today. Now project out 1 year, 2 years, 3 years. How will the market evolve? How will the needs of the customer change? What will each market participant focus on? At the end of this story - and yes you should construct this part of the presentation with a story metaphor in mind - it should be crystal clear to anyone listening to you speak where the opportunity lies and why all the other players - except you! - will have a tough time addressing it.A well thought out analysis as I have described above is a great way to engage your VC audience. Who isn't curious about what the future has in store for an exciting market.By the way, I openly acknowledge that what I have described above is a tough assignment to carry out. It takes deep thinking and, frankly, brilliant insight that most people just don't have. Of course, that is as it it should be. Few are bright enough and driven enough to see and pursue what the rest of the world doesn't. But what a rush when you make a prediction, place your bets on it - your time, your money, your career - and it happens as you guessed! Those are the joys of starting and building a great business that few ever experience.

One of Google's Management Problems

Yes, even Google has problems. Some are well discussed - like its difficulties in trying to break into the hand held market - and some are not. All great companies follow an arc of some sort. They rise to prominence. They become the status quo. Eventually, they fade as someone else invents a better approach to solving the same problem.Generally, it is only in hindsight that you can see where the troubles began for a business. Generally, but not always. Occassionally, a serious problem is hiding in plain sight. What problem am I referring to with respect to Google? Project managment. Specifically, the thousands of projects being undertaken by Google employees without proper corporate oversight of which ones makes sense and which ones don't. Google has proven itself competent at monetizing search results. Nothing more. Even the idea of exactly how to do that, of course, didn't orginate with Google. That idea came from Bill Gross, who started GoTo.com (later renamed Overture and acquired by Yahoo). That is it. Google has a great pay per click business but no where has it shown itself exceedingly capable at inventing other billion dollar ideas. Which isn't to say it isn't trying. It is just going about it all wrong.Google prides itself on its management edict that 20% of an employee's time is his (or hers) to do with as desired. The hope is that these bright and motivated workers will come upon a big new idea for Google to exploit. Fine in principal but not in practice. Consider that for all of Google's impressive revenue growth quarter over quarter, over 95% of its revenues still come from one source: Adsense. Yet, massive investment in money and time is being spent on thousands of other initiatives. What happens when its base business slows? My prediction? A radical wake up call to all of the employees who today consider it their right to explore projects willy nilly without regard to their realistic revenue potential. When that day comes, the culture of Google will have to change. Business discipline and accountiblity will become the new watch words. The strain this will put on the organization will be immense. Reeling in a loose culture and creating a layer of cold analysis is never welcome by line workers. At Google, it will be down right despised.Now, aside from increased management oversight (which will come from where in a company that has never had any?), what do you think the impact will be when subsidized cafeteria, dry cleaning and car washes get eliminated.Were I on the Google board, working on establishing a durable culture would be my top priority.....

The Quigley View of Bonus Programs

There was a time when pre-IPO companies didn't have bonus plans. Generally, such businesses are still unprofitable and no one is interested in increasing the burn rate through bonus payouts. No more. Most of my pre-IPO companies today offer bonus plans to at least some of the management team. I have even warmed to this idea - having previoulsy been alarmed at the thought of paying bonuses while the company burned cash.

So, what are the key ingredients of an effective bonus plan? This question is one that I have wrestled with over a number of years as a board member and chairman of numerous compensation committees. Based on experience, I have learned that a bonus system should incorporate 5 specific elements to in order to be an effective motivator. I discuss these below.

My philosopy of bonuses is straightforward. A person's paycheck is for his or her regular work. The paycheck should suffice as appropriate compensation for someone who performs as expected. If she performs her duties as requested, and does an adequate job in that effort, then the paycheck is her reward.

A bonus, on the other hand, is a reward for doing something more and it has a two fold objective. It is, foremost, compensation for work performed at a level above what is expected. But it is also a tool. A very effective tool I might add. It allows a CEO to put a spot light on a specific objective that must be accomplished in a particular time period. Achieve that objective, and you will be rewarded with cash or stock remuneration. It is this aspect of the bonus that I like best. People can be motivated by money. If you want to motivate a person to achieve a certain objective, put a price tag on what it is worth to you. When an employee hears "get that system installed and operational in one quarter and you will earn $20,000 in bonus money", that tends to focus his mind on making sure it happens.

Now, onto the elements that must be incorporated in any bonus plan to maximize its effectiveness.

Timely - This means quarterly, not annually. An annual bonus simply takes to long to bear fruit. Also, consider the challenge of laying out a specific set of objectives in January that will still be relevant to the company in December. Not very likely. The quarterly bonus has one more attractive dimension. It gives the management team and the board a reason to evalute people on a frequent basis - and adjust priorities as needed. That is extremely valuable.

Meaningful - The reward being offered has to be a motivator. What that majic dollar or stock grant amount is depends on a lot of factors. Just make sure the bonus matters.

Predictable - The best bonus plans are ones in which a person can easily calculate what he is going to earn. This means emphasizing objective measures of performance. I hate subjective standards when it comes to bonus plans. Making an employee guess what he might earn is not a motivator. Lay it out in with simple math. To that end, the components of the bonus calculation should include no more than 3 variables. For instance, a VP of Operations might be bonused on 3 measurements: COGS, product shippments and customer satisfaction results. I have seen too many bonus plans with 15 + factors driving the bonus award. That is too many. It makes it nearly impossible for the employee to quickly assess how his contribution to a given task will affect his bonus. And ultimataly, you want him thinking that way. You want to influence how he spends his time. When an employee must make the inevitable trade-off between doing one thing versus another, you want the information provided by the bonus to guide his efforts.

Consistent - The structure and mechanics of the bonus plan should be remain consistent over time (as much as possible). This means that things like the payout frequency (quarterly), the bonus amount (% of salary for instance) and the number of variables in the bonus (2 or 3 is best) should remain constant. What can change - and likely should - is the specific activity or result that the bonus will be based on. For instance, the VP of Engineering may have her bonus for Q2 based 50% on the delivery of a certain product and 50% on hiring objectives. The next quarter, all of her bonus might be based on opening an offshore development center by a certain date. It is fine to change the specific activity being bonused, what should not change (at least not often)is the method by which a bonus is calculated and paid.

Fair - The purpose of a bonus is to motivate certain behavior to obtain certain results. So it makes a lot of sense to ensure that the employee can actually influence the results she is being bonused on! That is what I call fair. Seems obvious but it doesn't happen often enough. In my opinion, "group goals" suck! Remember what the bonus is for. It is to communicate to the employee what you - the CEO or board - find important and to motivate him to achieve certain results that you desire. This requires a bonus scheme that he can influence.

My final advice. As you put together your bonus plan, ask yourself, is the reward being offered Timely, Meaningful, Predictable, Consistent and Fair. If so, you probably have the makings of a bonus plan that will drive the results you are looking for.

What Do VCs Read And Why Does This Matter?

What do VCs read? That is a question that comes up now and then when I am meeting with enterpreneurs. What they are really asking, I think, is "where do VCs get their inspiration about a deal or market space". In my opinion, most of what inspires a VC to get excited about a market comes from rumor, hear say and general media publications. I really don't know a lot of VCs who scour market research reports to confirm growth rates in a new industry or peruse 10Ks to confirm the gross margins of a market leading company. This is one of the reasons so many venture backed deals are flawed from the start. They get funded by VCs who have little more than a superficial understanding of the underlying trends in the industry.I mentioned that VCs tend to read a lot of general media publications (WSJ, NYT, Forbes, Fortune, ect). In fact, I am amazed at how well read most VCs are about what is gaining traction in popular culture. Getting a mention in one of these periodicals is an excellent way to stoke demand in your business from the investment community. There is a flip side to all of this, however. When a narrative starts building about an industry being troubled, VCs get skittish, even when that narrative is based on specious arguments. I believe this is one of the reasons the dot com tech crash was so immediate and severe. In late 2000, every mainstream publication in America was breathlessly reporting how the Internet sector was essentially one great big fraud. When Paypal came to Clearstone in 2000 looking for funding, many other VCs simply could not get past the fact that it was a 'dot com'. If it was an Internet company, it couldn't be valuable. The funny thing was that Paypal was actually showing great adoption patterns. But in the end, most VCs were too busy reading Forbes about the stupidity of Internet business models to stop and assess the attractive financials of that business.Let me offer this observation. If you are starting a company in an industry that is not well understood - 'below the radar' - in venture capital venacular, then you have an uphill battle on your hands. Getting a VC educated about your market space is no easy task. What can you do to improve your odds of getting funded? For starters, provide the VC with as much market data as possible about the trends unfolding in your market. This sounds obvious, but a lot of entrepreneurs believe that VCs are either already well versed about their particular market or that they have the internal resources to quickly find out. The truth is, most VCs have a long list of things they need to get educated about - given the variety of deals that they look at - and the easier you can make it for him or her to get up to speed, the better your chances of getting funded.

What Do VCs Read And Why Does This Matter?

What do VCs read? That is a question that comes up now and then when I am meeting with enterpreneurs. What they are really asking, I think, is "where do VCs get their inspiration about a deal or market space". In my opinion, most of what inspires a VC to get excited about a market comes from rumor, hear say and general media publications. I really don't know a lot of VCs who scour market research reports to confirm growth rates in a new industry or peruse 10Ks to confirm the gross margins of a market leading company. This is one of the reasons so many venture backed deals are flawed from the start. They get funded by VCs who have little more than a superficial understanding of the underlying trends in the industry.I mentioned that VCs tend to read a lot of general media publications (WSJ, NYT, Forbes, Fortune, ect). In fact, I am amazed at how well read most VCs are about what is gaining traction in popular culture. Getting a mention in one of these periodicals is an excellent way to stoke demand in your business from the investment community. There is a flip side to all of this, however. When a narrative starts building about an industry being troubled, VCs get skittish, even when that narrative is based on specious arguments. I believe this is one of the reasons the dot com tech crash was so immediate and severe. In late 2000, every mainstream publication in America was breathlessly reporting how the Internet sector was essentially one great big fraud. When Paypal came to Clearstone in 2000 looking for funding, many other VCs simply could not get past the fact that it was a 'dot com'. If it was an Internet company, it couldn't be valuable. The funny thing was that Paypal was actually showing great adoption patterns. But in the end, most VCs were too busy reading Forbes about the stupidity of Internet business models to stop and assess the attractive financials of that business.Let me offer this observation. If you are starting a company in an industry that is not well understood - 'below the radar' - in venture capital venacular, then you have an uphill battle on your hands. Getting a VC educated about your market space is no easy task. What can you do to improve your odds of getting funded? For starters, provide the VC with as much market data as possible about the trends unfolding in your market. This sounds obvious, but a lot of entrepreneurs believe that VCs are either already well versed about their particular market or that they have the internal resources to quickly find out. The truth is, most VCs have a long list of things they need to get educated about - given the variety of deals that they look at - and the easier you can make it for him or her to get up to speed, the better your chances of getting funded.

The Tyranny of Revenue Projections

What a senseless exercise we have all gotten ourselves into. I am talking about revenue projections for start-ups. These 'mandatory' projections that are supposed to be included in all powerpoint pitches to VCs. I know that I am part of the problem here, as I too expect to see a revenue projection from the management team when presenting its business to Clearstone. And yet, it does seem rather silly. I may be in the minority in saying this (but I do not think that I am): NONE of the 2 dozen start-ups I have funded over the years has ever hit its first or second year revenue target. Some have done much better, some have done much worse, but none have gotten to the desireable 95% accuracy rate I would like them to hit. The reasons for this terrible track record are quite obvious. Who the heck knows how a product will sell before it is even in the market? How long is the sales cycle? What ASP will the market accept? No one knows at the beginning. It is all assumption laden guesswork. So, why do we even bother with revenue projections until we have some bonafide sales data to build upon?I think I know the answer. It is about signaling. Signaling what? When an entrepreneur shows a revenue projection of what the business will do in year 3, she is sending a message about how big of an idea she is pursuing. The specific number is not so important as is the growth rate year over year and the order of magnitude. The problem comes up when we (the VCs, the board, future investors), start holding the management team accountible to a specific number. "Why did you only do $5M last year when your plan was to do $7M" is a common type of question asked of early stage companies. A proper, albeit politically incorrect answer, might be "who the hell knows why?. We pulled that original number out of a hat 2 years ago before we had even launched out product. The fact that we even got that close is a miracle". Of course, that would be considered an inappropriate response since it is not based on some analystical foundation. But it is more truthful than a lot of answers that I hear entrepreneurs give. In my next posting, I will provide some guidance on what I think a start up should do when presenting revenue forecasts.

Stock Market Slide Effecting Start Up Valuations

Early stage VCs typically say that the ebbs and flows of the stock market don't effect the valuations they pay in start up financings. That may be true. At the formation stage, when a start up is little more than a business plan and a few dedicated engineers, there are a host of other factors that influence valuations more so than PE multiples of public companies. VCs tend to put greater weight on the potential market size of the product being built, the reputations of the founders and the number of existing competitors than they do on swings (positive or negative) in the NASDAQ index.So to some extent, entrepreneurs and VCs can comfortably ignore the chaos of currency fluctuations, interest rate changes and other macro finanicial shifts. The operative phase here is 'to some extent'. You see, unless a company only plans on raising one early stage funding round, it must eventually seek capital from a different cast of characters: the later stage or 'growth capital' providers. And guess what? These firms most definitely do look at public stock market valuations as a measure of how to price a private company.Just six months ago, many companies in traditional venture backed industries (enterprise networking, wireless and storage to name a few) were trading at attractive PE and revenue multiples. For instance, in the enterprise networking space, companies like Riverbed, Aruba and Isilon were trading at better than 10 times sales. With valuations in these sectors now down 50% to 75% from their highs, later stage funds are becoming much more careful when it comes to valuing private businesses. In fact, if a VC backed company raised a Series B or C round in the past year, there is a good chance the NEXT round will be flat or possibly below the previous financing. The justification for these more conservative valuations? NASDAQ. Or rather, what has happened to tech heavy NASDAQ in the past few months. A growth fund wants to invest in a company that it can reasonably see going public in the next 12 to 24 months. No fund wants to face a situation in which the last private round valuation is ABOVE the expected IPO filing range. So what are they doing? These funds are being much more conservative in how they value the companies they invest in. And keep in mind, in January and February 2008, over 2 times the number of new issues were pulled than successfully completed their IPOs. So not only are valutions dropping but the bar to go public is being raised dramatically. The tightening of valuations for later stage financings (particulary the mezzanine or last round before going public) is having a cascading effect on the pricing for earlier rounds. Whereas just a few months ago it was possible to get a 3X step up in valuation from the Series A to the Series B round, it is now more likely that the step up will be 1 to 1.5X.Two observations fall out of this. First, as long as the public markets are under pressure, expect venture valuations to hold or decline, particularly in later stage financings. Second, as a CEO or founder, take a hard look at what you are planning on achieving with the most recent capital you raised. If the business achieves everything you promised to your most recent investor, does that justify a substantial increase in the valuation of the business when it comes time to raise the next round? If you have doubts, take another look at where the capital is being spent. This is what Clearstone is doing with its portfolio companies. Its a dynamic world and even the best laid plans have to be questioned.

Thursday, March 20, 2008

Do 4 Year Vesting Schedules Still Make Sense?

Four year vesting is one of the sacred cows of Silicon Valley. It is a birth right. A practice that can not be questioned. The persistence of this labor friendly term in start up comp plans would make the Teamsters Union proud. When it comes to pay packages in Silicon Valley, everything is negotiable EXCEPT the length of stock option vesting. That has to be 4 years. But does this make any sense? On balance, I don't think so. At least not any more.

During the dot com glory days, it was possible for a venture backed company to be formed and go public in 4 years or even less. Of course, many of these businesses were woefully unprepared for public market scrutiny and subsequently failed. But the idea of a 4 year vesting schedule was palatable when a start up could reasonably expect to be pubic in that period of time. Those days are long gone. It takes closer to 7 or even 8 years for a successful company today to go from launch to IPO. So what happens to all of those employees who are fully vested at the 4 year mark? That is an issue many VCs and boards, Clearstone Venture Partners included, are wrestling with.

If an employee's stock is fully vested, what is her motivation to remain in the company from a financial perspective? The answer is not much. She would quite likely be better off going to a new company and receiving a fresh grant of stock options. In another 4 years, she will have twice as many options as she would have had if she had stayed at the first company for the entire 8 years. She will also enjoy some portfolio diversification by having a financial interest in two different start ups. So the value of 4 year vesting makes a lot of sense for the employees. But what about for the company?

Most venture backed companies create option pools of 20% to 25% of the total shares outstanding. The hope is that these pools will be sufficient - plus or minus 5% - for all of the employee stock option grants from inception to IPO. But imagine a scenario where most of the early employees leave after 4 years. Those people will need to be replaced. And those replacements will need new option grants. So essentially the company is paying twice for the same position. And the situation can get quite odd. I have seen companies in which the collective stock holdings of FORMER employees exceeds the amount of stock held by current employees. Hard to see how a situation like that can be good for the current employees (who are creating value for those that have left) and the non employee shareholders. Eventually, if enough employees leave at the 4 year mark, a company has no choice but to augment the option pool in order to back fill the vacated positions. These new stock grants dilute the ownership percentage of every other stockholder - from VC to founder to employee. In summary, 4 year vesting is not a very attractve compensation structure for start ups given the current IPO time line.

What to do about this conumdrum is far from obvious. Ideally, from a company's perspective, stock options would only vest when a liquidity event occurs (wheher IPO or acquisition). If that takes 10 years, so be it. There are a number of drawbacks to this approach from the employees perspective so such a solution is not practical. However, I do believe that 5 or even 6 year vesting should become the vesting standard. As the holding period for venture backed companies elongates, I believe there will be more and more board room dicsussions about what is fair and reasonable with regard to stock option vesting. It was not that long ago when 5 year vesting was the norm, and getting back to that would be a good first step.

VC Industry to Shift Focus?

These are tough days for venture capitalists - and tech entrepreneurs. For every YouTube and Facebook, there a hundred other VC funded businesses that are just limping along. Heck, some might even be skipping along (generating revenue, perhaps even profitable) but it doesn't much matter. The is precious little 'liquidity' - the life blood of a heathy start up environment. The IPO window is almost shut for all but the most impressive companies. Wall Street wants to see revenues of somewhere in the $100 million range, and profitablity, to seriously consider a company for a pubic offering. Even then, with the dramatic downturn in tech valuations, there are few buyers for these nascent tech company shares. Certain industries, telecom, semiconductors and enterprise software are particularly difficult to attract Wall Street interest. There is a sense in these sectors that the best days are passed. While not true, Wall Street bias are hard to overcome.

Many investors - and founders - have been in their companies for 6, 7, even 8+ years. They are finding that it is not enough to build a solid revenue generating company. And those of us in the start up world know how terrifically difficult that is. No, revenues and profits are not enough. The public markets must also be in an accomodating mood. With tech valuations at signifcantly depressed levels, even the M&A market is in a slump. Acquirors like to use their generous market caps to buy smaller companies. When their market caps shrink, so does their acquisition currency - and their nerve.

So where will this take us? One effect of the long tech slump (going on 8 years) is a greater openness on the part of traditional tech VCs to consider investments in alternative industries. Clean tech is clearly one such example. But there are others. VCs are now investing in such non tech spaces as store front retail, apparel and even consumer products. Where this winds up is anyones guess. But I believe a growing percentage of venture dollars will find their way to non traditional industries. Should this trend gain traction, Silicon Valley itself may become less relevant over time. To be sure, it will likely remain the largest base of VC investment. It just won't dominate as it historically has. That is not necessarily a bad thing. Southern California entrepreneurship has a lot more to offer than just technology centric businesses.