Hazard Lights

Gear up your business (at the right time)

[Two posts in one day.  When it rains, it pours.  If you are bored, check out today's earlier post here]

One thing we as venture investors focus on, both at a theoretical level when we are making new investments and at at practical level when we as board members are helping our (particularly later stage) companies think through growth and investment strategies, is the concept of operating leverage.  Operating leverage, or as it is sometimes called, marginal profitability or gearing, is, at a simple level, the percent of incremental revenue dollars that flow to the bottom line.  This is important because most investors, especially public equity investors, and acquirers value companies based on earnings growth and a company with higher operating leverage will over time be more highly valued than a company with similar top line growth but lower operating leverage.

At a theoretical level, operating leverage is a sign of the health of your business model.  To the extent you make expensive widgets with limited ability to premium price, less will fall to the bottom line.  If you can sell the same high value, low cost product over and over again, more will flow.  If you have real network effects at work in terms of customer acquisition, sales and marketing costs as a percent of revenue will decrease.  If your R&D team can stay the same size, while revenues increase significantly, you will have high operating leverage.  Most venture investors are attracted to models with high leverage as it allows company to grow profitably very quickly, thus decreasing capital intensity (unless there are high capital expenses or financing costs, which i have ignored for purposes of simplicity).  As a result, as an entrepreneur thinking through your long term business model and the points of leverage becomes an important strategic planning exercise.

To bring this to life with some examples, I looked at Apple - the current gold standard among tech stocks -  and compared the P&L for Q1 2011 to Q1 2010.  In this time period, revenues grew 83%, or $11.2B, while operating earnings grew 98%, or $3.9B (taxes and below the line items have also been excluded for simplicity and comparison across companies).  This means that for every incremental dollar of revenue, 35% fell to the bottom line [$3.9/$11.2].  Pretty impressive.  I also looked at results for some recent IPOs and found that Zillow had operating leverage of 38%, Financial Engines 31%, Zynga 17% and Linkedin 9%.  The all time high I found in a quick scan through public filings was Microsoft, which in 1997 dropped an astounding 67% of their revenue growth to the bottom line.  Not surprisingly, other high fliers with fabulous business models have seen significant operating leverage in their business such as Google, which in 2006 dropped 47% of each revenue dollar to the bottom line, and eBay which had marginal profitability of 56% in 2002.

Apart from working to improve the fundamental attractiveness of your company's business model, as you grow one of the tradeoffs that a CEO (and their Board) of a high growth company faces is how to balance the trade off between investing for growth and showing leverage.  Some the examples above show the these trade-offs.  Linkedin, which actually showed 27% marginal profitability in 2010 versus 2009, is obviously now investing pretty significantly for growth.  Microsoft, on the other hand, may have under invested in 1997 when many competitors were emerging around them.  Conversely, if Linked in continues to invest heavily forever and only drop 9% of each incremental revenue dollar to the bottom line, and if they were to trade at Google's current 14x EBITDA multiple, they would need to grow their revenues a staggering 32 times to $7.7B from the 2010 level of $243M to merely meet their current value of $9.6B.   Zillow, on the other hand, at the same multiples, would only need to grow 6 times from their 2010 revenues to justify their current valuation given they have vastly higher marginal profitability.

So as your business moves out of survival mode and into significant growth mode, managing these tradeoffs should be a regular part of the conversations you have with your team and Board.

 

When to reach for the stars

As anyone who follow the start-up world knows, valuations for high potential young companies as of late have been trending upward (how's that for an understatement) and are fairly divorced from underlying traditional (ie revenues and earnings) metrics.  This is currently true with both "later" stage companies such as Foursquare's $600M valuation and earlier stage companies that are seeing pre-money valuations that are 1.5-2 times what one would expect to see in "normal" markets.  As an entrepreneur this naturally sounds like good news, and it largely is, although I thought it might be helpful to share some of the perspectives from the investor side as well as some potential watch outs.  

As an investor, when to "pay-up" for a compelling opportunity is one of the more difficult decisions we make on the new investment side of our daily lives.  If you do it across the board, you will end up with a portfolio that has sub-par performance, but if you miss out on great companies by being too disciplined, the opportunity cost is exceptionally high.  So when confronted with such situations as an investor, some of the things that cross our mind are as follows:

1. Is there downside protection in terms of the underlying asset?  The best example of this that I recall is a conversation I had with one of my former partners at Greylock in discussing their investment at $500+M value in Facebook.  At the time he told me that he was unsure about the upside from there, but that he was sure given the company's user growth, early revenues, relatively limited capital raised to date and the company's strategic importance, there was no way way they were going to lose money on the investment.  On Wall Street, they call these asymmetric trades: lots of upside and low downside.  While they may not all pay off, it can be a savvy approach for an investor to take.
2. Is the amount of capital being raised sufficient to get through important milestones?  Even if they long term upside is high, if the capital being raised at a high valuation is not enough to get the company through enough value creating milestones that allow the next round to be at a higher price, it is unlikely to be worth pursuing as the pain of down rounds,the impact on morale and other issues can be painful.  Interestingly, this thought process often leads to larger rounds, with more dilution for entrepreneurs, and creates a whole host of risks that come along with too much capital such as lack of focus and unrealistic expectations.
3. The last, and perhaps most obvious point, is that as an investor when you are reaching in terms of valuation, it needs to be for the right reasons.  At Flybridge, we rank our investments on a host of criteria including the strength of the team, the size of the opportunity, how robust the business model is, whether there are real network effects and how disruptive the approach is.  to reach on price, we need to be convinced on all dimensions as the criteria together indicate a strong likelihood of creating a lot of value and that the company can quickly grow into the value being established.  The wrong reasons to reach are competitive pressures or investments that are viewed as strategically important for the venture firm's brand.  Our LPs don't pay us to win all the time nor do they want us to use their capital to create a perceived halo that comes from being involved in high profile companies.

From an entrepreneur's perspective, raising capital at high prices sounds like a great thing.  There are, however, some words of caution that are worth running through having had a first row seat in the last overheated market.  The first is to recognize that a successful fund raise does not equal a successful business, so don't believe your own press and take an eye off running the business lest the next round be more challenging than the one you just closed.  Second, be careful about pushing your investment partners too far.  I remember one company where we were A round investors and they raised a Series B at very high prices and the VC director that came along with that financing was extremely dysfunctional when the business hit the inevitable bump in the road.  I don't think he was a bad apple, but rather was under a lot of pressure with his partners having gone to bat for the high price only to have the company do well, but not well enough to justify the valuation.  Finally, as alluded to above, reaching on valuation too early implicitly raises expectations that you have for yourself and others (employees and investors) have for the business and this can lead to the pursuit of overly aggressive strategies too early.  So the final word is be aggressive, but realistic.

 

King Pong in New York

I just landed back in Boston from two days in New York, the highlight of which was Flybridge's annual winter entrepreneur's event.  This year we switched lanes from bowling to ping pong, which was a great change of pace and proved that New York remains a city where indeed you can find everything, including a great club in Spin on East 23rd that is solely dedicated to ping pong.  If you have a chance, check out the play of their resident pros Dora and Kaz when they are featured on Fox Sports late in March.  Until I saw them play, I never knew a ping pong ball could be hit so hard with so much movement!

Thanks for the over 140 attendees for joining us including founders from companies such as 10gen, 33Across, Hashable, Art.sy, Betterment, YipiIt, TrustMetrics, SeatGeek, BetaWorks, EnergyHub, Panjiva, GroupMe, BaubleBar, MagazineRadar, Yodle, Scratch Music, and Kikin.  The energy in the New York entrepreneurial scene is impressive and the pong skills displayed show that it is not all work and no play.  Also thanks to our great sponsors from Goodwin Procter and Silicon Valley Bank, without whom this event would never happen. 

As is our tradition, the tournament winners got to nominate a deserving non-profit as the recipient of their award.  The tournament winners, Ray Lowe of SiriusXM and Scott Goryeb of Submedia/TUN.com (below) selected CampInteractive for the $1,000 top prize while the second and third place prizes went to DonorsChose and Endeavor respectively.

Looking forward to next year!

 

 

Beware the Valley of Death

While horse and hero fell,

They that had fought so well

Came thro' the jaws of Death

Back from the mouth of Hell,

All that was left of them,

 Left of six hundred.

- Lord Tennyson, The Charge of the Light Brigade

 

My partner Michael recently blogged about an interesting dynamic that is occurring in the venture industry, namely that for the last 2 years, and in aggregate for the last 10 years, the US Venture industry has been investing more into portfolio companies than it has been raising from investors.  For 2010, the numbers were $21.8 Billion invested and $12.3 Billion raised and for the 10 years between 2001 and 2010 the numbers were $245.5 Billion invested and $224.8 Billion raised.  Clearly this trend is not sustainable and the investment pace will need to decline. 

There are two other dynamics underway that are worth considering.  The first is, as many have noted, that it is easier then ever to raise seed funds and get companies off the ground.  At the other end of the spectrum, the second dynamic is that more and more of the dollars being invested are going to a smaller and smaller group of companies.  In 2010, 6% of the dollars went to 10 companies and if you include secondary purchases and recent investments from traditional VC firms in only three other companies (Facebook, Groupon and Zynga; Twitter is already in the top 10 deals), this number is more like 11-12% of the total capital invested.  In 2007, by comparison, more like 3-4% of the total capital invested went to the largest 10-15 investments. 

So what does this have to do with the Light Brigade charging into the Valley of Death?  Over the next few years in the face of a contracting venture industry, with more dollars going to very mature companies and very young companies, anybody in the middle (i.e. the prototypical Series B and Series C financing) is going to find life far more difficult.  In some ways this process is good: only the strongest of companies will survive.  But the risk is that companies pursuing real and valuable opportunities, especially those whose business models may not lend themselves to early explosive (often non-revenue based) metrics, may get caught in the crossfire.  So what is an early stage entrepreneur and investor to do?  A few possible suggestions for navigating the Valley of Death come to mind: 

1. Build a syndicate that surrounds your venture with all the potential capital you need such that you don't have to go externally for subsequent financing rounds if you don't want to.  In so doing, be explicit about milestones and ensure you and your investment partners have aligned expectations.
2. Alternatively, make sure your seed investors have an extensive track record of attracting up rounds from middle stage investors.
3. Either way, take the time to cultivate relationships with potential financiers to both establish relationships and develop credibility as you lay out (and achieve) critical milestones
4. Aggressively consider nontraditional sources of capital.  Early customer funding is obviously the best approach, but we are also seeing more corporate VC activity at earlier stages than we have in the last 10 years.  Corporate VC may come with strings that need to be carefully navigated, but executed properly there can be real benefits.
5. Finally, and most importantly, from a company development perspective, make sure the size of the opportunity you are pursuing is commensurate with the amount of capital you require.  This sounds obvious, but we see many companies that realistically needs tens of millions in capital to create a company with less than $20M in revenue.  At the same time as ensuring the pot of gold at the end of the rainbow is large enough, focus aggressively on reducing risk and generating early momentum.  At the end of the day the middle stage investor is making a risk-reward tradeoff between your company and another investment opportunity in an environment when they can no longer make both investments.

Any other suggestions?

Budgeting Best Practices

Ahh December.  Between closing out the year, performance reviews, holiday parties and family activities, it is always a crazy time of the year.  And to top it all off, for most of our portfolio companies it also happens to be the time when annual budgets are prepared and presented to the Board for approval.  Having been through several such sessions in the last couple of days, I thought it would be worth sharing some of the best practices I have seen across our portfolio.

1. Start early, but not too early.  In large companies, the budgeting process often starts in early October.  For earlier stage companies where much is in flux, this obviously does not work.  Conversely, starting the internal process in early December does not work either.  The best approach I have seen is to develop a high level forecast for the upcoming year in November and present that to the board for general reactions before refining and honing for final approval in late December.
2. Use the budgeting process to drive alignment across your organization.  While it is easy to look at budgeting purely as a financial exercise, the most important part of the process is using the financial plan as a way to represent the organization's goals and priorities and to use the planning process to drive alignment across the company on these issues.
3. Shoot for a confidence level of 80%.  There is always a debate in budgeting as to whether the plan should represent a stretch goal or something that is easily achievable.  While the stretch goal approach is often initially appealing under the theory that if you don't plan for greatness it may not happen, my experience has been that companies that have a history of hitting budget, tend over the long run to have more success.  While this is not necessarily a causal relationship, consistently hitting plans has a way of improving morale and developing a more accountable organization.  Conversely, letting the pendulum swing to far to "sandbagging" does indeed have the effect of not letting the dreams be realized, so in the end a plan that is a mixture of both and has a 70-80% confidence factor feels like the best middle ground.
4. Explicitly identify upside opportunities.  Related to a plan that is 80% likely of being achieved, i think it is critical in the budgeting process to explicitly identify upside opportunities that could change the company's trajectory and what actions are being take to see some of these to fruition.
5. Use a trigger based plan if you are operating in a highly dynamic environment.  For really early stage companies, or companies that are operating is a state of great flux, clearly identifying triggers that will move the company from the current plan to a new plan is a good way to ensure alignment.  For example, if you are running a company with an inside sales model, saying when leads reach a level of X or qualified opportunities of Y that will trigger hiring several more sales reps.  this allows you to this aggressively, but also realistically relative to resource constraints.

Finally, after all of this, remember your goal its blow through your objectives such that by mid-year it is back to the drawing board!

 

What I learned in school last week

It has been great to see the recent focus on the state of public school education in the US through the Race to the Top program, the release of the documentary Waiting for Superman and just today, Mark Zuckerberg's impressive $100M gift to the Newark school system.  

From my end, while I don't make movies or have Mark's net worth, over the past few years, my wife and I have spent some time and devoted some of our resources to a local Boston charter high school called MATCH.  Their record of achievement is amazing.  The students of the school are selected randomly after entering the charter lottery and as a result reflect the demographics of the Boston public school district: 77% live in poverty as measure by eligibility for free/reduced price lunch programs by the State; 63% are African American, 30% are Hispanic and the remainder are Asian or white.  Most of these students enroll at MATCH in 9th grade with math and reading abilities that are well below grade-level.  Despite this, by 10th grade the school is among the best performing instituions, as measured by MCAS scores and shown in the chart below, in the state of Massachusetts.  Further, and most importantly, come graduation time, 99% of the students in the school's first seven graduating classes have been accepted into 4 year colleges.

So why am i writing about this on a entrepreneurship and venture capital blog?  A few reasons: First, reforming public education is critical to our country's long term competitiveness and MATCH, and other such "no-excuses" charter schools are one demonstration that dramatic improvements can be realized with the right attention and focus.  Second, on the chance you find these topics interesting and want to learn more, I would love to connect you to the school so you can learn more first hand.  Finally, and to the point of this post, when I was at the school last week it struck me that there are some important entrepreneurial leadership points in how MATCH has achieved it success that are worth highlighting. So what I learned in school last week was:

1. The importance of a unifying vision.  Everyone at MATCH is 100% committed to achieving the school's goal: create a high performing environment where all students can change the trajectory of their lives by not just going on to college, but by succeeding in college.  This vision orients all of the school's activities, just as a unifying vision should orient the activities of your start-up.
2. The importance of consistent, strong leadership.  MATCH is blessed by a great founder with vision, Mike Goldstein, a phenomenal Executive director, Alan Safran and a superb High School Principal, Jorge Miranda.  Each has been part of the school since its earliest days and they set a tenor for the school that permeates the rest of the organization.
3. The importance of creating a culture of accountability.  Match does this by setting high expectations and demanding a lot of their team (in their case both students and teachers), while at the same time providing the right resources, training and support to help attain those goals, and then measuring and tracking progress very closely.
4. The importance of innovation.  While having an audacious goal is important, at times you need to be willing to do things differently to achieve those goals.  In MATCH's case, their innovations have included the MATCH Corps, a group of 90 recent college graduates who provide 2 hours of individualized tutoring a day to each student in the school, an extended day for additional academic programming and creative collaborations with two local universities, BU and MIT.
5. The importance of growth, but only once you have figured things out.  When MATCH started, they focused all their attention on building a top-performing high school.  Only once the model for doing so was well developed and honed, did they start to expand such that now they have a middle school, an application out for another charter in Boston focused on non-native English speakers, and a state-approved teacher training program that sends teachers not just to MATCH, but to other schools around the country.

So while many talk about lessons from business that can be brought to education, I have been thrilled over the years to take some lessons from education into my business.

While VCs & Angels debate, focus on first principles

There has been a lot of debate lately in the investor community about VCs vs SuperAngels and the best approach to financing early stage companies.  If you are an entrepreneur, you could spend all day catching up on the blog/twitter traffic, which of course makes it hard to focus on actually building your business.  If you do have the time and want to wade in, these posts/comments from Fred Wilson, Brad Feld, Eric Paley, Dave McClure and David Hornik (via TechCrunch) will give you the overview.

Given that 90% of all potential investors will deliver advice that is self-serving to their own particular agenda, in approaching the question of how to fund your business, to me it makes sense instead to focus on first principles.  As a first pass, this entails answering three questions:

1. How much money do I realistically need?  Put together an overall multiyear plan for your business, assume it takes longer and more money than what the plan suggests, and then determine what that means.  The simple point here is that the financing sources that are appropriate if you need a total of $1 million are different than if you need $10 million or $100 million.
2. What amount of capital upfront allows me to significantly decrease risk and increase valuation?  While every entrepreneur would like to raise all the capital required per question one in one fell swoop, this is often unrealistic and will result in a tremendous amount of dilution.  Instead, think about determining what allows you to prove you can build your solution, that customers will adopt and it fits a market need, there is a sustainable business model and that you have a path to access the market.  Funding through milestones such as these will allow you to raise subsequent rounds of capital at higher prices.  In the digital media world this often can be accomplished with less capital, in other segments it requires more, but regardless of the segment you participate in reducing risk and demonstrating potential upside will always translate into higher valuations.
3. Who do I want to work with, what do I expect to get out of them and are our objectives aligned?  When you bring on an investor, especially if they are on your Board of Directors, you will be together for a long time.  So make sure you both enjoy working with them, you see eye to eye in terms of the market opportunity, you are aligned in terms of what you expect from the investor and what they will be able to deliver, and there is agreement on the the ultimate goals for your business.  One of the greatest sources of conflicts between entrepreneurs and investors happens when this alignment is not in place from day one.

In all of this, avoid the trap of telling an investor your strategy is what you think they want to hear.  Instead, if you focus on what is right for you and your business, the answers should come to you.

Revealing Insights

Earlier today SAIC announced that they had signed a definitive agreement to acquire our portfolio company, Reveal Imaging.  This is an extremely positive outcome for the company, its customers, employees and shareholders and represents an import waypoint on a fascinating and successful entrepreneurial journey for the team at Reveal.  Reveal Imaging is a company that develops physical security solutions – primarily explosive detection systems - for the aviation security market.  While there are plenty of case studies about successful entrepreneurial stories, what makes the Reveal story uniquely compelling is that it involved a group of larger company executives who came together post 9/11 with a genuinely patriotic mission to bring innovation to the world of aviation security, a market segment that is normally outside of the purview of traditional venture capital success stories.  That said, many of the lessons learned along the way apply more broadly and I thought they would be illuminating on a several [a baker's dozen worth, highlighted in brackets below] dimensions for prospective entrepreneurs.

Before jumping into the story, the people and the lessons, I should explain what the company does.  Reveal Imaging provides threat detection products to the global transportation industry.   The company’s first focus was on explosive detection systems for the aviation checked baggage market, and their screening system today can be found in 100s of airports in the US, China, Israel, Mexico and other locations around the world.  The founding vision of the company was that in the post 9/11 world, the transportation security requirements of customers had fundamentally changed, but the solutions had not, and that this represented a unique and compelling opportunity.

We first met Michael Ellenbogen, Reveal’s CEO, and his 5 co-founders in January of 2003 at the suggestion of his CFO, Charlie Tillet who was previously the CFO of a former portfolio company. [Point #1: a warm introduction to a VC from a trusted source is always the best start].  At the time, while the company was a raw idea with only a PowerPoint deck, I remember being extremely impressed with the team, their deep domain expertise and breadth of experience in the market and the uniqueness of their vision.  As a group, they had been responsible for developing three of the only five explosive detection systems approved by the Transportation Security Administration (TSA) in the US, the key initial customer.  Each of the executives knew each other from prior companies, but they had also had worked in different companies so in many respects the best combination a founding team can have: prior working relationships but a diverse gene pool.  Further, they each had an important role to play in the new company: Ellenbogen as CEO, Richard Bijjani as CTO, John Sanders as Business Development, Elan Scheinmann as Marketing, Jim Buckley as Sales and Charlie Tillet as CFO.  [Point #2: pull together the best team you can, with unique market and customer insight, as you launch your venture]. 

While we loved the team from the outset, the market the company was targeting, explosive detection systems for the aviation security market, was by no means an industry segment we knew well.  In fact, after my initial positive reaction to the team, my follow up reaction was why on earth would we invest in a company building a hardware system that needed to be approved by a certification body that would be sold to governmental customers.  Not the traditional VC recipe for success!  That said, the team was able to articulate a vision for their first product that made sense: driven by a proprietary design and advanced software algorithms, it was going to be a smaller, faster, higher performance checked baggage screening system that would be lower cost from both a capital and operating expense perspective for the end customer.  As a result, it fit into airports where the existing solutions were not practical.  This IP based, better, faster, cheaper value proposition was one we could wrap our arms around and, in conjunction with the management team, we were able to build a market segmentation map that outlined the size and scope of the opportunity which led to the conclusion that there was the opportunity to build a company of significant size. [Point #3: even for the most complex and arcane technologies, work to distill your message into a simple, compelling, value proposition that translates into a large market opportunity].  Also helpful in this regard was that the company, through its network of relationships was able to serve up as diligence resources prospective customers and industry experts that had heard the company’s story and were able to validate this perspective. [Point #4: always run your idea by key customers and partners looking for both validation and ways to improve your positioning.  Also, if you are in an off the beaten path industry, be willing to lead your VC by the nose through the due diligence process].

Having come to the conclusion that we liked the team, their vision and the market opportunity, we had two remaining questions and challenges.  First, could the product be built (technical risk) and second, could we raise the necessary capital to fund the development effort (capital risk).  Capital risk proved to be a bit challenging for the Reveal team, as many VCs they spoke with turned down the opportunity to invest based simply on the fact that it was outside of the areas they knew well and was selling to governmental customer, although in the end, the team was able to build a strong syndicate including ourselves, General Catalyst and Greylock Partners. [Point #5: it pays to be a contrarian and don’t let conventional investor wisdom discourage you].  The size and scope of the technology development effort, especially as explosive detection systems need to be certified by the government and at the time there were only two companies with certified solutions, remained the last open item.  In the end, despite significant technical diligence from outside experts, this was the leap of faith that we decided to take.  That said, we structured the initial $10M commitment to the company in two pieces, where the second slug of capital would only come in once the first machine was certified.  The discussion around this point also led to one of the best lines in the entire diligence process when Michael, having been asked by a prospective investor what would happen if the machine could not be developed and certified in a timely manner, responded “Well then, I guess you and we are f#*$ed”. [Point #6: honesty and a sense of humor are always appreciated].

Armed with the initial capital, the Reveal team set out on developing the system.  This was a complex product development effort involving hardware, software and critical algorithms.  Soon after the initial VC financing closed, the company also raised capital in the form of R&D dollars from their target customer, the Transportation Security Administration.  This proved to be hugely beneficial as it both provided a non-dilutive financing source and established an early dialog with the customer to ensure that their needs were met.  [Point #7: early customer engagement and buy-in is critical to success and it is even better if they will help fund development].  Despite this, as is often the case in complex systems development, the product took longer and cost more than anticipated and we reached the end of the first round of venture capital money without being certified by the TSA – thus failing the previously agreed to milestone.  This was the first gut check for the team and investors, but we believed the technical problems were solvable in a relatively short period of time and the market feedback we were receiving continued to be positive, so we pushed ahead and put more capital into the business.  Helping this decision along were two other facts: first, the team was incredibly transparent through the process, so we always felt like we knew where things stood and second, given we had three investors, the incremental commitment from each of us was relatively small.  [Point #8: keeping your investors informed on all issues in an open, transparent way, especially in challenging times, is critical] [Point #9: if you face capital risk, syndicating early, even if the dollars are small, pays dividends later] [(Self-serving) Point #10: having supportive, well-informed investors always helps]. 

In December of 2004, 6 months later than planned, the machine was certified and first revenue shipments began in early 2005.  After that, given the company’s success in building pipeline, the company was on a steep growth trajectory.  Early in this growth, we received our first inbound acquisition interest, which was turned down and the investors provided more capital to fuel the growth of the business.  Given the team and Board were aligned around building a large company, this decision was relatively easy and in hindsight while the “quick flip” might have generated a nice IRR, it was far more satisfying emotionally and financially, to build a large company. [Point #11: ensure the founding team and each of the investors have aligned objectives around the eventual outcome].

By the end of 2006, the company was on a revenue run rate north of $50M per year and was profitable when the TSA, the company’s largest customer at this point, went through an internal re-organization and re-prioritization of their activities, leading the order flow to dry up for the next 4-5 months.  These were challenging times for the company, but the team’s belief in the mission, ability to manage expenses through the trough and a willingness to look for new strategic indicatives to reduce customer concentration and expand the company’s product footprint, got them through the dry-spell [Point #12: as an entrepreneur, resilience is a requirement, and don’t declare victory or defeat too early].  In the end, the TSA did come back on line as a key customer while many of the new initiatives launched in these tough times around international markets and new products, began to pay dividends in 2009 and 2010 when the company’s revenue run-rate exceeded $100M while remaining profitable, a milestone they achieved in 2006.  [Point #13: being cash flow positive is the only way to control your destiny].

So we take our hats off to the Reveal Imaging team for the success they achieved and for teaching us, again, some key lessons along the way.  Working with groups like this remains the most satisfying aspect of what we get to do very day.

From here to enternity

Earlier this week at the AlwaysOn Venture Summit East, Harvard Business School Professor Bill Sahlman declared that the "Median rate of return on VC will be 0% for the rest of eternity".  For those of us who have been in the industry for a while, this is not a new statement from Professor Sahlman, although the qualifier "to eternity" certainly is a new time frame for this claim (and for those of you keeping track at home, eternity likely exceeds the length of my investment horizon).  Rather than debate his point of view, when I heard this I sent out a tweet saying simply "I hope he is wrong".  Soon thereafter I got a reply, which I have heard from several entrepreneurs before, that went something like this: "Don't you hope he's right? We want entrepreneurs to get at bats, and the current model makes that possible".  

I was tempted to reply back quickly with the the short answer of No, but thought this topic may deserve more than 140 characters.  So here is the the longer answer.  In the short term, venture capital that is willing to be invested at a 0% expected rate of return is on the margin good for entrepreneurs in that it helps get companies funded and maybe some of these companies will emerge as real businesses and many entrepreneurs will indeed get their at bat.  In the longer term, however, it is unsustainable and bad for entrepreneurs for two reasons.  The first reason is that the abundance of capital leads to too many companies being funded in any given sector, with the net result being that interesting sectors that can support maybe 5 companies now have 20+ companies pursuing the same customers, partners, and employees and each company is weaker as a result of the level of competitive intensity for scarce resources.  The second reason is that venture capital as a "asset class" competes for capital from investors and if the returns are not interesting, capital will go elsewhere where the expected risk adjusted returns are higher.  Further, venture capital is an inherently illiquid investment and, because of the illiquidity, our investors look for a premium return when they can not access their capital for longer periods of time, just as you get (and demand) a higher interest rate from your bank when you commit to a 3 year CD versus the interest rate you get in your always accessible checking account.  The general rule of thumb is that venture capital needs to generate returns that are 500-1000 basis points greater on a per annum basis than a similar equity investment, say the S&P 500 or the Nasdaq 100.  As a result, unless you are expecting the broader public stock markets to decline by 5-10% per year, a 0% rate of return in venture capital is not sustainable and the industry as a whole will contract, resulting in less capital for the industry and entrepreneurial ventures.  So while it may seem appealing on the face of it to have the industry run for the broader good of innovation, in the end we - meaning entrepreneurs and venture capitalists together - need to earn our keep every day to ensure that capital remains available for great people and ideas.

VCs and Recruiting

There is an old expression in the Venture Capital business, coined initially I believe by John Doerr, that VCs are really just glorified recruiters.  Given a number of portfolio company searches I have been involved with over the past few months, this is definitely feeling like the case.  

So while I think the entrepreneurs in our portfolio companies do the real leg work in recruiting, and being an excellent recruiter and team builder is a key skill of the executives we back, there are a few important contributions a strong venture capitalist can bring to an executive search at a portfolio company:

1. A broader context.  If a founder of a company is looking, for example, to recruit a VP of Sales, depending on what they have done before this could be their first time doing so.  An experienced venture board member, on the other hand, might have helped recruit dozens of such executives which provides a broader context in which to assess the executive's skills and fit with the given company.
2. An extended network from which to surface candidates.  This can result in the VC surfacing up a specific candidate, or knowing enough people who themselves can surface up candidates.
3. An ability to more deeply reference check a given candidate.  As anyone who has recruited executives knows, reference checking the candidate's background is critical to understanding their skills and fit.  But being able to do so "off-list" is even more important as the key to references is not speaking to the people the candidate provides, but rather understanding who, and speaking with, the references they don't provide.  By the nature of having been involved with many companies over the years, a good VC will often be able to get to these off-list references more readily than the executive team.
4. An ability to help provide a candidate a third party perspective on the business and why it may represent a good fit for the candidate.  Talented folks will always have other choices and the best candidates will want to do significant diligence on the opportunity.  While not completely unbiased, a venture investor can often provide this perspective and share diligence on what led to their investment decision.
5. An ability to keep executive search firms honest.  Search firms, while often an important part of a successful recruiting process, need to be managed to avoid them slacking off at the end of a long search or promoting candidates to finish the search regardless of whether the particular candidate is a good fit.  A recruiter is less likely to do this with the involvement of a venture firm given that the venture firm often represents a long-standing relationship and a steady stream of referrals.

So if you are an entrepreneur looking to build out your team, put your venture board members to work!