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.

(...)

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