VCs invest first and foremost, I explained, in people. The team would have to be intelligent and tireless. They would need to be skilled in their functional areas, though not necessarily highly experienced. Moreover, they would need to be flexible and capable of learning quickly. Heaps of information about the market and the competition would be streaming in after they launched. They would have to course-correct, on the fly. Refine the strategy, maybe even radically. This team would have to be comfortable with uncertainty and change. That's why VCs look for people with some startup experience, people who have proven they can thrive in chaos. It significantly reduces the risk of failure.
“If we can get a VC to put in the money,” Lenny said, “and then work with us to fill in the gaps in our experience, we should be all right.”
If Lenny was relying on the VC to provide the startup experience his team lacked, he was confused about venture capitalists and their role. He wasn't alone.
Venture capital firms have a great business—the investment business. They bring in money from limited partners, and it's their job to give back to those limited partners a return that reflects the risk taken with that money and exceeds what they are likely to get from other investments. For that effort, the VC gets a fee and a carry, a percent of the deals gratis.
In the early days, VCs often rolled up their own sleeves to make their investments successful. Many had come from operating roles and could actively contribute to the businesses they funded. The total money they had to invest was trivial by today's standards, which meant they could make only a handful of investments annually, a manageable number that allowed them to bring their experience with their money to each venture.
Today's funds are huge in comparison, sometimes approaching a billion dollars. Because of this size, VCs now need to invest larger amounts of money in more companies to produce the returns that attract investors. It's not uncommon for a VC partner to sit on a dozen or more boards. To that they have to add the hefty demands of running their own businesses. Consequently most VCs (even if they insist otherwise) simply don't have the time to give close management attention to the companies they've funded. In addition, in contrast to the original VCs, who often gathered years of operating experience prior to becoming venture capitalists, many partners in today's firms have no executive management experience. They could be working on Wall Street as easily as on Sand Hill Road.
With frenetic energy and a natural penchant for risk taking, these armies of prospectors are smart, hardworking, and aggressive. They do bring connections and contacts to the aid of the companies they fund, in addition to money. Often stereotyped as “vulture” capitalists who drive expensive cars, drink pricey wines, collect extravagant toys, and wish they had the time to indulge in their expensive hobbies, they are reminiscent of Wall Street masters of the universe, or L.A. players—except for one thing: their bets build the future in remarkably tangible ways. While their N.Y. and L.A. counterparts feast on marbled steaks from the corner butcher, VCs birth, fatten, and butcher their own steers before the barbecue. Take them out of the picture, and the Valley and its financial boom collapse. A few of the venture capital firms are beginning to recognize the limitations of the current “stretched thin” situation, and there are, of course, some notable exceptions to the present trend. Regardless of the amount of attention they can spend on any single company, they are still some of the heroes of the new economy.
Nevertheless, for the past few years there has been no shortage of capital and new ideas in the Valley. Management talent has been the limiting factor. Startups require an odd mix of skills and personalities. Many top tier VCs use their credibility to attract big-name talent from corporate America, with the promise of huge payoffs in the Valley. This can ensure that a new venture sails smoothly out the gate. But when a small startup runs into trouble early—and many, if not most, do—carpetbaggers more accustomed to managing a multibillion-dollar business may find they just don't have the skills to make a startup work. Anyone can sail with the wind to his back. Startups usually sail into a stiff wind, leaking like a sieve, in high seas, without food or water. If Lenny got the money he wanted for Funerals.com, he would face that problem right away.
“How committed is the other founder?” I asked.
For the first time, Lenny deflected his gaze as he spoke. “She'll join soon as we can raise enough money.”
Was he lying to me or deceiving himself?
“Remind me how much you're looking for,” I asked.
“Five million dollars to build the basic service and distribution network, develop relationships with manufacturers, and flesh it all out. We could roll out in six months.”
Not an unreasonable amount, and consistent with the VC's need to put a lot of money into each deal. “Five million dollars at what valuation?”
“Twenty-five million.”
“Good luck.” I shook my head. Lenny was deluding himself. He was looking for a large valuation so he could raise his financing by selling the smallest percentage of the company possible, thus maximizing his ownership. The Valley calls that minimizing “dilution.”
“Fifty million in sales the second year will make that a bargain. And I can quote comps.”
“Lenny, you have an idea, a cofounder, and a business plan. Nothing earthshaking or inherently valuable like an exclusive market or a key patent. No track record. You need to reset your expectations.”
I had to explain. Valuation is all about risk and reward. Sure, $50 million is a sizable business, but what are the chances for failure or delay? And how much money would he ultimately need to be successful? Future dilution would have to be figured in the mix. The lead VC is more likely to want around 40 percent of the deal for his money at this stage.
If Lenny were to raise $5 million, 40 percent would mean that the post-money valuation, the value of the company plus the new money, would be more like $12.5 million. Subtract the investment, and you have a $7.5 million pre-money valuation, the implied value of the business. Nowhere near the $25 million Lenny was suggesting.
Everybody here brags about valuation, but Silicon Valley really operates on momentum. Many times I caution a company not to take the largest valuation they can in a financing, because it sets the wrong expectations and probably attracts the wrong investors. Peg the round at the highest reasonable price necessary to raise the desired amount from the right investors. The right investors bring credibility, experience, and networks. They support you with enthusiasm in later rounds. They raise your valuation merely by their presence in the deal.
The right amount to raise is a range with a minimum, but seldom a relevant maximum. In a fiery market like ours, raise enough for a year's burn rate, or net loss, assuming the worst. Then add on enough for another six months, and take anything reasonably offered above that. I have never seen a company fail for having too much money. Dilution is nominal, but running out of money is terminal. Set reasonable expectations among your investors, don't gouge them, and then out-perform expectations. Future rounds will be much easier if you are seen as having positive momentum.
If you are fixated on dilution, you can take less cash and focus maniacally on meeting critical milestones in order to raise your valuation before soliciting more investment and experiencing further dilution. But beware that you risk under-performing or, even worse, falling prey to changes in market attitudes or conditions that may make future rounds more expensive or even impossible to raise. If you hit a snag, your precious momentum goes out the window. The current euphoric markets make it advisable to take all the money you can while the bloom is on the rose.
Lenny took more notes. Two friends of mine noisily entered the Konditorei, deep in argument. Tom insisted that eBay was a buy at $150 per share. Steve was incredulous, as always, muttering about the tulip craze in seventeenth-century Amsterdam. Their debate revived itself daily without ever producing an apparent winner. Tom had made millions investing in Internet startups in the past few years. Steve had probably
scraped by on a balanced diet of blue chips and mutual funds, but he insisted he'd get the last laugh. They grabbed their takeout orders and waved as they left, aware that the door to my office was, for the time being, closed.
“Lenny,” I said, “you mentioned your exit strategy, selling out or doing an IPO in three years or so.”
“More likely a sale.” His explanation held little surprise, since the way to create a retailing business on the Web has become fairly straightforward. Raise money. Build a site, where you offer attractive, fun, and informative content, as well as a wide choice of steeply discounted products. Focus entirely on growing sales and your customer list at a phenomenal rate. Expand your product lines. Grow even faster. Go public. Profits and margins be damned. According to Lenny's logic, an established e-tailer suffering from negative margins might eventually be interested in acquiring niche lines of high-ticket, higher-margin products like his funeral gear. Most likely, he said, he would sell Funerals.com in two or three years to one of the larger Web retailers.
Personally I could not fathom Amazon selling caskets, but that wasn't important now. There was a bigger issue here.
“That's an exit strategy for your investors. Is it one for you too?”
“For me too?” He seemed confused by the question. After all, wasn't he an investor?
“Is that your personal exit strategy? Are you planning to get out?”
“Yes. Of course.”
“If you raise money and do this,” I asked, “but it doesn't work quite like you planned, and you don't get the gold, or silver, or even brass ring, will you think it was a waste of your time?”
“It would be a disappointment,” he said. He didn't say he would consider it a total failure, but that was the message in his voice and on his face when he spoke.
I thought about that for a second. Lenny was clearly mystified by my questions. “All right,” I said. “I think I have a better sense now of what you have in mind. I'll talk to Frank.”
“What will you tell him? Are you onboard?”
Am I onboard? That was the question. The market is huge and rather unusual. Lenny's plan demonstrated that he knew his beans about the business of dying. Iffy, but who knows? Funerals.com might be a big success.
“I'll tell Frank it's probably worth going to the next step and doing some due diligence,” I said. “He'll raise many of the same questions I did about your people and your ability to build some sustainable advantage. You'll have to see where that leads.”
“That's great!” Lenny leapt up from the table, hopefully. “So you basically like it?”
“I think Frank should go the next step.”
“Then you'll work with us?”
With a “yes” and a handshake, I could show Lenny a faint ray of light, after weeks and months of gloom.
“I don't think so, Lenny.”
His jaw dropped a fraction, and disappointment washed over his face.
Chapter Three
THE
VIRTUAL
CEO
SOME PEOPLE CALL ME AN ANGEL. In the world of startups, angels invest in seed or early-stage deals, and with their money they lend a bit of advice. They pay for the privilege of helping the company. But I'm no angel.
This was a point of confusion for Lenny. He'd assumed I was just some kind of newfangled Silicon Valley investor.
“But your VC analysis suggests that Funerals.com is worth a closer look,” he protested when I declined his invitation. “That's what you're telling Frank. Why wouldn't you do the same?”
“I don't necessarily look at things the way a VC does,” I said, seeing that my comments were tripping him up. I've worked in Silicon Valley since the early ‘80s. I understand how it functions and thinks, but I don't necessarily see things the same way.
“If you're not interested in helping us, Frank won't be,” Lenny said unhappily.
“Did he say that?” I asked. It sometimes happened. A VC, concerned about the lack of experience among a group of founders, might ask them to involve a little gray hair (or, in my case, a shaved head) with some startup management credentials.
“Not in so many words, but I thought if you invested …”
Sometimes I do put money into companies, but generally not in the startups I work with. If I invest, I am prone to think like an investor, favoring my return over what's best for the team and often its long-term business.
I explained to Lenny what I do: I incubate startups. To that end, I provide the scarcest commodity of all, leadership and experience. I help the people build their ideas into successful businesses. Neither an angel nor a consultant, I support entrepreneurs as a kind of junior partner, a full member of the team, an owner and a decision maker, not a hired hand. I invest my time, and, in return, I receive an equity stake in the business. With that stake, I think like a team member, and sink or swim with the founders.
Some people call me a virtual CEO. When Steve Perlman founded WebTV a few years back, I agreed to help him get started, first as an advisor, and then as a member of his board. Gradually I became more active in the business, but I declined to assume a traditional role as an executive in the company. One day in 1996 Steve presented me with business cards that read “Randy Komisar, Virtual CEO, WebTV.”
The title stuck. I started working with a handful of companies at a time. I generally devote myself to each for a year, perhaps two. In that period we should be able to raise money, develop the product or service, identify the market, create a business model, prove out its basic tenets, and hire an operating team. With that team in place, I retreat to an advisory capacity and give more hands-on attention to the next startup.
My specific work in each of the companies depends on the backgrounds of the founders and the particulars of the business. My work is improvisational. Though involved in all the planning and major decision making, I don't play any day-today operating role. On the org chart I'm a bubble around the management team. Startups require frenetic execution and relentless perseverance. My role is to keep my head out of the cyclone and provide insight, direction, and stability. I try to bring to each company the experience I've gained—raising money, setting strategy, building and leading teams, establishing strategic relationships, developing products and services and bringing them to market, doing deals. And I make available to the startup all my contacts in the industry.
Good entrepreneurs are passionate visionaries, usually with one or more exceptional talents, but rarely have they actually built a company from scratch. I fill in the gaps in their experience. The actual CEO is ultimately responsible for all the company decisions. As a Virtual CEO, I simply provide the team with guidance and leadership when necessary. I can be very outspoken, if I fear that we don't have room for a misstep. But the CEO is in charge; I'm there to make him or her successful.
When I advise a startup, the business for me is the founders. It's an expression of their collective vision. As a director of a publicly held company, I accept a fiduciary duty to the investors, but in a privately held startup I don't favor the investors over the founders. This is probably the crucial way my thinking differs from a VC's.
“Lenny, let's be clear on a few points here,” I said. “I need to understand why you're starting Funerals.com in the first place.”
“To prove I can succeed in this startup game,” he said. “And to get rich, why else?”
“OK,” I said, “but what will you do if you make the money? You have to do something, you're too young to clip coupons.”
He shrugged. “There are other things I want to do.”
Ah—the crux of the matter.
“There's nothing wrong,” I said, “with cashing out and making a lot of money—unless those ‘other things’ you intend to get to are what you'd rather be doing all along.”
I pointed at his plan. “My experience tells me if you do this for the money, you'll just end up howling at the moon. The money's never there until it's there. There must be something more, a purpose that wi
ll sustain you when things look bleakest. Something worthy of the immense time and energy you will spend on this, even if it fails.”
He began rearranging his files, giving himself busywork, time to think.
“What am I missing?” finally erupted out of him. “Isn't that how it works out here?”
“Lenny, that approach simply isn't interesting to me. I don't have time to invest in merely building bank accounts. I realize as much as the next guy that the average startup will be acquired. By any calculation, there's no call for the number of independent companies that we're creating in the Valley. Many are simply products or services masquerading as companies. I can accept that as the dictate of the market, but I can't muster the energy for a company whose founders never hope to accomplish anything more than making some bucks. By setting your expectations low, you almost guarantee mediocrity.”
The Konditorei had filled with the din of young children. One or two of the kids ran around berserk, their Nordic nannies chasing after them. I spotted an old friend, Sarah, from my time at Apple in the mid-1980s, and got up to give her a hug. She lives nearby with two small children now, married to one of the ex-vice presidents of engineering during the Sculley regime. She loves to ride horses, but the kids seem to occupy all of her time. I only run into her here, at the Konditorei. Whenever I see her quickly growing children I marvel at how much time has passed. Better watch out. I had never planned to grow old in this Valley.
I introduced Sarah to Lenny and then sat back down as she walked to her car, threatening to really get together one of these days.
“You know,” Lenny said, “I have to tell you, I don't get this at all. I thought you'd just say you didn't like the products. Too creepy. Or you didn't like my tie. But this is Silicon Valley. Where you go to get rich.”
Yeah, yeah. The entrepreneur's casino. Everyone knows the score. Get the venture money and return it at rates that make a loan shark misty-eyed.
The Monk and the Riddle: The Art of Creating a Life While Making a Living Page 5
