Structured Interviewing

A few weeks ago, I wrote a post on applied interviewing. Mark Tsimelzon, founder and President of Coral8, replied that Coral8 is a strong advocate of structured interviewing and has had tremendous success hiring the best and brightest by a well-defined, consistently applied hiring methodology. Mark kindly offered to serve as this blog's first guest writer and the post below is a wonderful "how to" structured interviewing guide. Thanks to Mark!

A Practical Guide to Structured Interviewing ============================================

All entrepreneurs agree that building a strong team is extremely important for their startup's success, but many first-time founders are not sure how to achieve it, and are baffled by the interviewing process. The number of questions and choices is indeed confusing: where to get the resumes, whom to invite to an interview, whether to conduct interview over the phone or in person, what to ask, how to evaluate the answers, etc.

Luckily, the structured interviewing approach Will wrote about recently can help. Below are some details of how we apply structured interviewing at Coral8 ( a Silicon Valley startup building a platform for real-time analysis of large volumes of data). While what follows applies mainly to engineers (software, QA, support, professional services), the same would apply to many other job functions and positions.

Like any complex process, the interviewing process is best structured and analyzed as a sequence of phases. At Coral8, we have four phases: email interview, phone interview, the first in-person interview (with 1-2 person), the second in-person interview (3-4 others). Whether you have the same stages or not is not important. What's important is having a clear understanding of a) why you are having each phase b) what you are trying to accomplish, and c) how you are going to evaluate the results. It helps if all the interviewers share this understanding, and keep the process as consistent across candidates as possible.

Let's consider the phases separately.

Email interview
---------------

Most startups complain that just finding a good candidates is the hardest part of the process. Post a job description at any jobs web site, and you'll receive hundreds of resumes, most of them from people who are not even remotely qualified. Hire a recruiter, and he'll be sending dozens of resumes your way, again often from poorly qualified candidates. Just opening and reading those resumes is often overwhelming.

The problem may seem impossible to solve, yet a simple solution exists, and here at
Coral8 we are still puzzled as to why so few companies use it. Here is what you do: You never, ever, publish a position description without an accompanying problem that someone MUST solve before you even open their resume. The problem
should: a) have a solution that can be easily reviewed b) take the right candidate about 10 minutes to complete c) test a skill that is core to the job
d) be somewhat interesting e) allow a super-star candidate to show off their
knowledge and skill. Since most of our positions require programming in some
language, our problems often require writing a simple program or function. The language and the complexity is adjusted for each position.

For example, when we interview C++ engineers, we want to make sure they understand polymorphism and virtual functions. It's disturbing how many people who call themselves C++ programmers do not. So here is a problem we sometimes
use: Illustrate the use of the keyword "virtual" by writing a short C++ program which contains this keyword and prints "Hello, world". If the keyword "virtual"
is removed, the modified program should print "Good bye, world".

Some may say that the problem is too simple, and it certainly is. But having a problem like this in your ad does wonders. First, it greatly raises the signal-to-noise ratio. Few Visual Basic programmers will bother to send their resumes if you require a solution to a C++ problem. If they do, or when the solution is wrong, you can quickly ignore the submission. The resumes you'll get are usually from people who are really motivated, and not just sending resumes to all the positions. If somebody gives you a correct solution, you immediately know that you have a strong candidate.

Some folks may think that having a problem discourages some good candidates from applying for a job. Who knows, maybe this is true for some candidates. In our experience, however, we find just the opposite. Some of the very best employees we've hired told us that they applied for a position with Coral8, back then a stealth-mode startup, precisely because they were intrigued and challenged by our posted problems.

What if you do not publish your job openings, but instead use recruiters? Easy!
Give the problem to the recruiter, and tell him that you will not accept any resumes without the solution to this problem. Some recruiters will tell you they don't want to do the extra work. Somehow these are often the recruiters who want to charge you 25-30% of the candidate's annual salary, and you just pass on them. A startup can and should negotiate a much better deal anyway, and, more important, a good recruiter loves the fact that you have this problem!
Why? They know that you get a lot of resumes, from many sources. They want to give you the candidates who are the most qualified, and they have to qualify them somehow anyway. And what better way is there to qualify the candidates than to use your own problem?

So this is what we call an "email interview". In most cases, unless we have a high-quality referral, we refuse to even look at the resume unless we see a solution to our problem. Life is too short to look at hundreds of resumes a week.

Phone interview
---------------

Phone interviewing is a much more traditional and better understood process, so I won't spend as much time on it. What we found important is to have a list of questions for each position, and to try to follow this list every time. It makes the process much better structured, and over time you learn which questions are harder than you thought, and which ones are easier. So it helps you calibrate your expectations better.

Since we only schedule phone interviews with the people who pass the email interview, we know they have at least some basic understanding of one area. So the phone interview is used to get a slightly better understanding of the breadth and the depth of the candidate's skills. We spend about 30 minutes with a candidate, and use a part of that time telling the candidate about the company and the position. After 30 minutes, it is usually clear if you want to invite the candidate to a face-to-face interview.

1st face-to-face interview
---------------------------

All right, the candidate comes in to see you, what do you do? As Will mentioned, too many interviewers go with "Tell me about yourself?" and "Tell me about your past projects?" kind of questions. These questions are ok, but spending more than 10-15 minutes on them is counter-productive. The last question is often useless, unless you happened to know a lot about specific areas the candidate worked in. If you do not, it's hard to evaluate how challenging the tasks really were, and whether the decisions he made were correct. Instead, what you should evaluate in these situations is the candidate's presentation skills. Whether you are an expert in his area or not, any good candidate should be able to clearly explain to you what he did, what the overall project was, what the trade-offs were, etc.

But most of the time should be spent with the candidates answering a carefully constructed set of questions. This may be a religious issue, but we at Coral8 strongly believe that the questions should be clearly related to the job, and not some puzzles that test nothing but the ability to solve puzzles.

Now, if you are interviewing programmers, then please, please, please, administer some programming exercises. There is an amazing number of programmers on the market with fancy resumes, fancy titles, and fancy degrees from fancy schools, who nevertheless cannot program well. You do not want to hire people like that. Any resistance to programming during the interview (e.g, "I don't program well during interviews") should be an immediate red flag.

Of course, when you ask somebody to code during the interview, be reasonable.
Many people do not remember the language syntax or the names of library functions. That's entirely ok. We either let people use some reference guide or Google, or just tell them that they should not worry syntax. To us, what matters most is algorithms, so this is what we pay attention to. You may worry more about something else, but whatever it is, make sure you carefully construct your questions to test for that, rather than just asking whatever you feel like at the moment.

2nd face-to-face interview
--------------------------

Now, the candidate passed your interview, and you invited him to come again to "meet the team." Sounds innocent, but this is one of the more challenging parts of the process. You've got to recognize that people have widely different interviewing skills, and sometimes even great engineers make poor interviewers.
Work with them. Agree, as a team, on which questions to ask, and who will ask them. Sit in on some interviews yourself, to make sure you are satisfied with the interview dynamics. It's often best if people interview in pairs: it takes less candidate's time and lets the interviewers to learn from each other.

The 2nd face-to-face interview is also a good time to further investigate some
personality issues. For example, the team may agree that during the interview,
one team member will try to push the candidate a bit, disagree with him strongly on some issues, and see how the candidate handles it. You don't want to go too far, but it's a useful test. Nothing kills productivity in a startup like engineers who do not know how to disagree with each other professionally.

All right, everybody has talked to the candidate, now what? This is the place where it's especially important to have a well-defined process. It's best to have a formal scale, on which everybody will grade the candidate. The scale we have at Coral8 was popularized by Siskel and Ebert: thumbs up, thumbs down, and we also have many gradations in between. It's not important what you have, the scale 1-10 works just as well.

It also helps to have a threshold. Let's say your threshold is 7. It means that you do not want to hire anybody with the average score below 7. If you have only one serious candidate for the position, you just need to decide whether he scored above your threshold or not. If you have multiple candidates, you need to compare them to each other, using their combined scores.

How you combine the scores given by different team members is an art, not a science. You may start with simple averaging. Or you may want to say that anybody with one or two votes below the threshold is automatically disqualified.
You may also keep in mind that one person's 9 may well be another person's 6.
The ultimate decision is yours, but what's important is that you as a team talk about the candidate, and discuss what people like and dislike about the person.
During this discussion, you'll learn a lot about the candidate, and you'll learn even more about your team!

Conclusion
----------

There are many parts of the hiring process that we have not covered yet: formal reference check, informal reference check, offer negotiation, etc. The important point, however, may have nothing to do with hiring per se. To many people, the words "startup" and "process" are mutually contradictory. Processes are for Fortune 500 companies, right? Not so fast. Like it or not, there are many processes going on in any startup. You may recognize, structure, and optimize them. Or you may hope that they just work by themselves. The interviewing process is a good example of a process that will produce some results either way: after all, no startups die because they cannot hire any people at all. But there are certainly ways to make this process much more effective, efficient, and enjoyable for all participants.

Managing Growth

Today, I had the good fortune of sitting in on a lecture by Verne Harnish on how to increase the value of fast-growth companies. Verne is the author of Mastering the Rockefeller Habits and CEO of Gazelles Inc. My host, a major Internet company, brought Verne in to provide senior and mid-level management a framework and set of best practices for managing growth and creating value. The subject matter is dear to my heart and a critical area of study for any start-up manager.

Verne's book is based on the management style of John D Rockefeller. Rockefeller's management style centered on three key areas: priorities (define the 1-5 most important organizational objectives), data (identify and manage to the key metrics and leading indicators), and rhythm (run a well-organized set of daily, weekly, monthly, and quarterly meetings that keep everyone aligned and accountable). The core premise is that success is the sum total of all decisions being made in an organization. Leaders/managers influence decisions, and hence success, and need a framework regarding how best to do so.

Verne laid out his 4-3-2-1 framework for how great managers can optimize decisions.

Managers have four decision levers:

• people (happiness, turnover, applicants/job opening, quality applications/total applicants)
  
• strategy (revenue/growth)
• execution (profit/time)
• cash

The four key decision areas are complemented by three key disciplines:

• priorities
• metrics/data
• meeting rhythm

The three disciplines relate to two key drivers

• reputation
• productivity

Finally, each manager needs a life coach who will push, challenge, and hold them accountable as you grow as a leader. The key point is that if Tiger Woods, Roger Federer, and Michael Dell have life coaches, why do you think you don't need one? Good point.

Often start-ups feel that data-driven management is an oxymoron, that meetings are a waste of time, and that communication by email is the most effective way to get things done in a crazy, fast-paced world.

Verne's rebuttal to that world-view is that relentless repetition and routine frees the company to shine and grow confident that energy and effort are aligned with the end game. He advocates meeting and managing to a few key priorities, daily "talk time" where the team can spend 10-15 minutes reviewing pressing issues, daily data and indicators, and bottlenecks that require resolution creates incredible energy, collaboration, and productivity. He recounted multiple examples of companies that make a daily meeting an essential rhythm of corporate life and benefit in doing so.

As an investor and ex-CEO of a start-up, I relate very well to Verne's approach. Companies need to select a framework and language of dialogue that centers the team on common goals, common metrics, and creates a forum for cross-function collaboration, problem resolution, and productivity. While this is common sense, too often common sense is lost to inertia and productivity grinds to a halt as misalignment and misdirection sap energy, cash, and momentum. Whether Verne's framework or another, picking a methodology to detail priorities, metrics, and company alignment and communication can make implicitly intelligent ideas explicit mechanisms of management and key tenents of company culture.

With respect to growth, he argued that the faster the rhythm (group meetings and metric reviews), the faster you will grow. Seems counter-intuitive that meeting time accelerates productivity - but if a short, stand-up meeting eliminates bottlenecks, realigns priorities and strategy, and enhances cross-team synergy then it is somewhat obvious productivity will be enhanced. This is very similar to the role of the Scrum master in agile development.

His site provides templates for strategic plans, daily and weekly meetings, and other useful materail.

Finally, he left the group with two sets of looming questions.

The first set is what is the business question we need to answer? What is the key problem/question whose answer will free us to grow at 2x the competition, 2x the cashflow, 3-5x the profitability, and 10x the market cap? He also suggests picking a key personal question that will similarly accelerate personal growth and development.

The second question is to determine what to stop doing. What wastes time, is inefficient, gets in the way of true productivity - answer the question and get rid of it.

Thank you to my host and to Verne for a great day and lots of food for thought.

Applied Interviewing

Interviewing candidates is an art and a challenging one. Hiring the best and brightest, establishing competency, qualifying cultural fit, and making interviewing productive are critical to the success of early stage companies. In order to avoid superficial discourse and backing-in to a process that rewards conversational skills rather than material functional skills, it is helpful to train people in structured, applied interviewing.

Too often, people walk into interviews armed with little more than a resume and ask, “so tell me about yourself.” There is an awkward dynamic where the candidate is eager to convey their strengths and the interviewer wants to qualify the “fit” of the applicant. And yet, far too often, the output of the interview is , “I liked them,” or,
“I don’t think they are a fit.”

Given the massive importance of hiring the right people, screening for the right skills, and making the best use of the time consuming interview process it really pays think about how best to evaluate talent. Structured, applied interviewing moves the interview away from conversational skills and the serial recounting of someone’s background to a focus on the specific skills that are relevant to the hire in question.

For each department, I encourage start-up teams to jointly develop a set of questions, case studies, and applied examples of the skills in question. Then train each interviewer in how to best ask the questions and use the structured material. Group evaluations can then center on a common framework and a targeted output. For example, for engineers the interview could center of logic and coding tests, for VP sales on forecasting methodologies, CRM systems of choice, pipeline and sales force management…In my case here at Hummer Winblad, the team asked me to present my thoughts on the future of the software industry, in a one hour presentation, to the full partnership. My ability to present, articulate a thesis, and provide a framework for analysis were made transparent and the final evaluation allowed for skills and cultural fit to be taken into account.

After interview-day dinners can help with the cultural fit questions, however, for the scheduled interviews I suggest avoiding the conversational approach for a vetted, structured approach that helps make the interviewing process more productive in terms of both time and results.

People, after all, are the most input into any growing business.

SVASE - VC Breakfast

Next Thursday, I will be involved in a SVASE VC breakfast event. The event is Thursday, May 25th at 8am at 50 Fremont St in San Francisco.

Per the SVASE site:

"The VC Breakfast club provides an intimate setting and meeting place for one VC and up to ten entrepreneurs who meet for breakfast every week. The participating VC listens to each entrepreneur's extended elevator pitch and provides immediate feedback - enabling fast, effective, accessible mentoring and relationship development."

I look forward to meeting some great entrepreneurs.

Cash Breakeven Analysis

In the spirit of sharing best practices in start-up management, I write to share some interesting analysis on cash breakeven forecasting that I saw at a recent BOD meeting. The BOD deck included a simple yet powerful slide that helps understand the size of the "cash gap" derived from analyzing the make-up of monthly cash expenses, current monthly recurring cash revenue base, and average monthly sales price. Simply graph total montly cash expenses by category vs existing recurring monthly revenue - illustrate the size of the gap and note how many incremental sales * contribution margin it will take to close the gap.

An example is below:

Follow the User

In 2006, American industry will spend $290 bn on advertising. How much will be spent on-line as a percentage of the total? 4.6%, or $13.4bn.

It is quite remarkable that despite the pay-for-performance advantages and closed-loop nature of on-line spend versus off-line spend that the number is so low. Newspaper spend is 6.6x that of on-line spend - why? How long can this last?

In many ways, on-line ad spending is changing our relationship to our service providers - more and more content and application functionality is ad-supported - email, storage, video, news, calendaring, IM, 411 calls, etc - and the companies that recognize the move to providing users high-quality product while providing advertisers high-quality demographics and targeting mechanisms are clearly winning.

Google's model: revenue = users x queries/user x ads/query x clicks/ads x revenue/click is powerful. Queries provide targeting information (what is someone looking for, watching, blogging about), clicks provide insight and accountability (how many consumers find this campaign relevant and useful), and revenue/click helps advertisers understand cost of customer acquisition and helps site that provide meaningful user populations, user segmentation and targeting monetize their users.

Questions to Ask

Quick post sharing some of my favorite questions to ask entrepreneurs thinking through enterprise business plans and strategies....the questions help me think through the merits of enterprise software start-up strategies given today's IT environment.

What is the time to value quotient? How long does it take for the customer to realize value from your product? Compare and contrast clicking on a URL to self-provision versus a two-month on-premise proof of concept.

What is the customization to value quotient? How much customization is required before the customer sees relevance and value?

How much manual labor is required to realize value? How many sales engineering and professional services hours are required to both explain the merits of the solution and have it running successfully in the customer's environment? The common element of MySQL or Salesforce.com appears to be that customers self-validate through low-risk experimentation without the need for vendor sales engineers.

What is the risk of experimentation? Does the customer need to pay for a proof of concept? Does the customer need to requisition IT resource (new servers, open up a firewall port, etc) to enable your product to showcase its benefit? As with the MySQL comment above, can the customer experiment and test the value proposition without material risk or expense?

What is the time to integration? Can the product provide standalone value that obviates the need for day one systems integration, a la SFA? To the extent integration is required, how standardized are the interfaces to relevant up and downstream systems that add value to the solution?

The consumer internet offers useful lessons and direction for the enterprise space. Customers self-provision, self-validate, self-integrate, and self-configure.

Business Plan Dependencies

In designing a business plan, it pays to ask, "what are the business plans' dependencies on variables beyond the company's control?" Why? Because the probability of success is inversely proportional to the number of exogenous variables.

Let's assume the business is dependent on five market factors materializing and each independent variable has a 50% chance of occurring - the odds of failure are then 1-(.5^5), or 96.875%. Not good. The odds of start-up success are already daunting; making the odds even more daunting by attempting to execute a plan overly dependent on external variables is a recipe for frustration.

What do I mean? Well, if a business plan requires

• distribution deals to reach the end-market (ex. wireless carriers)
• deployment of new networks, infrastructure, and network devices (ex. wimax, rfid readers)
• new device proliferation (ex. Windows Mobile only)
  
• new technology (broadband over powerline)
• etc...
  

Too often, I see great entrepreneurs looking to fund businesses that face massive external market adoption dependencies. Skating to where the puck will be is critical, but I would just make sure the rink is built before you strap on your skates.

America's Competitiveness

Today, the NVCA announced Magnet USA, a program designed to strengthen America's competitive position in the global economy. I am all for programs designed to stimulate and encourage innovation. Innovation creates jobs, wealth, and increased social utility. However, America's long term security and capacity to support innovation is under tremendous pressure.

Bill Gross' recent column compares the future fate of America to the current state of GM. Gross attributes GM's malaise to uncompetitive labor costs and the burden of pension and health care liabilities. He argues that we are glimpsing America's future in the GM's current struggle to remain solvent, reduce its fixed costs, and reduce future pension and healthcare obligations via employee buyouts. It is a worthwhile and scary read.

Is this overly negative thinking? I went to Whitehouse.gov and read through the OMB's assessment of America's future to find out. Unhappily, I found the following:

"While the near-term outlook for shrinking deficits is encouraging, the long-term picture presents a major challenge due to the expected growth in spending for major entitlement programs. In only two years, the leading edge of the baby boom generation will become eligible for early retirement under Social Security. In five years, these retirees will be eligible for Medicare. The budgetary effects of these milestones will be muted at first. But if we do not take action soon to reform both Social Security and Medicare, the coming demographic bulge will drive Federal spending to unprecedented levels and threaten the NationÂ’s future prosperity.

No plausible amount of cuts to discretionary programs or tax increases can help us avert this major fiscal challenge. As the accompanying chart shows, assuming mandatory spending continues on its current trajectory and the tax burden is held at historical levels, by 2040 Federal spending will accelerate to a level at which mandatory outlays and debt service would consume all Federal revenue. By 2070, if we do not reform entitlement programs to slow their growth, the rate of taxation on the overall economy would need to be more than doubled, placing a crushing burden on the economy that is required to produce the revenues to support the Government programs in the first place."

Wow. According to the OMB, by 2040 all our tax revenue will go to entitlement spending and debt service. How we will invest in the future - research, education, infrastructure - if we are seeing an ever smaller amount of US government revenues available for discretionary spending?

The technology market feels good right now - new companies, models, and innovation is strong. What frightens me is when the OMB and major bond holders forecast a financial meltdown and the eventual devaluation of the US currency, rising interest rates, and a social contract (entitlement spending) that will literally break the bank.

As the VC industry discusses globalization and the merits of offshore investing, a key part of the conversation may be the fundamental, long term macro trends that are shaping the face of future opportunity and innovation. Certainly, the OMB paints a bearish view of America and a compelling reason to start thinking about offshore investing and non-US dollar holdings.

I recently heard someone argue that capital is a coward - it seeks refuge in safe-havens. Unless, we in America are able to make difficult decisions and reduce the fixed costs in the governmemt budget, as GM is laboring to do today, capital will eventually flow out the US and to more attractive safe harbors. Hopefully, unlike energy policy/problems, these entitlement burdens will become part of the political discourse while we still have time to make painful choices to avert painful outcomes.

Concept to Company Update - Great Event

Tonight, VLAB and Hummer Winblad hosted a wonderful panel at Stanford Business School titled Concept to Company: Strategies for Swimming with the Sharks.

This year's Concept-to-Company event focused on the business formation of Cittio, a network management software company founded in 2001 and funded by Hummer Winblad last year. Ann Winblad moderated the panel, Jamie Lerner, Cittio's CEO served as the keynote speaker, and the panelists included Sandeep Johri, Oblix's founding CEO and currently HP Software's VP Strategy and Business Planning, Deborah Magid, IBM Software's Director of Strategy, and Elisabeth Rainge, IDC's Network Management analyst.

The evening's conversation centered on how start-ups best can enter mature markets dominated by incumbents. Network management is a $5+bn software market owned by IBM, HP, BMC, and CA. Jamie set out to answer how best to archetype an offering innovation, sales and delivery model, and marketing message that resonates with buyers in a market long controlled by larger vendors.

Jamie's advice centered on when to raise VC money, how to pick your VC partner, how to pitch VCs, how to sell against giants, and how to handle incumbents' FUD.

When To Raise VC Money
Jamie believes in bootstrapping companies. While I believe this is not a requirement, Jamie believes start-ups are best served by eliminating key market, customer, and product risks prior to soliciting venture firms. Jamie calls his strategy the "just add water approach;" walk in to meetings having validated a big market, shipped a solid product, sold paying customers, operated a well managed business, and hired a good team. He believes entrepreneurs should validate the following five hypotheses:

• Demand - select a large, established market to operate in and prove the innovation
  
• Product - develop a complete and working product
• Customers - referenceable accounts, good logos, and revenues
• Profitability - prove efficiency, discipline, and frugality
• Team - key players in place to grow

It is worth noting that Jamie met all five criteria before he looked for funding. Quite simply put, he focused on providing easy to use, easy to deploy, easy to install, and simply priced products into a market long burdened by bloated products that poorly served the customer. The pain proved to be so great that he sold Gymboree and First Republic on full enterprise deals before he hired a single employee.


How to Pitch VCs
Jamie suggested the following structure for good pitches:

• 10 slides
• be crisp, clear, and articulate about the market need, offering innovation, and sales and delivery model
  
• 5 year GAAP pro formas
• commit to the intellectual exercise of building, with the management team, and model that lays out in detail the business model and key assumptions that drive the model
  
• Demo
• Raise amount and use of proceeds
• Be comfortable talking extemporaneously about the business
• Practice and iterate
  

Not All VCs are Created Equal
Jamie suggests that entrepreneurs select VC firms that match the following criteria:

• Domain expertise - mentorship, advice, market knowledge, relationships, strategy, been there/done that
• Relationship - mutual trust and respect, genuine friendship, gut instinct positive
• Everyone rows - access to all members of the investing firm
• Patience - recognition that there is no deadline for success and that the best plans may take longer than originally forecast
• BOD - work hard to ensure a productive BOD dynamic and use VC BOD members to recruit value-added independents
• Remember that you need the BOD and VCs when things go wrong and having experienced VC investors and strong relationships will be critical in navigating the storms
  

Selling Against the Big Guys
In order to sell against giants, Jamie laid out the following suggestions

• He joked that selling against incumbents is more like jetskiing with whales than like swimming with sharks
• Focus on competing with bloated products that are overly complex to install, overly complex to price, and where the cost of sale requires very large deal sizes
  
• Sell into a market frustrated, scarred, and damaged by the incumbent vendors - lots of shelfware and history of failed implementations
  
• Pick markets where the incumbents illustrate a history of incompetence evidenced by frequent CEO changes, failed mega acquisitions, failed customer projects, etc
• Don't bloody your nose - sell where they cannot afford to compete (mid market or via delivery models they cannot afford to mimic). Don't take them head on - nip at their heels
  
• Sell deal sizes their sales teams, cost of sales, and quota models cannot support
• Leverage start-ups strengths
• Speed, agility, service
• Executive sponsorship
• Pricing flexibility
• Attention and support
• Fight FUD and vendor viability attacks
• Sell your business fundamentals when they question your viability and staying power
  
• Walk the customer through the clear demand for the product, customer references and case studies, profitability or revenue run rate, and quality of the team

Jamie and the panel did a great job and for those of you who could not make it, I hope the notes above provide some insights into Jamie's great advice and bases for his great success to date.

Venture Stats

VentureSource, a division of Dow Jones, just released their Venture Capital Industry report for 2006. The report is co-authored with Ernst & Young.

For those who follow the VC industry, below are some interesting 2005 statistics:

• Commitments to VC Funds, $22.2 bn. Up 18.7% from 2004
• VC Financings, $22.1bn. Up 2.8% from 2004
• IT Financings, $12 bn. Down 4% form 2004
  
• Software Financings, $5.11bn, Down 6% from 2004
  
• Number of Active Firms, 1,417
  
• Down 49% from 2000, 61% if you define active as > 4 deals per year.
  
• Number of exits, 397.
  
• IPOs: 41, down 38% from 2004, with $2.24bn raised via IPO
  
• M&A: 356, down 12% from 2004, with $27bn in total exit value
  
• Number of private companies funded since 2000 net of 2005 exits: 5,406 with $132bn invested in them
• Average of $24.4m invested in companies
• At current exit rate, will take 13.6 years to get through backlog
  
• Median M&A exit $47.5m
• Median Pre-moneys
• Seed $2m
• A $5.4m
• B $14m
  

Concept to Company

Next Tuesday April 18th at Stanford, Hummer Winblad and VLAB are hosting a great event titled Concept to Company.

For anyone considering starting a company and navigating how to take an idea to fruition, I strongly suggestion you attend. A write-up from VLAB follows:

"Every year, the MIT/Stanford Venture Lab (VLAB) has the honor of hosting a special session, called Concept-to-Company, moderated by Ann Winblad, co-founder of Hummer Winblad Venture Partners. Ann Winblad is a well-known and respected software industry entrepreneur and technology leader who has been chronicled in many national business and trade publications.

This years Concept-to-Company event will focus on the business formation of Cittio, a network management software company founded in 2001. No doubt, many people may question the viability for a startup to enter this mature market - where IBM, HP and other large companies own a majority share. Why would any VC decide to fund a start-up in this space? What strategies can be implemented to increase the chances of success? Hummer Winblad's investment in Cittio demonstrates how investors and entrepreneurs find clever ways to disrupt a mature industry.

In this panel, you will hear from the CEO of Cittio about their business formation strategies including; fund raising, product development and sales. We have also invited key representatives from IBM and HP to talk about how the incumbents plan to defend their turf."

Click here to read more on the panel.

Click here to register.

Post-close

Start-ups are by definition young, in constant motion, and experiencing massive change. The start-up environment and pressure to attract capital, talent, customers, and partners makes it challenging to take the time to plan carefully and wisely. I often notice post Series A close a sense of chaos amidst the hope and a need to quickly triangulate on key metrics to manage to and to report against.

Data-driven start-up management appears to be an oxymoron - there is by definition little data and hardly any trending possible. Despite the rapid changes, founders should move to quickly put in place templates, reports, and best-practices to manage with in order to reduce risk in the plan and unwise capital consumption.

Data can quickly overwhelm young companies and the real skill in management is to identify the key variables that drive value and progress. Every company is unique, however, a few useful first steps follow:

• Develop an operating plan
• I suggest the team develop, in concert with the BOD, a 18-36 month operating plan
• At a high level, the operating plan defines the business model - what drives bookings, revenues, margins, headcount, and cash...
  
• Develop a linked monthly income statement, cash flow, and balance sheet model that specifies, among other variables:
• Key assumptions regarding bookings, revenue recognition, gross margin, op ex by department, headcount hires and cost per hire, rent, benefits, T&E, IT costs, programmatic marketing spending, cash, accounts receivable, payables, deferred revenue, capital expenditures, etc
  
• Develop a compensation and incentive plan
• Incentives drive behavior. Accordingly, it is important for young companies to think through sales compensation plans that drive desired results.
  
• Similarly, senior management's compensation can be tied to critical corporate objectives, such as revenue, operating income, and period ending cash.
  
• Develop an option budget that maps to the hires forecast in the operating plan
• Post funding, start-ups typically reserve an unallocated option pool of ~20%.
• Based on the hires in the operating plan, it is prudent to develop an option pool budget that allocates appropriate levels of budget grants to the forecast hires.
  
• A cardinal sin is to blow through the option budget with key hires still TBD
  
• Develop a reporting template
• Data can overwhelm and distract. Accordingly, develop a one page tear sheet that summarizes the key financial performance indicators
• A dashboard that compares actuals, for a given reporting period, to the operating plan (this is typically called variance analysis) along:
• customer orders/bookings, average sales price, revenue, gross margin, op ex by department, operating income, total spending (net income plus capex), cash, accounts receivable, days sales outstanding, accounts payable, deferred revenue, and headcount
  
• Develop a pipeline and forecasting methodology
• Pick a sales forecasting methodology and build a sales pipeline that drives a forecast
• Develop a sales rep performance review template
• List sales reps, territories, months with the company, current quarter actual bookings per rep, year to date bookings per rep, current quarter quota per rep, total annual quota per rep and for whole team, and percentage of actual bookings to total quota for the given reporting period
• Detail rep analysis helps to understand ramp times (how quickly a rep becomes effective), which reps are performing (which begs the question why), and which reps are not performing

While this list may be exhausting, it is by no means exhaustive and I am sure people can easily add to the list. If the team lacks the financial, planning, and analysis skills required to build the models and reports, one axiom of venture capital is that hiring a part-time CFO or FP&A analysis is rarely a bad investment. Rather, taking the time to build the right plans and reporting packages can save significant capital and help keep the team and BOD focused on the material strategy issues rather than using the BOD meeting attempting to discern the financial state of the business and if management is watching the store.

Enterprise Start-up Strategy

Today, I attended Software 2006, an enterprise software conference organized by the Sand Hill Group. The conference highlighted several important strategy concepts related to how to architect a next-generation enterprise software start-up. Keynote speakers included Ray Lane, a McKinsey & Co partner, and Dave DeWalt. The following were my take-aways on salient points.

First, enterprise software start-ups must be designed cognizant of current marketplace realities. While much has been written on the subject, Ray Lane summed up the startup vendor challenges well:

• challenge of access to buyers
• long evaluation cycles and committee based buying
• integration requirements
• customization requirements
• installability
• ROI analysis and business case/spend justification development
• business model and licensing
• renewals

Second, vendors cognizant of the challenges above need to architect solutions that foot to the following McKinsey equation:

• software success = customer need x offering innovation x sales and delivery model.
• What is the need? What is the product's advantage over the current state of the art? How is the product sold and deployed?

Third, speakers highlighted certain key characteristics for success; the need to identify whitespace, build products that install quickly and easily, a linear value realized/cost relationship, an entry strategy that adds value to single users (immediate value and short and distributed decision cycles) while scaling organically to hundreds, and a total enterprise value that grows with the cumulative user count.

There was significant discussion with regards to how Web 2.0 will impact the enterprise. McKinsey posits four key areas of opportunity:

• Timely access to information and content (ex Google and Flickr)
• Improved decision making via better use of data and presentation of relevant information (ex. Zillow)
• Enhanced communication (ex. Skype, Yahoo! IM)
• Better collaboration (ex. Socialtext, Jotspot, and Typepad)

Finally, Greg Gianforte, Rightnow's CEO and founder, offered some useful insights into enterprise go-to-market strategies for SaaS companies. His key point is that large customers require choice and levels of parameterization not required by the SMB market. He laid out five types of choice to consider:

• Deployment choice (on-premise and hosted)
• Payment choice (monthly term, term net thirty, and perpetual). He made the interesting point that payment choice allows vendors to tap both capital and operating budgets.
• Upgrade choice. He believes that forced upgrades are rejected by large companies, accordingly, upgrade customization is important. This demands a competency in multi-tenant, multi-version support, with customer driven elections to upgrade from version to version.
• Integration choice. If a system of record is hosted, think through integration options and ensure pooling of relevant data is possible.
• Customization choice. Push configuration but be prepared to allow for presentation layer customization

All in all, a good day and one full of important ideas to consider when building and designing enterprise start-ups.

Marketing Best Practices

Capital efficiency and return on invested capital are the hallmarks of successful companies. Venture capital is a milestone driven investment model and companies benefit, with respect to dilution, by being able to achieve milestones and value creation on as little capital as practical.

A major area of potential inefficiency and burn is marketing. This post passes on a few marketing performance indicators that are worth tracking to ensure return on the marketing dollar. At scale, software companies spend 20-30% of revenues on sales and marketing, while start-ups, typically spend 50-60%+. Marketing, when done well, can be a critical driver of sales leads and growth. The goal must be to avoid being in a company where you feel like paraphrasing John Wannamaker, who famously observed, "I know I am wasting 50% of my marketing budget -- my trouble is that I don't know which 50%."

The goal of a start-up's marketing plan should be to drive leads into the sales process. Ultimately, management needs to track the cost per lead and the cost per close. My suggestions are to track the following

• Programs
• advertising (home page ads, newsletter sponsorships, banner sponsorships, search engine key words)
• direct email
• outbound telemarketing
• events
• Costs per program
• ex $2,000 to sponsor a newsletter geared to the target demographic
  
• Reach
• ex newsletter reaches 12,000 readers
  
• Expected response rates
• ex .5%
  
• Actual response rates
• ex .75%
  
• Costs/lead = cost per program/leads from program
• expected cost per lead = $2,000/60 = $33.33
• actual cost per lead = $2,000/90 = $22.22
  
• Leads/quarter from all programs
• Average cost per lead/quarter
• Total programmatic spend/total leads generated

Metric-driven management helps a young company quickly triangulate on what is working and what is not. Tracking costs, response rates, and the contribution of marketing to the success of the business helps make marketing more scientific and its contributions more tangible to the overall goal of reaching the next milestone as efficiently as possible.

Looking for a job in VC

In the last month, I have had the good fortune to speak to numerous graduate students regarding finding a job in venture capital. While much has been said about the process already, it appears the demand for guidance is undiminished. This post summarizes some of the advice I am giving people.

First, asking for how to get into VC is akin to asking how to get into medicine. Adam Smith famously stated that specialization is a function of market size. The VC market, while not as large as the health care industry, enjoys broad specialization and focus. As with medicine where one can be in internal medicine, orthopedics, pediatrics, etc, there are many flavors of funds with each flavor requiring and looking for different skill sets. VC firms differ by location, stage of investment, and industry focus. Later stage firms typically value financial analysis, deal structuring, and deal execution skills. Early stage firms typically value technology and market expertise combined with operating experience.

Second, the world is intensely competitive. To succeed you will need not only good fortune, but also a deep passion for the domain in which you operate. Accordingly, pick the stage, focus, and investment philosophy that maps to your skills and interests. There are simply too many smart people in the world who will run you over if you enter their market without the commensurate passion and commitment that comes from doing something you truly love.

Finally, if want to get into the early stage space, I believe the best path is the Zen approach. Ie. the harder you try the worse you will do and the more frustrated you will become. Focus not on getting into a VC firm right after graduate school, but instead on a market, company, and operating role that will provide the expertise, sets of relationships, and experiences that will prove valuable to a prospective VC firm employer. This is generally not a one year commitment but rather a multi-year investment that pays dividends in making you a more suitable candidate for hire and also provides the option value of discovering a joy for the operating side that may keep you in the executive ranks.

Larry Sonsini

Last night, I attended an HBS dinner honoring Larry Sonsini as the Bay Area's 205 business person of the year.

In his acceptance speech, Larry reminisced on a 40 year career working with growth companies. Larry's career serves as witness to the many industry changing companies started here in the valley and to his role in advising many of them along the way. By decade he rattled off a list of clients - Bob Noyce, TJ Rogers, Steve Jobs, Larry Page, Jim Clark, etc - and the pioneering vcs - Arthur Rock, Tom Perkins, Don Valentine, etc - who funded them.

He closed with a comment on three traits the great entrepreneurs all share:

• passion,
  
• adaptability,
  
• and not taking themselves too seriously.

Finally, he remains very bullish on the future of the valley. He took the audience back to the 1980s and to the fears that the Japanese would decimate the US tech industry. While he acknowledged challenges - education, burdensome regulation, etc - he remains confident that the next 40 years will be as bright if we continue to embrace change, reward innovation, promote meritocracy, and accept failure as a sign of trying something new.

Innovation Happens Elsewhere

I spent the last two days at pcforum 2006. Check out Technorati's tag page on the event for more detail. A highlight of the event for me was Bill Joy's talk. Bill discussed areas of opportunity. He commented on the threats endemic today from pandemics and of the drivers that led KPCB to raise a Pandemic and Bio Defense fund. Quick case in point - vaccination technology is still premised on 100 year old models based on using chicken eggs to grow vaccines. He also made a comment that I found very interesting, "Innovation Happens Elsewhere."

Bill's premise is that no company owns a monopoly on talent and innovation. As such, businesses need to be architected to leverage the innovation of others. Certainly the multiple benefits - cost, innovation, wealth - standards and open-systems have made possible speak to the value of building businesses that are premised on the axiom of distributed innovation. It turns out the quote comes from work done by Richard Gabriel, a distinguished engineer at Sun (Ron Goldman, Dick's co-author, pinged me to say the quote is from Bill and that they borrowed it from him. FYI). Dick Gabriel wrote a book titled Innovation Happens Elsewhere that focuses on open source software models. He has made the book freely available on his web site. I am certainly seeing the fruits of models based on the idea - open-source commerical derivatives, web 2.0 models that leverage 3rd party web services and components, and the rise and power of end-user content surpassing. As entrepreneurs design their businesses, it pays to think through how company and customers will leverage the undeniable fact that innovation will happen elsewhere.

Will Your Grandchildren See Dow 2,000,000?

Warren Buffet's recent letter to shareholder contains a few gems. In reading the letter, I am struck by his ability to simply and clearly articulate highly complex and challenging subjects - like insurance, derivatives, and signal rather than noise.

While the letter is full of interesting comments, one really struck me.

To paraphrase, from Dec 31 1899 to Dec 31 1999, the Dow Jones rose from 66 to 11,497. While a rise of 174x over the 100 years, the return to shareholders, a powerful illustration of the power of compound interest, was only 5.3%.

If we extrapolate the 5.3% rate of return over the next 100 years, the Dow Jones will close on Dec 31, 2099 at 2,011,011.23, or 11,497*(1.053)^100. The begging question is will the next 100 years see the same level of corporate wealth creation. Also, how many of you think the equity rate of return will not be higher than 5.3%? If the rate of return is 10%, for example, the Dow will hit 158,435,700 on Dec 31 2099.

Mr Buffet suggests that the replication of the past century's performance will be challenging. He argues that, "For investors as a whole, returns decrease as motion increases." His core premise and criticism is that shareholder wealth is a zero sum game. He argues that transactions (ie motion), transaction fees, and transaction agents (bankers, LBO funds, consultants) are transferring wealth from shareholders to service providers and threatening the future value of shareholder holdings. I suppose the key is to focus on true wealth creation rather than wealth transfer.

Y Combinator

Today, I had the pleasure of attending Y Combinator's Winter Founders Program Angel Day.

Angel Day is a show-case events for the eight companies currently in the Y Combinator Program. Twice a year, the Y Combinator team selects 8-10 teams and provides them intense coaching, $6k in seed money per person, and the opportunity to build a company and product. While cynics may associate Y Combinator with the now pejorative synonym - incubator - I left struck by the incredible energy, creativity, and productivity of the current crop of companies. It is simply remarkable what 3-4 very smart and very dedicated engineers can build in 10 weeks. Read the NY Times article for more on the model. In brief, in return for the micro-seed investment, Y Combinator takes a ~6% stake in the company. The plan is to be very Darwinian - companies either take hold and flourish or go the way of all flesh. The Summer program is full but start thinking about applying for the winter program.

While I will not jump ahead of today's companies launch plans, a few public Y Incubator companies include Reddit, Textpayme, and Kiko.com.


Thanks to Paul, Trevor, and Jessica for a great event.

In Honor of National Proscrastination Week

Cassandra

Bill Gross, Chief Investment Officer of PIMCO, writes a monthly essay, the Investment Outlook. PIMCO is a large fixed income investor and Bill's essays are wonderful reviews of economic, fiscal, and public policy.

His current essay - The Gang Who Could Not Talk Straight - is a highly critical review of the President's annual Economic Report.

In short, he argues that America's competitive position is being undermined by a collapse in our educational systems, sky rocketing health care costs, the lowest national savings rates in the developed world, and an addiction to foreign investment to cover for our inability to save. His conclusion is that these macro failings demand that investors begin to ship capital offshore to more attractive markets. His warnings, however, are important for all to hear. Hopefully, he and others like him, see Pete Peterson, will not be seen as Cassandras, but as concerned patriots helping us wake up to our daunting realities.

As investors, entrepreneurs, and technologists, we have a vital interest in functioning educational systems, health care markets, and positive net savings rates that allow for investment in the future rather than debt service payments to cover historical obligations and spending. If Gross Domestic Investment = Private Saving + Government Saving + Foreign Saving, then the low rate of private and government savings demands that we import capital. The key concerns are 1) that the debt service associated with the current borrowings drowns out the ability for net new investment or 2) foreigners stop providing us cheap capital and dollars available for investment (and hence growth) are limited.

A couple of his charts help tell the story.

Broadcast versus Subscription Business Models

At Hummer Winblad, we are seeing a tremendous number of innovative consumer-facing subscription services. Be it on-line storage, photo sharing, social networking, or other creative ideas, there appear to be a myriad of businesses emerging that are dependent on subscription-based business models. A major challenge looms for these young companies in that the major Internet companies' business models - Yahoo, Google, AOL, and MSN, are based on broadcast economics. Their revenues are are tied to page views and ad impressions rather than recurring application revenues. Accordingly, many of the consumer companies we meet with boast great teams and compelling technology, however, their business models are orthogonal to the business models of the dominant Internet companies, whose models allow them to aggregate and provide compelling services and content for free.

Broadcast companies are incented to provide the best content and services possible to draw in more users, more page views, and more ad impressions. Broadcast businesses seek to maximize revenue per impression/costs per impression, and the wonderful scale these models have achieved with respect to ads sales, affiliate models, and infrastructure costs provide for rich marginal profit margins. Scale allows for economics of scope, whereby they can offer great services - for free - knowing that their costs to offer the service are far lower than competing pure-plays and that their ad businesses will reward incremental users and page views.

Subscription companies require a certain level of free to paid conversions to make sense. The challenge is that to compete with the free versions, vendors get caught in a feature battle, where each incremental feature is valued by an increasingly smaller pool of people. Google and Yahoo are able to hollow out subscription businesses, if and when they choose to enter a given market, and stand-alone companies without ad network revenues and dependent on subscription services suffer the consequences.

Subscription models are, in general, driven by four key areas: cost per acquisition, monthly average revenue per user (ARPU), free cash flow (EBITDA), and churn (cancellations/average users per period). Subscription models require a clear focus on acquisition costs, strategies to drive ever higher ARPU, and customer retention strategies. I meet with many companies who are well-versed in subscription economics, however, their business plans often do not sufficiently factor in the power of broadcast/ad models to challenge their revenue models.

Internet broadcast models appear to be dominant on today's Internet. Unlike a focus on ARPU and churn, broadcast models seek to optimize their ability to profile their user base and to serve increasingly relevant adverstisements to their users. Competition centers not on conversion ratios, churn, and subscription revenues, but rather on powerful analytics, user segmentation, and behavioral analysis that allows for "perfect" ad targeting.

Each model relies on a different set of competencies and different set of goals. Consumer subscription models seek to entice free trial users to move to paid services, while broadcast models seek to maximize users and monetize them via advertising.

IMHO, when designing a model today, start-ups should focus on the type of model most likely to succeed - broadcast or subscription - knowing full well that the major players will continue to add functionality and services in a quest for more page views and ad opportunities.

PS. What is interesting to me is that on cable and radio, we are seeing the rise of subscription services challenging broadcast media - eg. HBO and XM Radio. This may be a function of FCC restrictions on broadcast content but is an interesting contrast to the current consumer Internet.

Stanford Panel on Software Trends and New Company Formation

This Thursday at Stanford, Hummer Winblad and BASES are hosting a panel on software trends and new company formation.

Please see the above flier for details. We are lucky to have a wonderful group of panelists committed to the event. Please feel free to attend if you are in the area.

The Kiss of Death

Venture capital is often described as a business of pattern recognition - experienced investors pick up on market patterns, management team dynamics, and seemingly random data points to draw powerful insights. While I am still relatively new to the industry, I am struck by a few capital structure patterns that are generally bad omens.

The Too Large "A" Round
Ideal company formation reminds me of agile programming - small teams driving quick, iterative cycles that allow for the most insights, appropriate changes in strategy, and, ultimately, the highest quality "product."

I often say that genius is a function of context, and until a company is fully immersed in the context of the given problem set the best insights and strategies are often not apparent.

Too much money too early and too many people too early interferes with the productive process of iteration. Large teams with lots of resources and a very uncertain sense of direction or purpose are a bad combination.

Too High "A" Round Post-Money Valuations
While a self-serving argument, an equally challenging problem is a too high "A" round post-money. High "A" round valuations are often Pyrrhic victories. High posts and middling execution often leaves a company in a grey zone whereby objective value creating milestones have not been clearly met, yet some qualitative progress has been made. A common result of such a financing is a bridge round that extends the runway and is designed to allow the company a quarter or two to "grow" into its post-money "A" round valuation. More often than not, the bridge becomes a pier and the company and founders suffer from a post-money that proved you can win the battle and lose the war because of it.

"A" round financing strategies should be tied to discrete logic tests and proofs and the goal should be to optimize the validation/dollars ratio. Can we validate the technology and business model on as little as capital as possible? The ratio forces founders to think through the material questions that need to be answered with the use of proceeds. Will the product work? Will customers buy it? Can we sell it? If so, how? How much do we need, with a slight cushion, to answer these questions? Given all the noise in a start-up, what are the real issues and risks we need to manage? The validation/dollars ratio is a measure of efficiency and a quasi measure of return on equity. Start-ups that maximize the ratio are generally rewarded for it.

A reasonable Series "A" raise and post-money combined with realized value-creating milestones generally leaves a company in an enviable position when raising the Series " B". The key hypotheses have been validated and a reasonable mark-up is possible.

To that end, Cooley Goodward's recent report on trends in venture capital reported that the median Q305 valuations for A-D rounds were $5m, $12m, $23.5m, and $41.71m respectively.

Patterns and data suggest that for software companies an $8-10m "A" post appears to maximize the probability of a healthy B round and good optics and pattern recognition.

DEMO

I will be at Demo next week in Phoenix. Given all the dynamic activity in the start-up world, I expect to see some great new companies emerge from stealth in AZ.

To set up a time to meet or grab a drink, please ping me (wprice@humwin.com).