IP: IEEE SPectrum Opinion: Speakout: An Engineer's view of VCs

[David Farber <dave@farber.net>]

>Date: Sat, 01 Sep 2001 11:55:42 -0700
>From:
>
>http://www.spectrum.ieee.org/WEBONLY/resource/sep01/speak.html
>
>Please don't attach my name to this for obvious reasons!
>
>
>An Engineer's View of Venture Capitalists
>
>By Nick Tredennick, with Brion Shimamoto,Dynamic Silicon
>
>I first encountered venture capitalists (VCs) in 1987. Despite a bad
>start, I caught the start-up bug. In the years since, I have worked
>with more than 30 start-ups as founder, advisor, engineer, executive,
>and board member. It's a lot more than that if you count all the times
>I've tried to help "nerd" friends (engineers) connect with the "rich
>guys" (VCs). Naturally, I've formed opinions along the way. Many books
>and articles eulogize VCs. But here I want to present an engineer's
>view of VCs. It may sound like I'm maligning VCs.  That's not my
>intent. And I'm not trying to change human nature. VCs know how to
>deal with engineers, but engineers don't know how to deal with
>VCs. VCs take advantage of this situation to maximize the return for
>the venture fund's investors.  Engineers are getting short-changed.
>
>Fortunately, engineers are trained problem-solvers--I want to harness
>that power.  Engineers, armed with better information about how VCs
>operate, can work for more equitable solutions. I'm not offering
>detailed solutions--that would be a book. Rather, this is a wake-up
>call for engineers.
>
><SNIP>
>
>Guide to venture capitalists The VC connects wealthy investors to
>nerds. There are few alternatives. You can self-fund by consulting and
>by setting aside money for your venture. That doesn't work.  You could
>go to friends and family, but that risks friendships. You could find
>"angel" investors, but that only delays going to VCs.
>
>The VC community is a closed one. It caters to a restricted
>audience. In fact, you don't get to meet a VC unless you have a
>personal introduction. Don't send them your business plan unless the
>VC has personally requested it.
>
>VCs don't sign nondisclosure agreements. That affords them protection
>if they like your ideas, but they want to fund someone else to do
>them. At least two of my friends have had their ideas stolen and
>funded separately. One case was blatant theft--sections of the
>original business plan were crudely copied and taped into the
>VC-sponsored plan. My friend sued and won a moral victory and a little
>money. The start-up based on the stolen idea went public and made lots
>of money for that start-up's VCs. Most entrepreneurs don't have the
>time, the means, or the proof to sue. In the second case, venture firm
>D sent its expert several times for additional "due diligence"
>regarding the possible investment. My friend got funding elsewhere,
>but D funded its expert with the same ideas.
>
>VCs are sheep. The electronics industry is driven by fads, just as the
>fashion and toy industries are.  The industry is periodically swept by
>programming language fads: Forth, C++, Java, and so on. It's swept by
>design fads such as RISC, VLIW, and network processors. It's even
>swept by technical business fads such as the dot-coms. No area is
>immune. If one big-name VC firm funds reconfigurable electronic
>blanket weavers, the others follow. VCs either all fund something or
>none of them will. If you ride the crest of a fad, you've a good
>chance of getting funded. If you have an idea that's too new and too
>different, you will struggle for funding.
>
>VCs aren't technical. Mostly, they aren't engineers--even the ones
>with engineering degrees. An engineering degree is a starting
>point. If you design and build things, you can become an engineer; if
>you work on your career, you can become an executive or a venture
>capitalist. VCs in Silicon Valley are as technically sophisticated as
>VCs come. As you get geographically farther from technical-industry
>concentration, investors become more finance-oriented and less
>technically-oriented.
>
>Like all people, they dismiss what they don't understand, your novel
>ideas, and they focus on what they know, usually irrelevant marketing
>terms or growth predictions.
>
>Experts aren't very good. The VC will send at least one "expert" to
>evaluate your ideas. Don't expect the expert to understand what you
>are doing. Suppose your idea implements a cell phone. The VC will send
>an expert who may know all there is to know about how cell phones have
>been built for the last 10 years. As long as your idea doesn't take
>you far from traditional implementations, the expert will understand
>it. If you step too far from tradition--say, with a novel approach
>using programmable logic devices instead of digital signal
>processors--the expert will not understand or appreciate your
>approach.
>
>One company I worked with had an innovative idea for a firewall: build
>it with programmable logic and it works at wire speed. Wire speed
>meant no buffering, no data storage, and therefore no need for a
>microprocessor or for an IP (Internet Protocol) address. Simple
>installation, simple management, but so different that experts--even
>those from programmable logic companies--didn't understand it. To
>them, proposing a firewall without a microprocessor and an IP address
>was like proposing a car without an engine. No funding. Back to work
>at a big company. Worse for them; worse for us. The industry
>loses. Progress is delayed.
>
>VCs don't take risks. VCs have a reputation as the gun-slinging
>risk-takers of the electronics frontier. They're not. VCs collect
>money from rich people to build their investment funds. Answering to
>their investors contributes to a sheep mentality. It must be a good
>idea if a top-tier fund invested in a similar business. VCs like to
>invest in pedigrees, not in ideas. They are looking for a team or an
>idea that has made money. Just as Hollywood would rather make a sequel
>than produce an original movie, VCs look for a formula that has
>brought success. They're not building long-lasting businesses; they're
>looking to make many times the original investment after a few years.
>
>When VCs build a venture fund, they charge the fund's investors a
>management fee and a "carry." The carry, which is typically 20 to 30
>percent, is the percent of the investors' profit that goes directly to
>the VC. The VC, who gets a healthy chunk of any venture-fund profits,
>may have no money in the fund. Even a small venture fund will be
>invested across a dozen or so companies, spreading risk. Also, the VC,
>as a board member, will collect stock options from each start-up the
>fund invests in.
>
>The rich investors take some risk, though their risk is spread across
>the fund's investments. The real risk-takers are the entrepreneurial
>engineers who invest time and brain power in a single start-up.
>
>Venture funds are big. Too big. If your idea needs a lot of money, say
>$100 million, then you have a better chance of getting money than an
>idea that promises the same rate of return for $1 million. The VCs
>running a $1 billion fund don't have the time to manage one thousand
>$1 million investments. It won't even be possible to manage two
>hundred $5 million investments. It's better to have fewer, bigger
>investments. In such an environment, if you need only $5 million, your
>idea will struggle for funding.
>
>VCs collude. VCs collect in "bake-offs" that are the VC's version of
>price fixing. They discuss among themselves funding and "pricing" for
>candidate start-ups. Pricing sets the number of shares and the value
>of a share, and is typically expressed in a "term sheet" from the VC
>to the start-up. VCs optimize locally. It wouldn't do for several of
>them to fund, say, six companies in an industry wedge. Limiting the
>options to two or three limits competition and makes the success of
>the few more likely. The downside: limiting competition stifles
>innovation and slows progress. As in nature, competitive environments
>foster healthier organisms. Innovation is the beneficial gene mutation
>to the current technology's DNA.
>
>I attended a recent talk by a VC luminary, who gloated over the state
>of the venture industry, after money for technology start-ups was
>scarce. Here's my summary of the VC's view:
>
>"A year ago there was too much money available, so there was too much
>competition to fund good ideas. Valuations for pre-IPO (initial public
>offering) start-ups were too high. Start-ups could get term sheets
>from several venture firms and select the most favorable. Too many
>ideas were getting funded. With too many rivals, markets might never
>develop. The current market is much better. Valuations are reasonable
>and, with few rivals in each sector, new markets will develop--as they
>might not have with many rivals."
>
>This is nonsense. Look, for example, at hard disks and floppy
>disks. In the hard-disk business, there have been as many as 41 rivals
>fighting for market share. Only three major manufacturers competed in
>floppy disks. The hard disk has improved much faster technically; the
>floppy disk is stagnant by comparison. I'm not talking about market
>size or market opportunity (the hard-disk business versus the
>floppy-disk business); I'm talking about rates of innovation.
>
>VCs don't say no. If the VC is interested, you can expect a call and,
>eventually, a check. If the VC is not interested, you won't get an
>answer. Saying "no" encourages you to look elsewhere--that's not good
>for the VC, who prefers to have you hanging around rather than going
>elsewhere for funding. Fads change; the herd turns; your proposal may
>look better next year. In addition, the VC may want more due diligence
>from you--to add your ideas to a different start-up's plan.
>
>If VCs think you have few alternatives, they will string you along:
>
>"I love the deal, but it'll take time to bring the other partners
>along."
>
>"We need more time to get expert opinions."
>
>
>"We're definitely going to fund you, but we're closing a $500 million
>fund, and that's taking all our time."
>
>
>"I'll call you Monday."
>
>Once your alternatives are gone, they negotiate their terms.
>
>VCs have pets. The VC's version of a pet is the "executive in
>residence." Many venture firms keep a cache of start-up executives on
>staff at $10 000 to $20 000 per month (a princely sum to an engineer,
>but just enough to keep people in these circles out of the soup
>kitchens). Start-up executives, loitering for an opportunity, may
>collect these fees from more than one venture firm, since the position
>entails no more than casual advising.  These executives have
>"experience" in start-ups. When you show your start-up to the VCs,
>they will grill you about the "experience" of your executive team. It
>won't be good enough, but not to worry, the VC supplies the necessary
>talent. You get a CEO. The CEO replaces your friends with cronies.
>
>The VCs' pets are like Hollywood's superstars. Just like Julia Roberts
>and Tom Cruise, the superstar CEOs command big bucks and big
>percentages (of equity)--driving up the cost of the start-up--but are
>"worth it" because they give investors and VCs a sense of security.
>
>Your idea, your work, their company. The VC's CEO gets 10 percent of
>the company. VC-placed board members get 1 percent each. Your entire
>technical team gets as much as 15 percent. Venture firms get the
>rest. Subsequent funding rounds lower ("dilute") the amount owned by
>the technical team. Venture firms control the board seats. The VC on
>your board sits on 11 other boards. Board members visit once a month
>or once a quarter, listen to the start-up's executives, make demands,
>offer suggestions, and collect personal stock options greater than all
>of the company's engineers hold, with the possible exceptions of the
>chief technology officer and the vice president of engineering. The
>VC's executives control the company. You and the rest of the engineers
>do the work.
>
>
>VCs take advantage...to maximize the return for the venture fund's
>investors.  Engineers are getting short-changed.
>
>
>One company I know got a good valuation a year ago. Over the year, it
>grew rapidly, developed its product, met or exceeded its milestones,
>and spent its money according to plan. When it was time to get money
>again, the funding environment had changed.  Last year's main investor
>wouldn't "price" the shares or "lead" the new funding round.  The
>"price" declares the number of shares and the valuation of the
>company. Think of the company as a pie. It is a certain size
>(valuation) and it is cut into a number of slices (shares). An
>investor "leads" by offering a specific price for shares for a large
>percentage of the next round. Other investors follow at the same
>price. Even though the company's engineers had executed flawlessly,
>the round came in at less than a third of last year's valuation.
>
>As a part of closing this "down" round, the last year's investors
>renegotiated the previous round, effectively saying, "Since this round
>is lower, we must have overpaid in the last round. We want more equity
>for the last investment." If there had been fraud by the entrepreneurs
>instead of flawless execution, renegotiating the previous round might
>have been reasonable. Imagine the opposite scenario: "In light of
>market developments, it's obvious that your idea is worth much more
>than we thought, so we're returning half the equity we took for last
>year's funding." It's so ridiculously improbable that you can't read
>it without laughing out loud. That we accept the converse highlights
>the entrepreneur's weak position.



<snip>



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