May 20, 2007

Too Much of a Good Thing......?

Historians (especially economic historians) widely believe that nations that discover a single huge natural resource (e.g., oil or gold) always rue the day.  For several reasons (in addition to the crippling corruption that always occurs), the natural resource skews (screws up) all governmental (and private) decisions.  Two main dangers:  (1) because the newfound riches make it impossible (or, at least, hard)  to calculate the "cost" dimension of "cost-benefit" analyses, lots of bad decisions (both public and private) get made (e.g., the resource gets squandered), and (2) countries that discover a single natural resource wealth always fail to diversify their economies, educational systems, and other "intellectual property" infrastructure; this is bad for the country while the resource is plentiful; even worse, obviously, when it runs out.

A couple of canonical examples are (1) Spain in the 16th century, via its discovery of gold in Central and South America, and (2) Saudi Arabia, via the discovery (by Britain) of vast oil reserves in the late part of the 19th century/early part of the 20th.

Spain's experience has been recounted many times.  A readable account (with much other interesting information and analysis) is contained in David Landes, "The Wealth and Poverty of Nations". A good book on the phenomenon (in part), more generally, is Jared Diamond, "Collapse" .

The Saudi Arabian story has also been much studied.  Tom Friedman has written about it numerous times in the New York Times (articles now only available behind the Times Select subscription wall).  Several good books (among many) on the topic are  Albert Hourani, "A History of the Arab Peoples" , Bernard Lewis, "What Went Wrong"  and Sandra Mackey, "The Saudis: Inside the Desert Kingdom".

I wonder if similar factors apply to companies.  I'm thinking Microsoft  and Google .

Seems foolhardy to wonder about Google  at the moment.  They continue to hit the ball out of the park, quarter after quarter.  But, a few years ago, it would have seemed equally foolhardy to wonder about Microsoft .  Now, after 5 years of the stock price floating within a fairly narrow band, and with the Company (1) either struggling in major new markets (the web) and/or (2) "succeeding" in new markets (e.g., video games) only at the cost of losing what has to be billions of dollars, one wonders....

For Microsoft , Windows and Office were their "gold" and "oil".  I wonder if those two gushers of cash made it hard for the Company (full of enormously smart people) to make hard decisions about where to take the business because, at least in part, there was nothing the Company couldn't do (from a financial POV).  So, it's sunk billions into efforts online (e.g., MSN), in video games (Xbox and game software), media tools, the home network, mobile, etc., with either limited success or success at enormous (and unprofitable) cost.

Same for Google ?  AdWords and AsSense are, obviously, hugely successful -- two more gushers of cash that appear unstoppable.  But what about Orkut, Google Maps, Blogger, Gmail, etc.  None of the other Google  offerings seems to have achieved anywhere near the dominance (and money-generating ability) of AdWords and AsSense, even with 20% of the Company's engineering time allocated to noodling new stuff.  This has been noted by industry observers, e.g., in Business Week, The San Francisco Chronicle, as well as others.

I wonder if the success of AdWords and AdSense makes it hard to decide what to do next because, in a sense, there's nothing the Company can't do.

Might be useful here to consider the parable of Buridan's Ass.

I'd love to hear from readers what they think.  Would also be fun to get a thoughtful response from MSFT and GOOG, although their status as public companies (subject of a future blog post) may preclude this.

May 20, 2007 | Permalink | Comments (3)

May 17, 2007

Clothes (Online) Make the Man

The other day, there was a bunch of news coverage (here's the article in the Financial Times) of a  recently-released report from Shop.org about how consumers (in the U.S.) spent more in 2006 on clothes and accessories (e.g., shoes) than on computers and software.  Very interesting sign of the growing mainstream acceptance of internet retailing.

Ordinary people now outspend geeks on the internet.

Shop.org, part of the National Retail Federation and the commissioner of the report, estimated that clothing sales reached $18.3 Billion in 2006 compared with the $17.2 Billion spent on computers and related gear. The annual survey of eCcommerce (in the U.S.) found that online sales, excluding travel, rose 29 per cent to $146.5 Billion.

Analysts quoted in the various news articles about the report attributed the gains to several factors: (1) free delivery promotions, (2) generous return privileges (often free), (3) features that enhance the shopping experience (such as zoom, rotate, change colors easily) and (4) the inclusion of so-called community features such as user reviews, ratings, etc.

Not mentioned (that I saw) were other, important, but more secular, factors: (1) broadband penetration (at home, school and work) is now at a level that the online shopping experience is good for the mainstream consumer, (2) large numbers of shoppers are no longer afraid to use credit cards online (we forget, but there was a lot written in 1998-1999 about how eCommerce would never grow large because of the credit card fraud and theft problem) and (3) people are used to doing everything online now -- dating, buying a car, finding a job, etc., etc.

The report was not all upbeat.  A relatively high percentage of online shoppers (~97%) who make it to the home (or landing) pages of online shopping sites fail to consummate a purchase, including a high percentage of transactions that are abandoned even after online shopping baskets have been filled.

This is probably more of an opportunity than a problem, however.  Historically, (paper) catalogue shopping has been roughly 10% of the retail market in the U.S. (don't know the #'s for the rest of the world). Given the comfort level with ecommerce mentioned in the preceding paragraph, and the fact that the online shopping experience is far superior (even though it generates today's high abandonment rates) to that of catalogue shopping (particularly for younger shoppers -- witness my 19-year old and 21-year old), my bet is that there is a long way for eCommerce to continue to grow (especially as infrastructure in the rest of the world  improves).

This growth should accelerate as entrepreneurs find ways to mix entertainment with online shopping -- think "QVC-meets-Ebay-meets-Reality-TV-meets-Electronic Arts". This is an area we're looking at here at Mayfield.  If you have great ideas, let us know.

May 17, 2007 | Permalink | Comments (2)

May 15, 2007

Size Matters

Time is the entrepreneur's most precious commodity.  For most entrepreneurs, the VC fundraising process is very time-consuming.  Bad combination.

In an attempt to help, I have previously offered tips to entrepreneurs on navigating the VC process -- "The Ten Commandments for Entrepreneurs", as well as some follow-on posts in this blog.

Here's another one.

There are many kinds of VC's.  Some focus on IT, some on healthcare, some on energy, cleantech, etc.  Some focus on early stage investing, some on later stage.  There are, no doubt, other important dimensions on which VC firms also vary.

But, regardless of other differences, one thing almost all VC's look for as the gating item in their investment decisions is market size.  Size matters; bigger is better.

Why is this?

A baseball metaphor is usually employed.  VC's, especially early-stage VC's, get paid to hit grand-slam homeruns (achieve out-sized investment returns).  In order to do this, VC's must "swing for the fences" each time they "step to the plate" (invest).  The bad news: in early-stage VC, as in baseball, if one swings for the fences every at-bat, one strikes out a lot.

One might reasonably ask: why don't VC's just "play it safe" by attempting to hit "singles" and "doubles", with fewer strike-outs?  The reason is perhaps not obvious.  Early-stage VC's don't use the "home-run every time" strategy just because they like high-stakes gambling (though some are high-stakes gamblers outside of work).  They operate this way because, in early-stage investing, it is damn near impossible to tell (with any consistency) which startups will succeed and which will fail.  One strikes out just as often hitting for a single as for a home-run -- so one is better off trying to hit a grand-slam every time.

In the VC business, it is received wisdom that no company can become large and successful unless it's addressing a large market.  In VC land, it's not unusual to hear something like: "Even good teams fail in bad markets; even bad teams have a shot in good markets."  Obviously, there are many other factors that determine success or failure of a startup, but addressing a large market is a necessary (but not sufficient) one.

Finally, most VC's (at least in the good firms, which tend to have the best deal flow) can't pay close attention to more than a small percentage of the deals that come across their desks.  So, like all human beings, VC's use triage strategies to cope.  Given that addressing a large market is a necessary condition of success for any startup, VCs ask the size-of-market question early on as a way to narrow the field of startups to a size they can manage. 

Together, these two factors, (1) necessity of large markets for success and (2) necessity for VC's to efficiently triage their deal flow, show why many VC's use market size (and structure -- see Postscript below) as an important initial filter to decide which startups they spend time on.

A first step on the path to VC funding, therefore, entails making clear to the VC's the size of the market one is addressing.

Postscript:  A useful nuance is probably worth noting here.  Sometimes, the largest opportunities lie with startups that attempt to create new markets (whether through "disrupting" existing markets or otherwise), rather than those who (merely) participate in existing markets by introducing new/improved products and/or services.  Valuable companies can be built in both situations.

May 15, 2007 | Permalink | Comments (0)

May 11, 2007

"Unsubscribe" Dynamics

I'm looking for advice on prudent use of the Unsubscribe button on commercial spam.

As does everyone these days, I get a lot of spam (and that, even though, here at Mayfield, we have deployed every anti-spam technology known to man).  Increasingly (and thankfully), the type of spam is "high-class" commercial spam:  e.g., emails from Investment Banks announcing their deals, conference promoters urging me to sign up for their conference, law firms announcing a seminar for VC's, etc.  I don't get as many Viagra ads anymore, thanks to our great IT staff.

Withing the category of "high class", however, spammers still are arrayed over a bell curve of "quality".

Most of the spam that makes it through these days has a way to "Unsubscribe".  Over the last couple of years, during which the Unsubscribe button became more widespread, I have oscillated wildly in my usage of this feature. Most of the time, I've not used it for fear that hitting the Unsubscribe button not only didn't "unsubscribe" one, but actually confirmed  back to the spammer that yours was a live email address  -- and ensured one would receive even more spam as an (inadvertently) verified email user.

Most recently, I've adopted the (somewhat unsystematic) rule that (1) I hit unsubscribe if the brand of the sender seems "OK" (not sure what that means exactly), and (2) if the sender seems at all sketchy, I just delete the email.

This is, I'm sure, about as effective as burning incense to stop spam, but it's all I've had to go on, so I do it as sort of a quasi-religious exercise every day.

I would love to hear from folks who understand how the "Unsubscribe" world works, so my "religion" could become more "scientific".

May 11, 2007 | Permalink | Comments (3)

May 08, 2007

Ad Spend Cut in Half?

There is a well-known lament by advertisers:  "I know half of my advertising spend is wasted; I just don't know which half."  This is usually attributed to one of three famous, early entrpreneurs of mass consumer product companies and retailers, John Wanamaker among them.

The thrust is clear:  historically, the effectiveness of "brand" advertising (~$200 billion last year in the U.S.) has been hard to check -- is my ad spend is reaching the right people? do those folks remember the brand message?, etc.  Principally, this was due to the lack of technology to check whether brand impressions reached the targeted audiences, and whether they remembered the message(s).

(BTW, much has been written about how this made for nice lifestyles for advertising agency execs and their clients -- marketing executives got to spend lots of money and build large organizations, while agency execs and creatives got to take all that money and do creative things with it (sometimes).  All the while, there was no way to see if it was actually cost-effective.  The kind of job I want in my next life.)

Brand advertisers, their agencies and online publishers are spending a lot of time these days trying to figure out how to effectively move brand advertising online.  Performance-based (cost-per-click) ads are, of course, growing like weeds.  But due to the paucity of great online content and the still inadequate safeguards against undesirable (even if unintended) adjacencies between online branding ads and content (an especially acute problem with user-generated-content), the transition is happening slower than everyone concerned would like.

Advertisers (and their agencies) claim that the draw of the web is the greater targeting capabilities they will have, as well as more (and more accurate) metrics around the effectiveness of their ads

But I wonder....

At an event for the Online Publishers Association (http://www.online-publishers.org/) a little bit ago, I made the following point during a panel:  "If (1) advertisers have historically wasted 50% of their ad spend offline (or, less metaphorically, a large percentage), and (2) if that's mostly due to inadequate technology to check targeting and effectiveness, and (3) the web offers better targeting and checks on effectiveness, does it follow that as brand ads migrate online that aggregate brand ad spend will go down by half?"

That's a lot of blood in the streets on Madison Avenue (and its ilk around the world), and a lot of unemployed marketers inside companies that heavily advertise.

If true, this is a big deal.

I'd love to hear further thoughts from readers on this.

May 8, 2007 | Permalink | Comments (4)

May 06, 2007

Fidelity vs. Convenience

Recently, I’ve been considering investment opportunities in entertainment media (as part of some broader thinking about how brand advertising (as opposed to performance-based advertising) will move online). In connection with that, I’ve been also musing about whether there is a secular trend in entertainment media in which “fidelity” of the experience gets traded off for “convenience” (portability) of the experience.

Here are some anecdotal data I’ve observed, some from my kids, 19 and 21, and their friends. The data do not categorically support a hypothesis, but they do seem to indicate a general movement.

 Audio: 

When I was a teenager, we (mostly boys) were obsessed with getting the best stereo (“hi-fi”) we could afford (or build). The goal was to achieve the closest “fidelity” to the “live” (studio, usually) performance from which the recording was made. 

There weren’t many “convenience” (portability) options. Real audio “nuts” could buy portable, reel-to-reel tape recorders, but they were difficult to use, and almost no one had them. We were pretty much tethered to our stereos: turntables, tuners, pre-amplifiers (and, for the audiophiles, an amplifier) and speakers. Actually, the experience was (metaphorically) very similar to that of a desktop computer. 

Then convenience became available. The major examples: Transistor radios, Cassette Tape Players (the original Walkman), CD Players and, most recently, MP3 players (iPods being the canonical example). In each case, the (pure) audio experience was inferior to that of sitting properly positioned in front of a good stereo system: inferior system components, digital vs. analog files, smaller file sizes (e.g., MP3 vs. CD). 

Yet portable music has obviously exploded. 

Today, neither my kids nor their friends have stereos. Their laptops serve as their media centers. Whether on their laptops or through their iPods, they listen through the crummy built-in speakers (laptops), through low-end earphones (earbuds) or through decent PC speakers. Even the best quality music they listen to (MP3’s ripped directly from a CD – I hope legally) is inferior to the quality of a CD (or, God forbid, a vinyl LP). 

But, they can take their music wherever they go. 

Video:

In video, the story’s harder to decipher. 

For our purposes, the first video was films watched in movie theaters. By the mid-to-late ‘50’s, the quality of films was pretty good (film recording techniques had gotten good, and many movie theaters had good projection systems and sound systems). Obviously, however, watching a movie in a theater is not very “convenient” (in the sense of being portable). Drive-ins were, in this sense, more convenient, but lower fidelity, both video and audio (though, for other reasons, drive-ins have largely died out). 

One couldn’t watch portable video (of any type) until the ‘70’s when so-called “portable” TV’s began to appear. In this context, portable meant that you could use them in any room in the house that had reception and an electric plug. That’s also (roughly) when usable video recorder technology began to become available – though only for institutions (e.g., schools), not consumers.

In the early ‘90’s, handheld TV’s began to be sold; great convenience, terrible picture quality. 

Sales of theatrical release (and other straight-to-DVD) films for home consumption began in the late ‘90’s or early this century (can’t find the precise dates). Again, more convenience, less “fidelity” (except at the expensive, high-end, most home theater systems are poor substitutes for a modern multiplex in this regard). Portable DVD players also became available in the mid-to-late ‘90’s – lower fidelity, more convenience. 

Then cell phones and video MP3 players (again, the canonical example: the Video iPod). I was very surprised when I watched my first video on a video iPod – when you put the earphones in, that little screen becomes quite large and it’s an amazing experience (compared to one’s expectations, at least). Super convenient, but less fidelity than a movie theater. 

Not all the data line up neatly behind my hypothesis. The DVR is an example of additional convenience with no loss of fidelity. If one subtracts the increasingly annoying experience of going to a movie theater (audience conversations throughout the film, many on cell phones, etc.), it may well be that watching a DVD on a great home theater system without the annoyances of a movie theaters is better on both dimensions: fidelity and convenience. 

My hypothesis also probably only makes sense if the growth in more convenient ways to consume audio and video media has been accompanied by a decline in less convenient but higher fidelity experiences. 

Finally, there are other media types or experiences (e.g., virtual worlds, MMOG’s, video Skype-type applications, movies projected on a sheet in a college dorm room from a laptop through a cheap LCD projector, radio on the web, YouTube, Metacafe and similar sites) that deserve treatment, but time doesn’t permit here. 

I’d love to hear from anyone with other examples (or counter examples), as well with views of the implications of this hypothesis that the trend is to trade off fidelity for convenience.

May 6, 2007 | Permalink | Comments (7)

January 22, 2006

Keep the Faith

I spend a lot of time with internet consumer services startups. Currently, a meme circulating in this area is whether something fundamental has changed in the paths to liquidity open to startups in this space – a fundamental change that is foreboding to VC’s.  A number of recent stories in magazines and newspapers have made the “sky is falling” claim that the internet consumer services world has fundamentally changed, and that VC’s who work in the area are yesterday’s news. Angel investors now rule the roost and are best positioned to take advantage of this new evolutionary niche.

The truth, of course, is more nuanced. 

The argument typically goes like this: a titanic battle over the future of the web is shaping up among the major “new media” companies: Google , Yahoo! , Microsoft (MSN) , TimeWarner (AOL) , IAC/Interactive , News Corp. , etc. As the arms race among them accelerates, they will add features to their offerings by buying small start-ups (Flickr, de.licio.us, Pyra Labs, Oddpost, Picasa, et al.) who can innovate “around the edges” faster than they can.

Because most of these small companies have a cool feature, but not a lot of users (until they can access the massive distribution of one of the major players), they sell for a range of values between $10 million - $30 million. But they also don’t need to raise much money to build their cool feature. Accordingly, a $10 million - $30 million sale price can be a terrific outcome for the founders and angel investors – but terrible for a VC (who depends on a few grand slam home runs to stay in business). 

Implicit in this argument is the assertion that internet consumer services company can no longer go public, and that the only liquidity outlet for any such company is (1) to build a cool feature and a small (but fast-growing) user base of early-adopters and (2) sell to one of the major incumbents. 

Offered as compelling evidence of this is the current dearth of internet consumer services IPO’s…… 

And, no question, the IPO market is down from historical levels. On page 113 of the February issue of Wired (just out), Chris Anderson notes (“The New Boom”) that about 50 technology companies went public in 2005, compared to more than 300 in 1999. While 1999 was obviously the peak of the IPO market, each of the 10 years prior had more than 50 tech IPO’s. 

So things could be said to look bleak for VC’s and the companies they typically have financed.

But here’s an alternative view from the VC trenches.

We’re already starting to forget that almost no internet consumer services start-ups were funded in the “nuclear winter” between mid-2000 and mid-2003 (dates not precise). Only in the second half of 2003 did VC and start-up activity in this area start to revive.

Because we still remember the quick-hit, fly-by-night IPO successes of 1999-2000, we have forgotten that, in the 35 year history of Silicon Valley, it has always taken 4-6 years to build a successful and enduring start-up. And, it still does.

Therefore, it should surprise no one that there isn’t a crop of internet consumer services start-ups currently popping out the IPO chute. In fact, given that most startups in this space were founded after mid-2003, it would actually be a surprise if there were. I predict that we’ll start seeing an increasing number of IPO’s in this area in Q1 2007 (going public off 2006 financials), and accelerating through 2007-2008 -- back to historical norms. 

If I’m wrong, then I think it is fair to examine whether something fundamental has changed. 

End note: the actions by the Federal Government (Congress, the President and the SEC) aimed at the financial scandals of 2000 – 2001 (Enron, WorldCom, Tyco, et al.) have dramatically increased the costs of being a public company. This will have a depressing effect on technology IPO’s even when the crop of 2003-2004 companies matures. I think these actions have been entirely misguided, and have redounded almost entirely to the benefit of lawyers (disclosure: I used to be one) and accountants -- with no benefit to investors. More on this in a future post, but consider that (as far as I know) all of the convictions of the 2000-2001 fraudsters were won under laws that pre-dated Sarbanes-Oxley and related laws and regulations. The pre-existing laws worked fine; we just needed to enforce them. 

Write your Congressman.

January 22, 2006 | Permalink | Comments (33)

August 21, 2005

The Problem of the Forgotten Founder

Some more thoughts on carefully choosing your co-founders.

Startup teams form in many different ways. Often, the “core” founder does some homework and recruits the founding team. Sometimes, teams are, more or less, recruited by a VC who has a startup idea but needs entrepreneurs to make it a reality. Most often, however, startup teams are formed by people who either currently work together (at the company they’re planning to leave) or who have worked together in the past. In my experience, this process is usually informal and based at least in part on a (sometimes fuzzy) mixture of friendship and perceived competence. As I’ve written in the last two posts, it not infrequently goes wrong because one of the founders doesn’t work out and leaves the company with an equity stake disproportionate to the value he added – to the economic detriment of the remaining founders. 

There’s a flip side to this problem as well. 

I call it the problem of the “forgotten founder,” and here’s how it works. 

As noted above, most often startups are the result of informal “nights and weekends” discussions among friends. Not infrequently, the cast of characters changes over time, with “peripheral” people leaving and joining the core group. Early on, the group rarely has any formal legal structure. That is, the group is not usually formally established as a corporation until the founders “get serious”. Incorporation involves lawyers, and most founders don’t have “that kind of money” – certainly not to spend on lawyers. 

Even after the founding team has coalesced, quit its jobs and decided to “go for it”, a VC financing can take a long time. To entrepreneurs, the VC world moves at a glacial pace, even at its best. During this part of the process, it’s also not unusual for one or more of the founding team to leave. Reasons vary. Quite often, however, the departing team member has a spouse and kids who need to be supported, and their net worth is insufficient to sustain them for long without an income. 

What’s the problem? 

It involves two related legal concepts: (1) what type of legal entity, if any, has been formed during the “nights and weekends” phase and (2) what ownership rights can be claimed by someone who participated in the startup discussion and brainstorming – but who didn’t stay on part of the team. 

Forgotten Founder Situation #1. In the early, informal stages of forming a company, you don’t want to be deemed a “general partnership” – for a bunch of reasons. One important reason is that the rules on (1) whether a general partnership has been formed and (2) who’s a general partner (and therefore possibly entitled to part of the ultimate benefits of a successful venture) are not as clear as the rules involving who’s entitled to a stake in a corporation (or possible other “formal” types of business enterprise you might choose). Believe me, you don’t want someone who participated in some portion of the early brainstorming, but who left and didn’t become part of the continuing team, to later claim that he was a “partner”, helped create your new venture and therefore is entitled to some economic stake in it.

Forgotten Founder Situation #2. The law governing who has rights in different kinds of intellectual property is not always straightforward. Moreover, the law in this area is under development because the facts are usually different in each of the cases that make the law. Who is the “co-inventor” of a patentable idea, or the “author” of a copyrightable work (e.g., software code) is not always intuitive. After several years of blood, sweat and tears to make your startup a success, I guarantee that you will not want to share the fruits of that labor with someone who claims that it was partly their idea, but who didn’t make all the sacrifices you and your co-founders did. 

As a lapsed lawyer, I’m not going to give legal advice – particularly any that can be applied to a particular situation. Indeed, the final bit of advice in this post is to engage a good lawyer early (how to pay for it is also discussed). Entrepreneurs do need to know, however, that sometimes the law can have counter-intuitive results in disputes over who owns what – especially when the “what” is intellectual property. 

Here’s some advice aimed at helping you avoid the “forgotten founder” problem.

First, be careful (not paranoid) about who you include in discussions and/or brainstorming sessions about your new company idea. It’s good to test your idea(s) on constructively critical friends and colleagues, but be careful about having someone whom you don’t intend to have as a co-founder deeply participate in the discussions over an extended period of time. 

Second, keep notes of the discussions, including (in general terms) who said what.

Third, see a lawyer early in the process to make sure the details of your particular situation are kosher and that you’re protected (especially about how to apply my preceding two items of advice to your situation). While lawyers are expensive, most of the good ones will work for promising startups on a deferred or discounted billing arrangement. If the lawyer you’ve been introduced to won’t do this, find another lawyer. The really good ones will. To be clear, even lawyers who focus on startups can’t work forever without getting paid. So prudence and clear communication will also have to be your guides. 

It’s really hard to build a successful startup, even when all the planets align. The startup process throws up plenty of unavoidable problems without any help from you. The problem of the forgotten founder is avoidable. When starting your company, do yourself a favor: avoid it.

August 21, 2005 | Permalink | Comments (19)

August 14, 2005

More on "Tough Questions"

In my last post, I advised entrepreneurs seeking VC funding to think carefully about choosing their co-founders. I claimed this decision is often gotten wrong and that, not infrequently, one or more co-founders leave the company with an amount of founder’s equity disproportionate to their contribution (in the eyes of their co-founders). Finally, I noted that, in this situation, the “remaining” co-founders almost always bear the economic brunt. 

How to avoid this? I wish I had a crisp, clean and clear answer. Like a lot of other important questions in life, however, the answers are messy, ambiguous and highly context-dependent. All of us, VC’s and entrepreneurs alike, wish we could just call up “Central Casting” and order “the perfect startup team”. But, of course, we can’t. That said, there are some useful ways to think about this situation, and, below, I’ve set out some guidelines that a VC will likely use in evaluating this aspect of a startup. I hope these will be helpful to entrepreneurs as they’re building out their co-founding teams.

As I mentioned in my last post, founders don’t always pick their co-founders with a beady, cold-eyed, calculating gaze, and with a tough-minded focus on who can actually make the biggest contribution to the Company over its lifetime. Instead, co-founders are often picked because they are friends, or like-minded, or “great people, the kind you’d pick if you were in a foxhole under fire”. For any entrepreneur contemplating starting a company, there is an interesting and helpful analysis of this “choosing-who-to-work-with” phenomenon in a June 2005 Harvard Business Review article entitled “Competent Jerks, Lovable Fools, and the Formation of Social Networks”. If you don’t have access to a hard copy, you can purchase reprints online at: 

.http://harvardbusinessonline.hbsp.harvard.edu/b02/en/common/item_detail.jhtml?id=R0506E 

Starting a company is an act of courage. It’s also tremendously complicated. Almost always, the elements that are “unique” to a particular startup are as important as the elements that are “common” across the universe of startups. As with any set of simple guidelines, the ones below should be considered with a grain of salt. When applying them to your startup, keep your common sense hat on tight at all times. 

1. Incomplete Team vs. the Wrong Team Member? 

A key question any founder seeking VC financing needs to answer is “How complete does my team have to be?” On the one hand, experienced teams with domain expertise covering the principal startup business functions (e.g., product development) are very attractive to VC’s. On the other hand (as I’ve previously posted), teams with the “wrong” people on board are less attractive. A person can be “wrong” for a startup (in this sense) either because (1) he has insufficient business experience, talent or maturity for dealing with the swirling, chaotic world that surrounds every startup, or (2) he is in charge of a business function that no startup needs (e.g., a CFO). So, how should a founder think about this quandary…….? 

As I’ve previously posted (10 Commandments for Entrepreneurs), picking the right VC firm is critically important for any entrepreneur seeking VC funding. VC firms (as well as the individual partners within them) have investing passions for certain markets, as well as areas of market expertise, that will affect their interest in, and appropriateness for, any particular startup. In a similar way, VC firms (and the individual partners within them) have different levels of comfort in dealing with incomplete startup teams (and very early stage deals). When making your list of VC firms to approach, do whatever it takes to find out whether a particular VC firm has the right appetite for a startup at your stage of development. 

As an example, at my firm, Mayfield, we are very comfortable with early stage startups – which almost by definition have “incomplete” teams. Recently, we calculated that over 20% our investments in the past 5 years were companies “incubated” at Mayfield, where the founding team consisted of 1-2 people. Even at Mayfield, however, comfort with incubations or seed financings varies among different Managing Directors (as it will with any VC firm). It also varies – even among the Managing Directors who are comfortable with “seed” stage companies -- according to their workloads. Seed/incubations require lots of work, and don’t always generate a commensurately greater return. So, do your homework. 

I’ll end Guideline #1 with the following rule of thumb (NOT a commandment): for a VC firm that is comfortable with early stage startups, an incomplete startup team is preferable to a team with the wrong team members. 

Why?

First, VC’s pride themselves (some are even good at it) on being good at helping their companies recruit. If a startup has an attractive couple of founders and a terrific business idea, a VC can imagine how additional, world-class team members could be recruited to fill out the team (as you might expect, the more incomplete the team is, the more important will be the judgment about how easy recruiting will be). 

Second, as I wrote earlier, it’s always hard to transition the “wrong” co-founder out of the Company – it’s also economically unattractive to the remaining co-founders. 

2. Is My Org Chart "Contorted"? 

We’ve all seen a “standard” organization chart. It has (1) the CEO at the top, (2) Four to eight Vice-presidents below, each in charge of a business function and reporting to the CEO, (3) Directors in the reporting chain below the Vice-presidents, and (4) a variety of folks with different (and non-standard) titles in the reporting chain below the Directors. 

I would claim that this “standard” org chart is actually a good template to follow in organizing a startup through, say, the first 40 people. I’m not sure if the converse is true, but I can say (without having done a rigorous study) that, in my 25 years of working with startups, there is an interestingly strong correlation between (1) startups with org charts that were “contorted” in some way (compared to the “standard” one) and (2) startups that ended up with some kind of founder trouble. Thus, if there are “odd” lines of reporting, or if there are “odd” titles that don’t fit in a standard org chart, it usually raises a red flag. If you’re having trouble fitting one of your co-founders into a standard org chart, you should think about whether he’s the right person (or, at least, in the right role). 

A few examples may make this clearer: 

(1) almost no startup “needs”, and most startups don’t have, a “Chairman”; the office has no real meaning in a setting where most of the board members represent major stockholder interests (including holders of founders’ stock); rarely, it might make sense to give the Chairman title to an outside board member who brings particular prestige and gravitas to the Company, and who is “active” in helping the Company in some way; otherwise, it’s usually window dressing and no startup should have window dressing; so a startup with one founder as the CEO and another as the “Chairman” feels to the VC like window dressing intended to assuage an ego rather than a tough-minded business decision. My advice to founders: avoid extraneous uses of Chairman. 

(2) Almost no early-stage startup seeking VC funding should ever have one founder as the “CEO” and another as “President” or “Chief Operating Officer”. This is almost always a sign of title inflation (usually to assuage someone’s ego). Almost guaranteed, any startup that has both a CEO and a President/COO has the wrong person in one or the other (or both) of those roles. This sort of title inflation and proliferation is almost always – like most other “contortions” of the standard org chart – a red flag to VC’s. Can easily be taken to indicate that some of the co-founders are more worried about titles (and ego’s) than success. 

(3) In case I haven’t beaten the “excessive” Vice-presidents issue to death, here’s a final note: almost no startup seeking VC funding should ever have anyone with the title of “Executive Vice-president” or “Senior Vice-president”. Maybe when your startup has 1,000 employees, but not when it’s just getting off the ground. In my 25 years of experience, both as a lawyer representing startups, as well as a VC investing in them, this particular kind of title inflation has almost always been a bad sign: either that someone (the one with the high falutin’ title) is overly concerned with ego and resume-building instead of rolling up his sleeves and actually working, or that “room” in the org chart is being “cleared out” for someone else, who though not ready, nevertheless demands it. 

Another thing founders often fail to realize: not every member of the founding team has to be a Vice-president (or higher). It’s OK to have “TBD” in a number of the Vice-president “boxes” in the org chart of a startup (and elsewhere). For example, don’t worry if you have a great Director of Engineering but no Vice-president of Engineering in your startup. Any Director worth his salt should be able to manage a startup engineering team through 6-8 people, particularly if the CEO has technical experience. In this situation, the VC’s question will be: will the combination of the CEO, the Director of Engineering and the company idea be attractive to a great Vice-president of Engineering when hiring one becomes appropriate. 

Moreover, some Vice-president boxes in the “standard” startup org chart should be empty. Example: almost never is it appropriate for a startup to have a Vice-president of Finance/CFO. 

We have, VC’s and entrepreneurs together, created a somewhat “macho” culture around the act of starting a company. As part of this, entrepreneurs are expected to have a “can-do” attitude, high levels of self-confidence, etc., etc. While some of this is actually productive and helpful, it can also – like any ideology carried too far – be counter-productive and unhelpful. A small, but important, example of this is the concern entrepreneurs have about ever putting “Interim” before their title on the org chart. It’s easy to see how an entrepreneur could assume that a VC would view this as a lack of self-confidence, or as evidence of some other “un-macho” attributes.  My advice, however, is to not be afraid of putting “Interim” in front of anyone’s title when it’s reasonable to assume that an early task of the startup is to recruit someone else to that role. This is particularly, but not exclusively, true of the CEO role. VC’s love entrepreneurs with the self-confidence and guts to start a company, as well as the wisdom to realize that they’ll need help. 

3. Can All My “Vice-President” Co-founders Recruit World-class Talent? 

In their early days, most technology startups don’t need more than one, maybe two, people in any business function other than Product Development/Engineering. Even in a startup, a principal (not the only) job of a Vice-president is to recruit. So, not infrequently, the only Vice-president a startup will need is a Vice-president of Product Development/Engineering (and, as noted above, not always even that).

If one has other co-founders with the title of “Vice-president”, one should be very comfortable that they will be able, when the time comes, to recruit high-quality talent to work for them. In this regard, there are two old, hackneyed maxims that founders should nevertheless repeat to themselves when considering their co-founding team: (1) “A” quality people only want to work for other “A” quality people, and (2) while “A” quality people hire other “A” quality people, “B” quality people hire “C” quality people. Given the difficulty (and economic consequences of) “transitioning” a co-founder out of the Company, make sure any co-founder you make a Vice-president is an “A” quality person. Otherwise, you could have a problem.

August 14, 2005 | Permalink | Comments (10)

July 04, 2005

Some Tough Questions You Should Ask

If you want to raise money from VC’s, here’s a really tough, really important question you ought to ask yourself very early in the process: “How many co-founders should I have?” Having the wrong “answer” to this question can make your life difficult in some subtle (and odd) ways. Plus, unlike some miscalculations, here the wrong answer hurts only the founders, not the VC or later employees. Here’s how to look for the right answer.

Although entrepreneurs are motivated by things in addition to money, money’s important to everyone I’ve ever met trying to start a company. Monetary rewards in a startup, as everyone knows, ultimately derive from ownership of stock (not salaries or bonuses). Since there can never be more than 100% of the founders’ stock available for allocation, every co-founder should focus on ensuring that the allocation best matches the realistic, expected contributions of each founder to the success of the Company. 

In Silicon Valley (assume it’s the same in other startup regions), “founders” have a bunch of iconic attributes, some good, some bad.

Although we don’t, we should have a statue dedicated to “The Startup Founder” prominently displayed somewhere in Silicon Valley. Founders are passionate about their businesses, and will run through brick walls to make them succeed. In large part, Silicon Valley’s success is attributable to this passion and “never-say-die” attitude.

That’s the good part. 

Founders are also “expensive” in terms of equity (usually, and sometimes even rightfully, to reward them for taking the risk in joining a startup). Founders are harder than normal employees to transition out of the Company (not legally, just emotionally: “How can we fire Joe? He’s a founder.) Just like most people (including VC’s), founders usually have skills and experiences that are narrower than they, themselves, believe (even sincerely). And finally, founders don’t always pick their co-founders with a beady, cold-eyed, highly calculating gaze with a tough-minded focus on who can actually make the biggest contribution to the Company. Often, co-founders are picked because they are friends, or like-minded, or “great people, the kind you’d pick if you were in a foxhole under fire”. 

That’s the bad part. 

Let me illustrate the problem with a hypothetical (though not uncommon) four-person startup. 

Four friends decide to start a new company. After some jockeying (since they’re “peers” at their current company), they finally settle on the following titles, roles and percentages of the equity: (1) President and CEO (35%), (2) VP Marketing (25%), (3) VP Engineering (25%) and (4) VP Finance/CFO (15%).

To them, it seems logical to have these four (eventually) important business functions covered by the founding team. Moreover, these responsibilities roughly match their (perceived) skills and experiences, although none of them has ever had a title higher than Director, and none has ever had general management experience (i.e., responsibility for a complete P&L). 

They work hard on their business plan and actually come up with a very interesting idea. 

Having studied the “Ten Commandments for Entrepreneurs” at www.allensblog.typepad.com and mastered its lessons (sorry, had to do it), off they go to Sand Hill Road.

Because the idea’s interesting, they quickly arrange several first meetings at top-tier VC firms, but receive no call-backs. They know that the odds of getting VC financing are low, but can’t figure out why they are having no success at all. Without exception, their first meetings have been energetic and enthusiastic – and no one has pointed out any blind spots in their planning or preparation. 

As it turns out, the VC’s actually liked their idea a lot. The VC’s also actually liked two of the four founders (marketing and engineering) a lot, although no VC they met believed that either of them was ready for a “real” VP role. Unfortunately, when asked, the marketing founder and the engineering founder were defensive about deserving “their chance to step up to the VP level”. That paled, however, in comparison to the defensiveness of the CEO when questioned about his future role in the Company. Finally, the CFO couldn’t really describe what kinds of CFO-like duties he would perform for the first two years. Every duty he did describe could be done by a competent, high-level office manager. 

Spotted the problem….? 

Actually, there are several: (1) the CEO and CFO, who owned 50% of the founders’ stock, were not appropriate for their roles, (2) neither of the “continuing” founders was really ready for a VP role (and was defensive about the issue) and, though less importantly, (3) no startup needs a VP Finance/CFO. 

From the VC’s perspective, this is a deeply “broken” situation, despite the interesting business idea. And since the “broken-ness” involves founders (with all the iconic complexity that entails), “fixing” the situation involves some really hard work and tough decisions. Given the tensions (and lurid myths) that surround VC’s replacing founders, any VC with decent deal flow will simply move on to some other interesting startup that doesn’t have these problems. 

What’s the big deal? 

First, it is extremely difficult to transition a founder out of “their” company. Moreover, as hard as it is for the Board of Directors to make such a transition, it’s virtually impossible for the other, continuing co-founders to do it. After all, they were friends and “peers” who took a huge risk together, as well as a blood oath: “All for One and One for All!”. 

Second, even if it can be done, it’s usually “expensive” in terms of founders’ equity. Frequently, all founders have some form of accelerated vesting (or full vesting) of their founder’s stock if they leave the Company otherwise than by voluntary resignation. In our example, if some VC had loved the business idea enough to undertake the tough job of reorganizing the founding team, the departing founders would have taken as much as 50% of the founders’ stock with them. 

It’s important to note that it is NOT the VC or angel investor who gets screwed here – it IS the continuing co-founders. How so? Think about it for a second… 

When considering an investment, any investor, whether VC, angel or otherwise, will place a pre-money valuation on the Company when they offer to invest. That’s what they think the Company’s worth, regardless of who owns the founders’ stock (a slight oversimplification). If a good chunk of the founders’ equity is in the hands of co-founders no longer with the Company (and therefore who won’t contribute to its success), it doesn’t alter the investors valuation calculation. So, the continuing founders will end up with substantially less equity than they “deserve” – but not because the VC’s were unfair. 

In fact, it can actually be worse than this for the continuing founders. If enough stock has left the Company in the hands of the departed co-founders (in our hypothetical, up to 50%), an investor may simply decide that there isn’t enough equity left to properly motivate the continuing founders (calculating what additional stock must be reserved for future hires). In this case, the top-tier VC simply moves on to an equally interesting, but less troublesome, situation. 

What would have been a better strategy for this startup? Like everything else important in life, it depends…… 

In my next post, I’m going to suggest some things for entrepreneurs to consider as they put their founding teams together. 

Hopefully, they'll help.

In the meantime, however, before you prick your fingers and take the startup company blood oath, do the tough part and carefully evaluate who is on the founding team – you owe it to each other.

July 4, 2005 | Permalink | Comments (20)