Bruce Sterling on Sun, 2 Sep 2001 08:42:22 +0200 (CEST) |
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<nettime> Engineer's Guide to Venture Capitalists |
(((It's the "greatest legal creation of wealth in history"! Engineers Versus Capitalists in an incestuous death-struggle for the future of civilization! Nerds versus Rich Guys... place your bets, ladies and gentlemen -- bruces))) http://www.spectrum.ieee.org/WEBONLY/resource/sep01/speak.html 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. (...) 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. (((Where's the T-shirt? -- bruces))) 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. (...) # distributed via <nettime>: no commercial use without permission # <nettime> is a moderated mailing list for net criticism, # collaborative text filtering and cultural politics of the nets # more info: majordomo@bbs.thing.net and "info nettime-l" in the msg body # archive: http://www.nettime.org contact: nettime@bbs.thing.net