Altos Ventures Musings

Overcommitted

Hard working entrepreneurs and their companies often feel over-committed. There are always too many things to get done and not enough resources.

One of our companies that is growing at 200%+ this year was feeling that way and we had a serious discussion about various options. One was to do a better job of account management so that expectations of customers and partners do not get ahead of our ability to deliver. Another option was to raise more funding and hire more people. A third option was to make tough decisions about what to cut (this is not an exhaustive list but will give you a flavor for the discussion).

The third option is a hard one to swallow, especially when things are going well. We have customers lining up and a window of opportunity that may close if we don't go for it - NOW! An easy answer would be to raise more money and ride the momentum.

After much discussion/debate, we made a decision to cut. We did not cut people. In fact, we will continue to hire. But we cut some very promising initiatives and we will have to turn away customers that are ready to pay (or have already paid).

Cutting can be scary, but it can also be liberating. It is not 100% clear that we made the right decision but here are two interesting quotes to think about, if you ever find yourself in a similar discussion with your board/investors:

"The essence of commitment is making a decision. The Latin root for decision is to 'cut away from,' as in an incision. When you commit to something, you are cutting away all your other possibilities, all your other options."
    -The Lombardi Rules, Rule #6 - Be Totally Committed 

"A great company is more likely to die of indigestion (from too much opportunity) than starvation (from too little)."
    -David Packard ("Packard's Law")

Don't Worry, Be Scrappy

“Don’t worry” does not exactly sound like responsible advice at a time like this. After all, we often remind our CEOs of Andy Grove’s famous adage that “only the paranoid survive”.

But it is a serious piece of advice that we are giving to all of our portfolio entrepreneurs. Over the last two weeks, many of our portfolio CEOs (and fund investors) have been asking us for our take on the current financial crisis. So here it is:

The bad news

Let’s first understand that things will be bad – really bad. In fact, this downturn will almost certainly be deeper and longer than the post-Bubble “nuclear winter” of 2001-2004 that so many of us struggled through as entrepreneurs and investors. That crash was precipitated by a financial bubble seeded largely by the venture/technology markets and abetted by all-too-willing public investors. But despite the fall in IT spending and concurrent drop in the NASDAQ index, the general economy kept humming along. In the five dark years following NASDAQ’s peak on March 9 2000, the Dow Jones actually went up. In the same five year period, the national housing price index nearly doubled. Most Americans hardly noticed the Internet Bubble and crash.

Now this is a totally different story. This economic crisis is about all of us. It’s about a fundamental realignment in global asset values. Whatever happens to venture/technology will be collateral damage, but will likely be worse than what we in tech experienced after the Internet Bubble. If that felt like a nuclear winter to tech companies, this one may well be an ice age for all of us. We may be wrong about this, but we’d rather be wrong on the upside than wrong on the downside.

The good news

As an entrepreneur, there are a lot of factors that figure into your success or failure. Some you control and most you don’t. Macroeconomics is one that you certainly don’t. So if, like me, you believe in worrying only about the things you can control, then this is a great time to get focused on building your business and stop fretting about the economy (see Focus on the Controllables).

In fact, a recession is probably the best time to start a company. Great companies like Disney, GE, HP and Microsoft were all started during recessions. As the clever folks at Google like to say, “creativity loves constraints”.

Why?  Bad times can build good DNA.  A down economy does not leave room for entrepreneurial sloppiness. It forces entrepreneurs to be honest about how good their products are. It mandates financial discipline. In other words, it is a perfect time to get focused, get real and get lean.

After the giddy NASDAQ highs of March 2000, it took most people way too long to come to grips with reality. I had personally just joined the venture business and my first company, Evolve Software, went public in August 2000 – a full half year after the peak. Most companies did not start cutting back until late 2001 and by then it was too late. The smart and lucky ones survived the ensuing five years and some became big winners. But most companies just ran out of money and ran out of time.

The rules

Plenty of smart people have already made prudent recommendations to their teams about what to do in this environment, so I won't repeat. See in particular Sequoia’s doom and gloom presentation to their portfolio CEOs earlier this week and Jason Calacanis’ email. But let me summarize with just two simple rules that we've tried to impress upon all of our CEOs:

Rule #1: Don’t run out of cash.

Rule #2: See Rule #1.

Then, go out and build the next great company.

Ousting the Founder

I was shocked to learn this week that Diane Greene, the co-founder and CEO of VMWare was ousted. I was not alone. Except for senior management (who found out very late, the night before) the employees of VMWare read about it, just like I did on Tuesday morning.

I guess $1.3B in revenues, $14B market cap, 50% growth rate and market dominance was not good enough for the board/EMC. One slight miss in one quarter and BANG! You're out. Perhaps the board believed industry pundits and worried about competition from Microsoft. So they brought in a "heavy hitter"...former Microsoft exec Paul Maritz as CEO.

I'd guess that the more likely reason was that Diane Green was a difficult person to deal with. There is no doubt that she was a controversial CEO. It was her way or the highway and she churned through senior execs (especially in sales and marketing). She never gave much respect to the folks at EMC either (who owned the vast majority of the stock - and controlled the board).

Some other hard-headed, "controversial" founder/CEOs that come to mind are Bill Gates, Larry Ellison, and Steve Jobs. These founders may be difficult to deal with but I'd rather go with them than take my chances with a new hired gun CEO.

Over the years, we've observed that it's difficult, if not impossible, to match the passion and commitment that founders bring to their companies. It's not just a job for them. It's deeply personal. The difference in commitment is akin to the differences you might observe between missionaries and mercenaries (or hedgehogs versus foxes).

Look, I have nothing against Paul. I'm sure he's a very smart, capable and hard working guy. But this whole situation reminded me of the time Steve Jobs was ousted from Apple more than 20 years ago.

As co-founder and CEO, Diane Green built one of the all time great successes in Silicon Valley. Very, very few companies ever reach $1B in revenues. Even fewer in the technology industry. Even fewer in the software industry. And even fewer ever exceed $10B in market cap.

Why the hell would you fire her?? No, don't tell me...I've heard all the reasons. VCs oust founders all the time. I've been in plenty of board level discussions around this topic!

It's almost a rite of passage in Silicon Valley. As a founder, you start a company, get VCs to fund you, recruit a "world class" management team...and eventually, find your replacement (or get ousted).

What people seem to miss, however, is that just about every great company ever created - in technology as well as low-tech, was built by a founder (or a CEO who happened to join the company very early in its growth phase) and a team of dedicated people who grew with their companies.

I don't believe in "world class" management in the generic sense. "World class" in what??

What I believe in is people who learn on the job and become - over time - the best at what they do. Along the way, they make plenty of mistakes. But that's part of the learning (and perhaps the luck of it - because the mistakes happen to be not fatal for the survivors).

Think about it. Some examples of great companies led by founders for decades are GE, UPS, FedEx, Wal-Mart, Southwest Airlines, HP, Intel, SAP, SAS, Apple, Oracle, Microsoft, Adobe, Sun, Dell, Qualcomm, Broadcom, Nvidia, Dolby, Amazon.com, Salesforce.com, etc.

There are some great companies where the original founder(s) did not grow the company but the CEO who grew the business to $1B+ in revenues joined very early on in the life of the company (typically below $10mm in sales): IBM, McDonald's, Starbucks, Veritas, Cisco and Google are examples.

It'll be interesting to see what happens. Even a founder hanging on to the bitter end won't save some companies (i.e. Wang, DEC). But I'd rather take my chances with the founder who built a $1B business from scratch than go with someone new.

The average tenure of the CEOs in our three largest companies is 9 years. They learned on the job. None of them had been CEO before we started working with them. None had much experience in their industry - the market did not exist, and the technology and business models had not yet been invented. But they are guys who took us this far (average sales of nearly $90mm this year) and we will gladly stick with them as long as they still want the job.

I'd rather take my chances with the people who built the business and grew their companies than the "professionals" - the hired guns - the mercenaries - coming in, after the fact, to "fix" things or to "take it to the next level."

We tell all of our companies this - if you want to build the leader in your industry, you have to have the world's leading experts in your field working for you. But do NOT expect to find them outside of your company. Someone senior from the outside won't come in to show you the way. They won't save you.

Think about it. If you can go outside and hire a CEO or other very senior executives to come in to YOUR company and tell you what to do and how to do it - better than you - then you've created nothing special. There is no secret sauce and you have NO CHANCE of building a truly great company.

We like to tell all of our companies this - the world's leading experts in your business will be the people you develop. The young people you hire today will be your future leaders. Five to ten years from now, they will BE the world's leading experts in your business. You will have to figure it out - together - along the way.

Don't count on those mythical "world class" managers to come in to save the day. Not only are there no guarantees, I believe they will end up hurting your chances of building a special, lasting company. If you do try to hire them anyway...good luck. What I will guarantee is this - they will negotiate HARD for a nice severance package.

No Substitute for Time

Like many things in life, there is no substitute for time. A solid enduring company takes time to build for a number of reasons.

Markets take time to develop. How many times have you encountered venture-backed companies that reminds you of startups that failed years ago? These companies were too early to market. The infrastructure wasn’t there the first time around. The experience wasn’t right the first time around. The customers weren’t ready the first time around. Startups, by their nature, are early to the market and they have to wait for the market to catch up. Many startups try to push markets to develop faster with evangelical selling and marketing, essentially substituting time for money. But, success is rare and certainly expensive. More often than not, they pave the road to riches for companies that follow them.

Companies take time to develop. Look at the history of “overnight successes” and you’ll find that they actually took many years. That’s certainly true of many of the larger and enduring companies in Silicon Valley. On average, venture-backed startups take seven to eight years before an exit of any kind. Looking at IPO’s over the past several years (post-bubble), companies take an average of eight to nine years to exit. Products take more time to perfect, business models require more experimentation and sales take more time to ramp than expected. Some of the best companies we have backed have taken several years and several course corrections before finding success.

Managers take time to develop. Nothing beats learning from experience, but this takes time. You can try to learn from others, but nothing leaves as strong an impression as personal experience. Over the years and over the dozens of companies we have backed, we’ve come to recognize that certain pitfalls develop time and time again. We’ve found that no amount of cajoling or arguing can keep management from avoiding certain types of mistakes and that in some cases we shouldn’t try.

There’s no better teacher than reality. We try to minimize the impact of mistakes and help avoid repeating them. Many companies seek to circumvent the need for time by throwing out the founders or current management and parachuting in "proven" people with built-in experience who have “done it before.” Unfortunately, they’ve done it before elsewhere. Each company, especially at startup, is unique and offers different lessons to learn. And by jettisoning existing management, the company can lose valuable experience and learning that has already been acquired.

That solid businesses take time to build seems obvious. Yet again and again, we see entrepreneurs who present business plans that show growth from zero to $100 million in five years or less. Again and again, we see investors who want or expect such growth and dismiss companies with smaller numbers as unsexy, unambitious, niche opportunities.

All of this is not to say that a startup need not move fast or that we'll wait around forever for people to learn from mistakes. Let’s not confuse the fact that some things take time with a low sense of urgency, moving slowly, or tolerating inept management. A startup should always move as quickly as it is able. It is the ability to move quickly and nimbly that gives a small company an advantage. But if a startup is moving so quickly that it is years ahead of the market, or never has a chance to develop a sustainable business, or allow its people to develop the skills to run the business, it will not develop into a solid enduring company.

All of this is to say that entrepreneurs and their businesses should be pragmatic even as they keep pushing harder and harder, trying to do what may seem impossible to those with less faith. Decisions should be made understanding that some things just take time. A startup should be capital-efficient. The cash burn should be low so that you can wait out immature markets, so that you can experiment with the business model, so that you can change course when necessary, so that you can learn from experience, so that missteps are less costly. Managers should question the rate of growth, especially in the early years. How ready is the market in reality? Do plans account for the time necessary to tinker with the business, the fact that people need time to learn, the reality that many of the new hires won’t work out?

As they say, you can’t put nine women in a room and deliver a baby in a month. The process can’t be rushed. The same is true of a truly good company. We back entrepreneurs who appreciate this and plan for it.

Cargo Cult Capital

During a Caltech commencement address one of my childhood heroes, Richard Feynman, introduced a tribe of people who practice a peculiar form of science. Here  is an excerpt:

"In the South Seas there is a cargo cult of people. During the war they saw airplanes with lots of good materials, and they want the same thing to happen now. So they've arranged to make things like runways, to put fires along the sides of the runways, to make a wooden hut for a man to sit in, with two wooden pieces on his head to headphones and bars of bamboo sticking out like antennas -- he's the controller -- and they wait for the airplanes to land. They're doing everything right. The form is perfect. It looks exactly the way it looked before. But it doesn't work. No airplanes land. So I call these things cargo cult science, because they follow all the apparent precepts and forms of scientific investigation, but they're missing something essential, because the planes don't land."

In past articles, we've described VC investments as "controlled experiments." We don't build new businesses through random trial and error; we develop them through a process of deductive tinkering. We try things out and perform tests against market realities, the way that scientists set up experiments to test hypotheses - and iterate and adapt along the way.

Unfortunately, almost three hundred years into the scientific revolution most people still don't get it. Perhaps this should not be a surprise. From a genetic perspective, humans beings are still pretty much identical to neanderthals who honed their instincts roaming the Earth for more than two million years.

Using Feynman's analogy, many people practice a form of business which I call "cargo cult capitalism." Delusions in the business world have been covered in books such as "Fooled by Randomness," "Hard Facts" and "The Halo Effect" so I'll focus on a special form of cargo cult capitalism practiced right here in Silicon Valley.

In our neck of the woods, the planes revolve around "top tier" venture capitalists who have become mini celebrities...sort of like in college sports, where coaches tend to be the stars (in the big leagues players are the stars). If entrepreneurs are fortunate enough to get funding from a Silicon Valley celebrity, their company might gain instant credibility and become branded as the next hot thing.

There are service providers who market the fact that they have "access" to the top VCs. There are later stage funds who raise money based on claims that they can access deals of the top firms. There are also angels and "feeder funds" who hope to co-invest with top VCs by courting them from the other side. They cultivate relationships with powerful deal makers and give them first looks at deals so that they might invest once key "milestones" are met.

The cargo cult capital wheel keeps spinning around and around...as the crowds scramble to "get in" to what is hot (or what they speculate might get hot). Once funded, some entrepreneurs might feel like they are playing with the big boys. They retain the top law firms, the best PR agencies, and the most exclusive recruiters.

Armed with prestigious backing and exclusive relationships of kingmakers, the hottest companies hire the best talent that money can buy. The hired guns then create more frenzy...attracting even more capital to support ballooning headcounts and lofty salaries.

There are definite patterns followed by the cargo cult crowd. The form is perfect - the top deal makers, "world class" talent, a hot sector and business model du jour. Yet, ironically, I'd bet the next Bill Gates, Michael Dell, Phil Knight, Chuck Schwab, and Sam Walton are quietly going about doing their own thing...building companies based on business fundamentals.

Real entrepreneurs cut through the hype - they know what is essential. Their sense of pride doesn't come from who they know or what others think - it comes from making a contribution and creating value. They will do it their own way - which won't include wads of cash from outsiders. They figure out how to do more with less by using their brains, guts, and sweat.

Disruptive new entrants that topple giants belong to determined, frugal and independent minded entrepreneurs - and in their minds, the true stars are the customers they serve and their tireless co-workers who help turn dreams into realities.

Swinging for the Fences

I recently sat on a panel with Howard Hartenbaum, the founding investor of Skype, which yielded a 1,400x return in 36 months. Howard humbly noted that he was fortunate to have had such a deal so early in his VC career. In his words, "Skype was not the deal of a lifetime, it was the deal of three lifetimes!"

Venture capital is a hits driven business. Over time, it's likely that only 20% of the deals will generate 80% of the profits. (The 80/20 rule originated from Vilfredo Pareto's observation that 80% of his peas were produced by 20% of the pods. He also noted that 20% of the people owned 80% of the land in Italy).

Apply the 80/20 rule to the top 20% and the Pareto principle says that 4% of the deals will produce 64% of the returns. Apply it again and less than 1% of the deals will produce more than half the returns. You get the picture? It’s all about the homeruns.

Given the concentration of returns, LPs are lining up to invest in the "top funds" who have hit the biggest homeruns. Top venture funds are over-subscribed because it is believed that those who produced great returns in the past will continue to do so in the future.

As time passes, the gap between the winners and losers often gets wider. For example, about half of all returns in the VC industry have been generated in public markets due to post IPO (or acquisition) run-ups prior to distributions. If lock-ups and holding periods were longer, the gap would get even wider.

However, in the frenzy to "get in" to top funds, people seem to have doffed their thinking caps at the door. Even as the most sophisticated LPs are cutting back from many so called "top firms," new LPs to the asset class are not only taking their place but piling on.

Impact of consolidation

Over time, consolidation happens in just about every industry and venture capital has been no exception. A small number of firms have been growing to control a large percentage of the capital. Even firms with mediocre track records have been expanding in both scope and scale (because they are still considered to be "brand name" firms).

It's hard to turn down all that money flowing in, especially once people get used to a fancy lifestyle, nice offices, support staffs, and lofty salaries. Assets under management has become the proxy for success and VCs are becoming accustomed to making more money from management fees than carried interest.

With growth, the mentality of VC investment professionals has changed. When people get paid for activity (putting money to work) rather than results (which may take years to sort out) you will get more activity. Compounding the problem, there are pressures mounting to hit even bigger homeruns.

VCs are making bigger bets than ever (which are needed to move the needle on larger funds). Unfortunately, this is leading to value destruction of unprecedented proportions. Between 1990-2001, 63% of invested capital resulted in almost total loss (the median deal lost money). In contrast, between 1969-1985, partial or total losses occurred in only a third of the deals.

Predicting the future

A VC's job is to pick winners that emerge out of a confluence of technologies and markets. Some people seem to think that they can keep doing it even with bigger piles of money. Let's get real.

Obsessed with the future, all types of investors attempt to predict the future (usually by looking in the rear view mirror rather than out the window) - like the direction of interest rates, inflation, deficits, markets, etc. Unfortunately, predicting the future is hard to do.

Alan Greenspan once said "It's very rare that you can be as unqualifiedly bullish as you can now." That statement was published in the New York Times on January 7, 1973, right before the two worst years for economic growth and the stock markets since the Great Depression (yes, even back then he was considered to be one of the nation's top economic forecasters).

Ever the contrarian, as Fed Chairman, Alan Greenspan warned us about "irrational exuberance" before the last bubble crashed. Unfortunately, he said it in 1996. If you had listened to him, you would have missed out on the greatest bull market in history (when most of the venture returns were made).

Creating homeruns?

Alan Kay once said that "the best way to predict the future is to invent it" so perhaps the VC's job is not to pick the winners but to create them. Go visit any VC website and you will see a lot of chest thumping about how great they are at doing this.

Perhaps past successes have gotten into people's heads (see Leggo My Ego). VCs have started to think that they can not only see the next homerun coming, but actually create it (I'd bet that more than 75% of VCs think that they belong in the top quartile).

As a fan of baseball, I've observed that good coaches can help manufacture runs, but they can't do much to create the homeruns. If homeruns in baseball are the outcomes of duels between batters and pitchers, homeruns in the VC industry are the outcomes of battles between entrepreneurs and markets.

In the quest for homeruns, VCs invest tens of millions of dollars, "add value," and put together "world class" management teams to build companies. The funny thing is that it takes less capital to start companies these days. You don't need to pour money behind the homeruns because they don't need it. The best companies generate cash, even as they fuel growth.

Some of the biggest homeruns were not even venture backed - they didn't need the money. Even for those which were venture backed, many were already profitable at the time of funding and, with few exceptions, ALL of them required very little capital to become huge.

Let's get real. VCs don't create the homeruns. The great VCs do help their companies...but there is a fundamental difference in mindset. It's all about the entrepreneurs. The big VC firms may try to inspire confidence (or strike fear), but the best entrepreneurs do their own thing with or without the VCs.

Deductive tinkering

The hands-on, "get big fast" approach is the most common practice among VCs. The opposite approach is a hands-off approach where lots of bets are placed across companies. There's a method to the madness and some unconventional investors have done quite well letting natural selection take its course. People have called this "spray and pray" or the portfolio of options approach.   

Unfortunately, a blind, random process (like evolution) can take a long time to play out. It is also risky particularly as bet sizes get bigger. To our knowledge, not a single significant company has ever been attributed to a spray and pray VC.

There are huge multiplier effects that stem from early decisions and we believe that it is critical to be hands-on. We believe there is a third approach. Venture capital should really be a process of deductive tinkering.

The best entrepreneurs are all classic tinkerers. They experience failures along the way (if you are not failing, you are not really experimenting), but they don't make foolish bets. They give themselves a chance to succeed (or get lucky) by making sure that they survive and stay in the game.

Thomas Edison failed in his first 100 attempts at making the light bulb...but he learned every time about what didn't work. We don't mind the failures. The key is to make the cost of experiments as low as possible. It's like flipping a coin where heads you win and tails you don't lose much. Flip enough times and the odds are that you'll come out ahead.

Some might argue that VCs invest big dollars AFTER the tinkering (to scale or "get big fast"). However, in our experience, the tinkering never stops. While we try to take out the greatest amount of risk with the least amount of dollars, companies take on new experiments at every level.

The idea that there is less risk at later stages is a fallacy. Competition to get into good later stage deals is far more intense (at later stages money is more of a commodity). Not only are valuations higher but a lot more capital is put at risk.

As our companies grow, we create new experiments within companies (it's like creating portfolios within portfolios). For example, several of our companies completed acquisitions or started new divisions over the past year. Our portfolio of experiments would grow even if we did no new deals as long as our companies grow in a capital efficient manner (where we reinvest retained earnings rather than other people's money).

Risk and uncertainty

Conventional wisdom says that in order to shoot for higher returns you have to take on greater levels of risk. We choose to follow a different path.

We look to invest in highly uncertain situations. We call such deals "experiments with unknown upside potential," where the range of possible outcomes is very large (on the upside) but require little capital. This is better than gambling or lotto which have defined, bounded upside. We'd rather take unknown/unbounded upside and known/limited downside.

One of the ways we like to limit downside risk is to invest in bootstrapped companies. In our most recent fund, more than half of our Series A investments have been made in companies that have been in business for several years. Such companies seem to learn more than companies that burn through millions of dollars. People with less money learn to use their brains more.

In other cases, we might even invest in companies that are already profitable but might need a little extra capital (and some assistance) to accelerate growth. Many VCs as well as "growth equity funds" who target bootstrapped, profitable companies have minimum investment sizes of $20 million or more. We look to invest less than a quarter of that.

A third type of investment is starting companies from scratch...but following a deductive tinkering process, rather than a conventional one (see Venture Lotto). The beautiful thing about our business is that we don't need to predict the future. We just keep our eyes open and learn along the way.

Learning requires an active, hands-on approach (so there is a cost) but it leads to value, often realized in totally unexpected ways. Some of our most successful investments are directly linked to a past a disappointment or failure.

We don't feel the need to take on big risks. One of the great advantages of venture capital  is that even multiple failures can't "blow-up" a fund (see articles on LTCM for how billions of dollars can be lost in a matter of days. Hedge fund and other types of blow-ups are discussed at length by Nassim Taleb in "Fooled by Randomness" and the "Black Swan"). There is a huge difference between high risk and high uncertainty. We prefer the latter.

The conventional VC strategy of investing tens of millions of dollars is a risky proposition. There are thousands of venture backed companies that burn through millions of dollars only to get to a point where they seek even more funding to grow. We have some (rather painful) personal experience with this. Some of our companies have gone through Series A, B, C, D...and then after running through most of the alphabet started over with Series 1 or A1.

After making more than our fair share of mistakes, we've realized that such impatient consumption of capital creates fundamentally weak companies. Compared to our bootstrapped companies, they seem to have a much lower chance of becoming a homerun, unless another bubble bails them out (depending on the greater fool is an awfully risky way to try to make money).

VCs cannot manufacture the homeruns by pouring tens or even hundreds of millions of dollars behind companies. It's like pushing on a rope. Such a strategy requires not only a lot of capital but a lot of confidence, ignorance or arrogance. Perhaps VCs should remember the words of the great hall of famer Satchel Paige: "It's not what you don't know that hurts you, it's what you know that just ain't so."

Expecting the unexpected

New technologies can lead to waves of creative destruction. Even in low tech industries, companies come and go. The vast majority of Fortune 500 companies drop off the list much faster than it took to get there - creative destruction is everywhere.

Small innocuous events can set off avalanches of changes which are inherently impossible to predict. Such unexpected changes are extremely dangerous for the giants (who have everything to lose and not a lot to gain). At the same time, they can be hugely advantageous for the hungry new entrants who have everything to gain and little to lose. The beauty of venture capital is that we can bet small but win BIG!

Experimentation and failures go hand in hand - so it's critical to limit the dollars. Lots of money is not required to get value out of experiments - it takes a little patience, an open and prepared mind (willing to observe, learn and adapt), and the right attitude toward risk and return.

Venture capital should not be about putting money to work. Over the years, we've learned that if we focus on the fundamentals and keep doing intelligent things, we can make money even if a company is sold for less than $50mm (the typical value of M&A exits in the VC industry). Rather than trying to predict or create the homeruns, the focus should be on the productivity of capital.

If we build good companies, we've also discovered that some of our companies will just keep growing and growing. We just have no clue which ones will take off (and keep going) and which ones won't at the time of investment. However, we have faith that some of our companies will become the dominant new market leaders (we have several promising ones so far). Creative destruction favors the new entrants. 

The key to great returns

One of the legends of the VC industry recently told me that to be a great VC "you must have the courage to walk away." Maybe it takes courage because mainstream VC investments are becoming so big that they seem too big to fail?

We have a different view. If you invest very small amounts and the experiments fail, it doesn't take much courage to walk away. Our "losers" seem to do a fine job of dying without much help from us - they don't need to be killed.

The key to great venture returns is not the courage to walk away but deep conviction and passion for the big winners (see our Raising Sheep article on the issue of conviction vs. convention).

To paraphrase another great VC...the key is to have a little teflon coating so that you don't get jaded...you have to have the ability to fall in love - with technologies, entrepreneurs and companies - even after you've had your heart broken. Great VCs are just as passionate as the entrepreneurs. It's personal, not just business.

However, perhaps paradoxically, it's also critical to be rational. The homeruns are rare - really rare. If you think that everything can be a homerun, you probably won't even recognize one when it stares at you in the face.

Over the course of decades (if we are lucky enough to be around that long), a very small number of our deals will yield more profits than all of our other deals combined. It's just the way the math works. We can only lose 1x, so if we have a 100x or a 1,400x along with a bunch of 3-5x winners, the overall numbers will be skewed toward the few big homeruns.

So in between the homeruns, the key will be to keep losses to a minimum, learning to a maximum, and generate decent enough returns to stay in the game. Such an approach might not sound terribly sexy or exciting, but we believe that the key to achieving great results is to stick to a rational strategy (rather than gambling money away).

The great investors and businessmen we know are all pragmatic practitioners. They first think about (and protect) the downside, before going for the upside. Following such a strategy takes a lot more faith and courage than you might think. It forces clear headed thinking and hard, disciplined decisions rather than sloppy, wishful thinking and shoot-from-the-hip betting.

Ultimately, it's not about how much we invest but what we own of great companies. We feel - in our bones - that only a few companies will really matter in our lifetimes (and they will NOT require a lot of capital). So, like every other VC we're swinging for the fences too...but we're not going to leave smoking craters in the field if we don't clear the fences.

Compounding Value in Venture Capital

Last month's post was a somewhat lengthy introduction to a simple concept I learned in a Tax/Finance class I took from Myron Scholes. (Yes, the guy who co-invented the Black-Scholes model). Had I known that he would someday win the Nobel Prize, I probably would have paid more attention - but one thing I did learn was the concept of compounding.

Getting past the math (Scholes loved to write equation after equation on the blackboard), a key lesson from class was that if you invest in securities which grow in value for a long time, and pay taxes at the end, you end up much better off than if you invest for short term gains and pay taxes in interim periods. (This is one of the rationales behind Bob Kirby's "coffee can portfolio" - the exact opposite of the trader's approach to wealth creation).

Luckily, as venture capitalists, we are saved from ourselves - we're more apt to resist that strange human impulse to monitor stock quotes because our capital is locked up in illiquid investments. When we invest, we price securities based on our assessment of intrinsic value, potential for appreciation, and negotiations between private parties. Once we make an investment, our job is to assist entrepreneurs and help companies grow and grow.

To compound value in venture capital, two critical factors to remember are patience and capital efficiency. These factors, are often overlooked by VCs who seem to care more about other issues - they ask "how big is the opportunity?" (it must have homerun potential), "how quickly can they get there?" (the company should have $100mm revenue potential within 5 years), and "how much money can be put to work?" (bigger funds must deploy more capital per deal - or end up with too many deals).

Why is patience relevant to the discussion on compounding? Because time is required for compounding to take effect. In Silicon Valley, VCs as well as entrepreneurs want very fast growth rates - 100% per year or more. In contrast, we'd rather focus on building a growth engine which can last a very long time. The only way this can happen is if we build a great company - one with smart, responsible management, sustainable competitive advantages, and a commitment to creating long term value. There are no short cuts.

(To see the impact of time, refer back to the Buffet examples from the last article. There is a HUGE difference between 1.243^10 and 1.243^49 - the latter being Buffet's track record from his partnership days to today: 1957-2006. Compounding growth at 24.3% is quite satisfactory!).

Perhaps the above point is totally obvious. But why is capital-efficiency relevant?

After we make an investment, if substantial amounts of additional funding are required to grow, then over time, the compounding rate of shareholder value will be far lower. Myron Scholes' equations showed that death and taxes are certain enemies of compounding. So is dilution! (Too much funding is not only bad for investors - it's even worse for founders, managers and employees who suffer liquidation preference overhangs as well as dilution).

Capital efficiency and patience are inextricably linked. Over the years, we've learned that if we help our companies become profitable quickly, we can afford to be more patient. In contrast, companies which burn through lots of capital or play venture lotto produce far lower rates of return (or fail in spectacular fashion).

At Altos, we place less emphasis on 100% growth or conventional VC metrics like "$100 million revenues in 5 years." We've seen thousands of business plans with such projections. It's like they were cut and pasted from the same "VC 101" business plan!

We've learned that the key to great returns is to be impatient when it comes to burning cash and patient when it comes to growth. When companies figure out how to make money early on, they are more likely to figure out how to make money later, as they get bigger and bigger. If companies grow without learning how to make money, they may never figure it out! They lose their edge. They become more in tune with what investors want rather than what customers want.

We look to invest in companies which can grow consistently, at compounded rates (i.e. in a capital efficient manner), for long periods. It's not to say that we won't take fast growth when we can get it and we certainly would love to invest as much as possible if ROIs meet our targets. However, we've learned that hyper-growth is far more a function of market dynamics than of managerial brilliance and the best companies do not require much capital. Investors who invest more than what is required or pressure companies to grow at unsustainable rates can make things far, far worse. Start-ups are risky enough as it is - we don't need sloppiness, wishful thinking, or foolishness in the mix.

Great companies win based on ingenuity and relentless drive, not by hosing money behind projects. Sometimes they win because of superior technology, or marketing, or service - but more money is not the answer. Think about it. If access to capital was the key to winning, then big companies, the ones which have access to the most capital, would always win. Perhaps, in the old days, when physical assets were more important than informational assets, capital was more of a barrier to entry. But take a look around - it's just not true anymore. Information, knowledge, and creativity are the most compelling competitive weapons in more and more industries.

We believe there is an inverse correlation between huge winners and the amount of capital raised (for example, think about Microsoft, Google, Cisco, eBay, Oracle, SAP, SAS, Qualcomm, RIMM, Broadcom, Intuit, etc). To quote Marissa Mayer of Google, creativity loves constraints. Time and time again, the best companies are created with very little outside funding. It's guerrilla warfare vs. conventional warfare. The disruptors vs. the establishment. We've seen over and over again that companies which stay hungry and figure out how to do more with less end up developing much more staying power. It's a paradox which confounds investors with too much money to put to work - when it comes to creating companies built to last, less is more.

As a final point, we have to concede that, as venture investors (managing other people's money with limited fund lives), we can't buy and hold investments forever (like Warren Buffet). But the key to spectacular returns is investing in, and helping to nurture, create and build great companies - those which will stand the test of time. The traders and flippers, or investors looking to get rich off management fees, may get lucky once in a while, but they will never create wealth in the leagues of a Warren Buffet, Bill Gates or Sam Walton.

The power of compounding is pretty straightforward. But I've found over and over again that the human mind has a surprisingly hard time grasping its effects which is why I've devoted two consecutive articles to this topic. (Here's a quick mind puzzle - if you had to choose between taking $1 BILLION, or a stream of payouts which starts with just one dollar on the first day - that then doubles every day for 31 days, which would you choose? Click here for the answer: 1*2^31)

Too many VC backed companies seem built to flip rather than built to last. There is a better way to create real value.

If we are going to be competitive in a more global world, we have to change our way of thinking. Many foreign entrepreneurs grew up in cultures which have an appreciation for much longer time horizons. (For example, in Korea, my ancestors are buried in a cemetery dating back 600 years - and my father's family has owned that land throughout the centuries. In China, they probably think about millenniums).

As VCs and entrepreneurs, if we want to build the dominant companies of the next millennium, It's time to start thinking about the power (and the joys) of compounding.

Lessons from a professional gambler

Every year, we host a meeting which brings together entrepreneurs, investors, and other members of the extended "Altos family." One of our speakers this year was Jeffrey Ma, whose adventures as a professional blackjack player were chronicled in "Bringing Down the House." Here is an excerpt from the book (Jeff's character is Kevin Lewis, the protagonist).

"He found himself escorted to a private booth in a newly opened club at the Hard Rock Hotel. Surrounded by strippers and starlets from L.A., Teri, on his arm,... Kevin watched the flickering lights and wondered if life could possibly get any better. He had seventy thousand dollars in a money belt around his waist and another quarter million back in his room. Card counting was the key that had unlocked the casino's coffers, and there was no reason to think the party ever had to end."

So what does this have to do with entrepreneurship and venture capital? Surprisingly, after telling some funny stories, Jeff drew interesting parallels between his former profession and our business.

First, the thing Jeff missed most about his days as a gambler was not the high stakes betting or the hobnobbing with celebrities. It was the fun and the camaraderie he felt being part of a great team. Every team member handled large amounts of cash so trust was paramount. Eventually, he found it again at Protrade, a start-up he co-founded. As we've stated before, there is nothing more important in our business than people. The commitment and passion of entrepreneurs is infectious and the best ones are able to form teams with deep common bonds.

Second, maintaining faith as well as discipline and patience is critical. In blackjack, you can do all the right things and still lose bets. Jeff eloquently described some intense moments when he could have given up, but instead kept going. In professional blackjack, perhaps it's easier to maintain faith because it’s about math. In our business, there are no card counts. However, we have faith because there are levers under our control. We avoid doing foolish things like playing venture lotto, and increase the odds by patiently following our strategy, making good decisions, one at a time. As the saying goes, "luck is what happens when preparation meets opportunity."

Third, it is critical to maintain discipline as you grow. After delivering great financial results (47% IRRs), everyone wanted to invest more money in Jeff's blackjack fund. Greed took over and fund sizes grew fast. They had to make bigger bets and target larger casinos, increasing the chances of getting caught. (Jeff eventually broke off and formed a smaller team).

In venture capital, success inevitably leads to opportunities to raise larger funds. Only a handful of firms turn away money (there is a difference between a fund which may be "oversubscribed" after trying to create a feeding frenzy and funds like Kleiner Perkins and Sequoia who effectively turn away billions of dollars). Partners at certain firms also commit significant personal capital. In contrast, the vast majority of fund managers personally commit only the minimum (1% of capital) while taking full management fees and share of profits, with no downside risk.

The real issue with larger funds is that interests start to diverge between VCs and entrepreneurs. VCs have incentives to swing for the fences while entrepreneurs prefer lower-risk paths. Entrepreneurs can't count on a portfolio. Also, entrepreneurs don't collect management fees, which are becoming a critical component of investor compensation. Large fees create an "asset manager" mentality - the incentives are to "put the money to work." Without alignment of interests, it's hard to develop the trust and bonds needed to build great companies.

To align interests, VCs should raise smaller funds, invest more personal money, and focus on building solid businesses rather than exits. This will lead to less failures and, paradoxically, lead to larger homeruns because companies will be built on customer funding rather than on investor funding. Too much money stifles creativity, drains the hunger, and makes it more difficult to create company DNA which is tested against market realities. The brute force method of company creation rarely works. It's like pushing on a rope.

Even highly risky ventures can be capital efficient. Companies which never raised venture funding include Autodesk, EMC, RIM, Qualcomm, SAP and SAS (for a longer list see the post on venture lotto). Companies which were already profitable and well on their way to success by the time they raised venture funding include Apple, Cisco, Microsoft, Oracle, Intuit and eBay.

In the case of Apple (I have a copy of their original business plan), the initial round, completed in January 1978 when they were already profitable, included Venrock $288,000, Sequoia $150,000, and Arthur Rock $57,600. The initial round of Cisco was $2.4 million split between two VCs. They were in business for two years and already profitable by the time they raised Series A. The next round was IPO.

Companies which burn through lots of capital usually end up as acquisition targets or fail in spectacular fashion. Some may end up being nice "exits" but they don't become enduring, great companies.

What was meant to be a fun, lunch-time distraction from a full day of company presentations and investor meetings turned out to be quite relevant. Thanks Jeff, for keeping it fun and real.

Venture lotto

The pressures to put money to work are increasing. Entrepreneurs who hit Sand Hill Road looking to raise one or two million dollars, end up walking away wondering if they should raise more. We've experienced this phenomenon first hand. We've helped raise hundreds of millions of dollars for our portfolio companies. We typically have more difficulty finding co-investors who are willing to invest less than two million dollars than finding much larger co-investors.

Compounding the problem, there is an increasing sense of urgency to hit bigger and bigger home-runs. Venture capital is a hits-driven business. Take away a few homeruns and returns look mediocre at best.

Smaller hits no longer move the needle. Investors chase hot deals while small or "low-beta" opportunities are overlooked. Billions are invested in companies targeting big, fast-growing markets, and great people are recruited into those companies hoping to create "the next big thing." Companies get over-funded, and feeling pressures to grow quickly, they ramp-up to high burn-rates and experience high rates of failures, which are acceptable as long as enough winners materialize. The sobering reality is that most venture-backed companies are sold for less than $50 million, if they don't go out of business. The typical deal will lose money.

Some people might read this and say that there is nothing wrong. Failures come with the territory and VCs are supposed to take risks. Paradoxically, despite high failure rates, entrepreneurs think that VCs don't take enough risks. They get turned away because their teams are not “proven,” or there is not enough market traction, compelling technology, or big enough upside potential. In the quest for big hits, a lot of stars have to be lined up.

Bill Reichert, in his "Small is Beautiful article," offers a good explanation for why investment criteria are narrowing. Clayton Christensen offers another theory. In an article entitled "Changing Values: The Disruption of Venture Capital," he observed that "entrepreneurs with disruptive innovations are finding it harder and harder to capture the interest of VCs...while there is too much capital pursuing sustaining innovations."

Whatever the reason, in the game of venture lotto, "too much money chasing too few deals" is an oft-cited phrase among VCs who find themselves in competition for deals. The most sought after deals are led by proven managers. Especially popular are entrepreneurs who have made money before - they get investors lining up like sheep.

Ironically, the people who end up creating the blockbusters are usually unproven managers. They emerge from the fringes, and start small, in niche or overlooked markets. They take time to learn and iterate and burn very little capital before turning profitable. They follow a slower, but lower-risk path. In our own portfolio, the companies which raised less funding not only performed far, far better but had much lower failure rates.

Microsoft took 11 years to go public. They were also profitable by the time they took venture funding, as was the case at Oracle, Cisco, Intuit, eBay and many others. Companies such as Adobe, Autodesk, Broadcom, Dell, EMC, HP, IBM, Motorola, Paychex, RIM, Qualcomm, SAP, and SAS never raised traditional venture funding. A common trait across all of these companies is that the founders retained large equity stakes (and helped build their companies for many years, even decades). Combined, these companies have a market cap of $1.2 trillion dollars (this list is not comprehensive). SAS, still a private company, has been ranked by Fortune Magazine as one of the best companies to work for in America every year, with six top-10 ratings.

Entrepreneurs can't count on a portfolio. The best ones we know are much more risk-averse than conventional wisdom might suggest. They don't take foolish chances. They spend money as if it were their own. They observe, listen and adapt; but fundamentally, they strive to control their own destinies, which is best done by generating profits. They do need a little capital, but they want help and advice even more. Being an entrepreneur is, at times, a very lonely endeavor.

Getting back to a point made in our last article, even the best people will struggle in a bad system. We have to stop playing lotto with our money and with people's lives. What would happen if we cut fund sizes to dedicate more time and energy to small investments? By not obsessing over "moving the needle," could we increase hit rates and, paradoxically, hit even bigger home-runs? Companies built on solid fundamentals need less capital and more time. The management fees wouldn't be as good, but wouldn't we be better off in the long run? To pull it off, VCs would need to reduce personal burn-rates (due to lower management fees), work harder to support entrepreneurs, and develop more patience.

There is too much money in the hands of deal pickers (and deal flippers). Driven by ambition, ego, or envy, we are marching down a dangerous path. Every VC should consider which is more important - building companies or picking deals? If the answer is not obvious, we'd recommend the hedge fund business which is much more lucrative (and scalable) for traders and deal pickers. Entrepreneurs need help and advice as much as capital from their investors. Money can be made in many ways but venture capitalists have a special role in the investment world - to help entrepreneurs build companies.

The lines have started to blur between the hedge fund, private equity, and venture capital industries. Maybe that is part of the problem. But, as investors, we have no-one else to blame but ourselves for reaching out too far and too fast. Warren Buffet once wrote:

The most important thing in terms of your circle of competence is not how large the area of it is, but how well you've defined the perimeter. If you know where the edges are, you're way better off than somebody that's got one that's five times as large but very fuzzy about the edges.

We'll end with a question - if you don't know where the boundaries lie, is there really a competence?