VC Returns through 12/31/06

Today, the NVCA released venture capital returns performance data through year-end 2006.

The data suggest an early, if not yet sustained, recovery in venture performance.

While Keynes famously said, "In the long run, we are all dead;" retrospectively the long-term investment returns are excellent.

The key question is whether the current structural reality - i.e. # of funds, amount of committed capital - of the venture industry will support like returns over the next 10-20 years.

Returns are driven by two key components, systematic returns and idiosyncratic returns (see CAPM model). Systematic returns are market returns. Idiosyncratic returns, however, are where professional investors earn their stripes - they are returns in excess of the market.

To be a decent investor, one must at least deliver systematic returns. To be a great investor, one must deliver idiosyncratic returns. In the bubble, random investments looked genius. The systematic returns (returns for the asset category at large) were simply amazing, thereby creating great wealth and perhaps reputations for genius that were more due to circumstance and timing than investing prowess.

The questions for us to ponder is what will be the future systemic returns to the venture capital asset class, and has the inflow of money and people into the venture capital industry made it impossible to generate idiosyncratic returns. Are funds' returns systematic (an index of the market) or extraordinary? Will there be a Vanguard-like vc fund that is a low-fee provider of index funds for the private markets!? What is the basis for extraordinary performance over the market index? Is the success of vc investors and funds due to serendipity or to process?

These are key questions for investors (both general and limited partners). Can one deliver quality returns in an industry full of capital and people chasing "good" ideas?

One key difference between the public equity markets and the venture capital markets is the degree to which information is transparent. The public markets are by regulation open and transparent with data available to all.

The private markets are marked by imperfect information, proprietary insights, and information asymmetries. Certain private investors simply enjoy access to information, ideas, and talent that are not generally available to others. For example, certain leading firms leverage the footprint of their portfolio (talent, ideas, reach) to drive insights that lead to investments that others are not in a position to make. An obvious example, is Sequoia Capital's investment in Yahoo! and Google. With a BOD seat at YHOO, Mike Moritz enjoyed access to information relative to GOOG's search technology simply not available to others weighing the decision to invest in GOOG, presuming they even had the chance.

The question for venture capitalists may be as simple as, "what do I know that others don't?" With the corollary, yet vital question begging, "will I be smart enough and sufficiently certain of myself to act on such information?" For as Keynes famously once said, "Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally."

If one knows nothing proprietary, has no unique relationships, access to ideas, and information, then life may be very challenging.

Limiting H-1Bs: Economic Suicide

In a prior post, H1-B Aliens and the Myth of Free Labor Markets, I wrote,:

"In my daily meetings with founding teams and start-ups, there is not a single company that does not have an emigre as a key member. The contribution of Indian, Chinese, Russian, Bulgarian and other nationals to our economy is beyond question and a vital source of our success. From professors, to engineers, senior managers, company founders, and venture capitalists, our current success and prosperity is very positively influenced by our ability to attract the best and brightest to work and study in our country.Unfortunately, America, while often a champion of free trade, is not a practioner of free labor markets. While technology talent is perhaps the most important input in Silicon Valley's decades of innovation, the US government artificially caps and limits the number of ambitious immigrants to our economy ."

This week's Economist includes an article titled Deportation Order.

Since 2003, the US government has reduced the number of H1-B visas by 66%; from 195,000 in 2003 to a measley 65,000 this year. Within hours of the application deadline, 150,000 applicants submitted visa requests; a frightening 85,000 on-time applicants lost out to a random number generator that selected the lucky winners.

The article quotes the Harvard Crimson commenting that "many of the foreigners in its class of 2007 have received their deportation orders."

The valley's position as the leading cluster for technology innonvation is contingent on the seamless flow of ideas, capital, and talent. Artifical limits on the ability to source talent will have profound downstream consequences, reducing the quality of innovation, wealth creation, and utility.

If you feel so moved, please reach out to your Congressperson and Senators; for how to contact your House representative click here; for your senator click here. Ask them to eliminate ariticial limits that are keeping the next Sergey Brin's of the world from joining us.

Large Companies - New Equation of Big Company Behavior

Start-up time is to dog years as enterprise time is to human years. Start-ups move 7x faster as the urgency of the next fund raising, competitive threat, cash position, etc... drive Herculean efforts.

A familiar start-up complaint is that the contrast in cadence (btwn small and nimble and big and slow) is incredibly frustrating. The time it takes to negotiate on OEM deal, partner with, sell to...large companies is often maddening.

Yesterday, over coffee with a great entrepreneur I heard the frustration summed up in a moment of brilliant wit.

The entrepreneur argued that:

an individual's competency x company size = a constant

In essence, the bigger the company, the less competent the people.

Now, we all know that there are many smart and hard-working people at large companies. There is, however, also a common malaise that somehow limits the ability of large companies to make decisions, to move quickly, and to be productive.

Many of my friends work at large tech companies and frequently complain of the siloed thinking, the blackbox decision making, the inability to make decisions, and the frustrating inability of the company to harness the collective energy and initiative of the group.

Why?

What is it about size that limits effectiveness? Why do people feel so powerless in large company settings and so frustrated?

While there many reasons, I see three core drivers

1. incentives
1. the incremental compensation that accrues from initiative is not worth the risks and costs of fighting the corporate inertia
   
2. politics
1. a preponderance of energy is invested in internal battles
   
2. companies and individuals have finite stocks of energy
1. employees of large companies spend more energy on internal issues than on external customer facing and value-creating issues
   
3. dead wood
1. large companies become safe harbors for mediocrity
2. middle management gluts the system and limits the ability of the young and the restless to advance
3. the Wall St "up or out" culture ensures the young hard chargers always have room to advance and that seniority and tenure are no guarantee of protection

While the "constant" above is certainly extreme and unfounded - it underscores the failing of many large companies to provide exciting career choices to younger go-getters and a suboptimal use of talent, resources, and energy.

VC Interviewing Best Practices

VC firms hire infrequently. Given the slow cadence of new hires, it is critically important to hire well.

Two years ago, when I interviewed at Hummer Winblad, I went through the traditional in-person interviews where partners probed my educational, operating, technology, and investing background.

The last step in the hiring process, however, proved to be the most challenging and most rewarding. After having met all the partners, I received a call saying that things were looking good. There was one more step, however, that they wanted to me to pass. I remember thinking, okay...what now?

The request...come in two days from now and present your thoughts on the future of the software industry to the full partnership. The guidance...don't mess it up as things were looking good.

I presented the embedded deck to the HWVP team. Since then, I have been asked many times about the process of interviewing at venture firms and what to expect. I believe that a "best practice" is to give the candidate a platform to share their thoughts and analytical skills. One should be prepared to white board or present a deck that lays out an investment thesis, sample company of interest, etc; thereby providing a window into how you think.

The key point is not the deck itself, but rather a "candidate pitch" moves the process from conversation pleasantries to structured information exchange.

The file can be downloaded from here.

The Value of Scenario Planning

A standard part of the investment process is to identify a business model's key variables and to generate scenarios that test their impact on revenue and cash.

Sure signs of a thoughtful management team are:

1. the ability of the management team to articulate the material business drivers in the model
2. to test the impact of the variables on material financial metrics
3. to sanity check the assumptions with market comps - i.e. not to base the business on a black swan outcome
   
4. to focus the management team and company KPIs on the identified variables.
5. the inclusion of scenario analyses in investor presentations
   

A very effective means of testing variables is the data table, which allows one to test how different input variables affect the results of a given formula.

The attached example illustrates the value of data tables in analyzing

• the impact of CPM rates and
  
• revenue share on an ad network.
  

The analysis takes the company's forecast and key assumptions and calculates the required page views to hit the plan. The requried page views are then compared to known market comps to test for "black swan" risk. Finally, with CPM rates and revenue share the key variables, a data table tests the the impact of a range of CPM rates and revenue share splits on the page views required to hit projected 2008 revenue.

For example, the analysis illustrates that for the company to hit 2008 revenue

• at a $5 cpm, 20% revenue share
• the company needs to grow monthly impressions to
  
• 333.33m PVS/month
• 6.67x current traffic
• 56% of MSNBC's current monthly traffic
• However, at a $2 CPM and 10% revenue share
• the company needs to grow monthly impressions to
• 1.666bn PVS/month
• 33.33x current traffic
• 282% of MSNBC's tarffic
• Ie, the model begins to look precarious and "black swan-like, ie possible but highly improbable"
  

In summary, the effective modeling of scenarios helps to highlight the impact of key variables on the business, helps communicate the maturity of the management team's thinking, and frames the sanity (relative to market) of the plan in question.

Board of Directors

Corporate America is intensely focused on corporate governance and on the duties of Directors. Whether CEO compensation, corporate performance, ethics, financial statement integrity... boards are increasingly subject to exacting standards and accountability.

Students of finance are familiar with the principal-agent dilemma; management, agents of the principals, often fail to act in the best interests of the principals, shareholders. The degree to which directors are truly independent speaks to their ability to ensure agents maximize shareholder and not agent wealth.

Warren Buffet believes there are four key requirements for board members:

1. owner-orientation
2. business-savvy
3. interest
4. true independence
   

Private equity and venture capital structures eliminate large measures of principal-agent issues.

How? Ownership is concentrated into the hands of a few firms who have direct board level representation. By definition, VC board members are owner-oriented and interested. Whether they are business savvy is subject to a case by case analysis, while independence is not possible.

The question for venture capital boards, therefore, centers not on how best to represent owners, but rather on how best to create a productive board that maximizes the probability for company success.

On Wednesday, I am speaking at the LA VC 2007 Investor Conference. My panel is focused on "Building Boards." Since, my specialty is early stage venture, my thoughts on an ideal board follow (modeled on Buffet's four criteria.)

For aspiring entrepreneurs, I would seek a board with the following characteristics

1. small and nimble
1. 3-5 total directors (CEO, 1-2 VCs, 0-1 independent)
2. start-ups are fast paced and iterative; often board issues are event driven and pre-scheduled meetings often fail to coincide with the natural cycle of progress
3. being held hostage to scheduling logistics drives CEOs nuts and delays the time to decision and action
   
2. economically aligned
1. if the economic incentives of the board are different, consensus regarding financings, M&A events will become more complicated
2. if people make money at very different exit outcomes...
   
3. empowered
1. ensure the VC board member is well established at their firm and has "juice."
2. the start-up road is long and bumpy, VCs with limited internal power are often more proxies than decision makers and their limited internal power may unfairly taint the credibility of the company
3. their political weakness will limit their ability to support the company in times of peril
4. value-added
1. VCs must be able to accelerate the cycle time to success and understand the business
2. The best VCs truly understand the human, financial, and market dynamics of their companies
   
5. effective CEO-board and director-director communication
   
1. CEOs must share information - both good and bad
   
2. Directors need to work well together in executive session issues: compensation, audit, financing and other core issues
3. Failure to act quickly on compensation/bonus programs and other executive session issues impacts morale and limits the effectiveness of company management
   
6. informed directors
1. Early stage companies need to begin to track, measure and report on relevant and timely data. Good board packages make for good board meetings.
2. This is normally an iterative process but data and KPIs enable informed decision making and analysis
7. productive processes and meetings
1. Develop well structured meetings with adequate frequency and cadence
2. Focus the meetings on critical path issues
   

As companies grow, the size, make-up, and roles of the Board change with it. This post reflects my observations of the critical success factors for healthy, functionining Series A boards.

For a more in depth analysis, please read "The Basic Responsibilities of VC-Backed Company Directors."