Marketing Expert's Corner

This is a "greatest hits" collection from the articles written in 2002-4.  As I wrote about VCs in every early issue, this collection is long -- a "double CD" collection if you will.  Some of the references and data are old, and these missives were written in the Dark Years for Venture Capital.  That said, it's gratifying to see that the most of the underlying logic and advice still hold.  


Venture Capital and IT

Getting funded -- whether to start up or expand -- is essential to growth.  In today's economic environment, it's also, as the Japanese would say, "very difficult" unless you fit two critical criteria below.

Let me get the bad news out of the way.  Getting a first round of funding "the 90's way" just won't happen any time soon.  Most Bay Area VCs will take an initial meeting, but they are doing this mostly to gather intelligence about your sector and they will disqualify you in the first 5 minutes.  Unless you have:

  • Enough revenue to cover your current sales costs, or

  • A team that has already successfully run a startup that went public or was acquired,

your chances of getting funded via standard VCs this year or next (2003) are very low indeed.  The bottom line:  most companies will get VC funded later in their life cycle, and in the early days a typical startup must grow up in bootstrap-city.

How the World Looks to a VC

There's been sea-change in the VC world.  The whole ecosystem is changing: Upside and Forbes ASAP shut down their web sites; Fast Company and Red Herring went out of business; Brobeck (the law firm) ceased operations this quarter; and Wilson Sonsini shrunk.  Looking at startups (the product that VCs produce), 75% of the companies taken public since 1997 are out of business or valued below 50% of their IPO price.  This has not been fun for anyone.

A stunning statistic: something over 60% of *all* the VC money ever invested was invested after 1996.  The recent ones weren't the greatest investments, and almost every VC's portfolio of pre-public firms shrunk during 2001.  Two of the big trends right now is compression-round financing and shotgun mergers, where significant amounts of equity are erased from a startup's balance sheets.   It's amazing that VCs themselves haven't had to shrink as their investors pull in their horns.

But the real story of venture capital is that there is almost no demand for their real product:  companies ready to IPO.  Only 22 VC-backed companies of any category held IPOs in 2002, down from 35 in 2001 and hundreds in 1999.  As M&A activity is also way down, there are few of the "liquidity events" that make money for the VCs.  In the simplest terms, they have an inventory problem.

The VC community will have to shut down or merge more IT firms than the number of new companies they fund this year.  An interesting statistic:  there were 2500 VC-funded private  software firms in January 2002.  Very few can be expected to go public.  To put this in perspective, there were never more than 900 publicly traded software companies -- total worldwide -- at any time before 1999.

Given the speed of technological obsolescence, the VC's inventory is perishable.  And there's this little problem of end-user demand for IT:  only 30% of public IT companies are profitable right now, and almost no pre-public IT firm is close to breakeven.  So everyone is burning cash even when they do well.  This is not a formula for happy VCs.

The situation will fundamentally improve when end-user demand firms up, startups prove to be investment grade, and investors get an appetite for IPOs.  These are going to take time, and VCs are getting lessons in patience.

Where they're investing

Many VCs are moving away from seed or even "A" rounds. There are simply too many unknowns and compounded risks.  Once a startup has a working product and some sales volume, VCs are in their comfort zone:  working with a money-machine, where cash burn rate can be calibrated against revenue growth rate.  

But new startups are getting funded, even in Enterprise Software. I know of 4 firms that got funded in the last 6 months, most getting several million before having revenue or even a demo. The common threads of these firms:

  • a founding team that knows how to deliver product and is proven in early-stage situations (in other words, the VCs know they can execute and this team has made them money before),

  • a very clear product idea that isn't a tool (web infrastructure, when it's significant, is still a draw),

  • a highly specific customer definition with a very focused value proposition, and

  • a credible business model based on license revenues.

If these sound obvious, or like a return to 10 years ago...well, that's pretty much where we are. There's an air of relative conservatism on Sand Hill Road, and a VC said to me "we're investing in software only when a company has a $20 M run rate."   Yow.  It's going to take a while for things to balance out, but the days of getting funding based on an email or cocktail-party conversation are long gone.   

"Venture capital absolutely has its place, but that's during the expansion phases -- not early on."        
      -- A successful "serial entrepreneur" CEO

I think it's a good thing that VCs aren't investing so much, so early.  I'll even argue that VCs shouldn't be the only source of funds for early-stage companies, even when they want to be.  VCs' priorities can push early-stage companies in unhealthy directions:

  • They would much rather have a fast failure than a slow success.  From their perspective, a slow success is a failure.

  • They tend to push for a high burn rate, spending on sales and marketing way before the magnitude of demand and length of sales cycle are known.

  • They tend to like Enterprise Sales cycles and high price points; an increasing number of product categories and market conditions just don't support this any more.

What You Can Do

So in this uplifting environment, what's the actionable advice?

The VCs still need to invest:  putting money into contained risk is their business.  The lessons learned from my recent VC pitches are clearly linked to the investing environment:

  • Your pitch must be quick, compelling, and obvious.  Less really is more -- in slide count, word count, and idea complexity.  You need your business proposal to look sledge-hammer simple.

  • The fundamental risk is demand: revenue is the overriding issue.  Relentlessly answer the question:  is there a market, will there be paying customers for your product, and how will you access that demand cheaply?

  • You've got to project four critical attributes about your team:

    • You are solving an economically important business problem that has immediate ROI.  There is focused pain around the problem, and you've identified who has it and who can pay.

    • You believe passionately in the importance of your solution.  You have realistic expectations about the sacrifices and payoffs from building a business.

    • You've got intellectual property and can create other barriers to entry. You can execute faster or better than the other guys.

    • Your plan is measurable and executable. You've designed your plan with incremental (at most, yearly) funding tranches triggered by revenue-bearing milestones.

  • When pitching, don't be preoccupied with valuation and dilution.  Of course you need to have some control, but it's more important to have some funding on onerous terms than none at all.

Know that the VC's perspective of time is completely different from yours.  They are in no rush:  they are awash in cash and they see no compelling event for any specific deal. They are not competing over deals any more.  Give yourself as much lead-time as possible, so that you don't put yourself under deadline pressure.  Give yourself 6 months, not 6 weeks.

The VCs make decisions based on perceived risk.  You must chase as much risk out of the deal as possible, so you'll need:  a working "v0.5" product, some initial (license or consulting) revenue, and a customer or design partner with skin in the game.  Unless you have a proven, winning startup team, polish and pitching finesse won't be much of a substitute for near-revenue product.

The one lesson to learn from all this has to be: "don't build a product - or start a company - until you've found at least one paying customer for it."

All this begs the question, "how do I get the funds to build the product in the first place?"

DON'T mortgage your house or pull out your 401-K.

DO find a way to bootstrap yourselves with early sales (consulting or otherwise), and pursue alternative funding sources.

While the mix of funding sources -- customers, partners, private placements, angels, family -- will depend on the specifics of the product and your personal network, the general things you need for attracting capital are always the same:

  • The problem you are solving must be real and short-term.  Pain levels and penalties for not-fixing-it must be immediate.  (Be brutally honest with yourself on this one.)

  • Your value proposition must be clear and quantifiable (with significant cost improvements, and ROI calibrated in weeks).

  • Your strategy must be focused, providing a deep solution even if it's narrow.  (Be the best in the world for a clear set of customers, rather than a generalist selling to everybody.)

  • Your product must work and be deployed in at least three separate companies.

  • At least one of your users must have paid you money for product or services.

  • Your reference customers should be part of your investment mix.

In the early stages, where nobody knows whether your vision can even be produced, let alone sell well, you need to show that you're different -- and can have a lower cost of customer acquisition, by thinking about the following:

  • The VCs appear to be willing to selectively invest in Security, Infrastructure, Storage and Appliances. You'll notice the common thread: a "cost savings" and "increased security" value proposition. I don't know of anybody who has gotten funded recently with a "revenue enhancement" end-user value proposition.

  • The Enterprise Sales Model produces hypergrowth when it works.  But it is fantastically expensive for small companies and has a very low probability of working in the current environment.  At the very least your business plan must supplement Enterprise Sales with other channels and demand sources.

  • A hybrid business model (for example, perpetual license plus hosted rental) gives you more revenue diversity.  Make sure that you keep your entry price and implementation costs down, to shorten the customer's decision cycle.

  • Bring a customer and, if you can, a partner, to the table with you when pitching your plan.  This will set you apart from the hundreds of business plans being thrown at investors these days.

  • Be willing to give away software and services to get a toe-hold in your first (pre-funding) accounts. There is simply no substitute for customers, even if little money has changed hands. Of course, you'll want to structure your first customers' contracts so that they become revenue sources after some period of performance or measured savings.

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