The problem, of course, stems from the following: Entrepreneurs often have mixed goals in starting a business. They want to deliver on a product vision, want to grow a major enterprise and make money, and also want to be the boss. Venture capitalists have only one goal: To make money for their investors and themselves. Sometimes, if the company gets off track and management doesn't seem able to fix it quickly, VCs want to bring in people who they believe can.

How's that for a direct quote (modified for family viewing) from a recent due diligence call I made?  And yes, when the words hit my ears I broke out laughing so loudly that Linda in the next office stuck her head in my door to see what had happened.

This is one of the joys of doing due diligence on a new deal.  It's very much in the Forrest Gump "box of chocolates" model - you never know what you're going to get.  But sometimes, just sometimes, you get far more than you expect in just a few words.  In this case, I was probing around with an executive on our Technology Advisory Group who was getting his first exposure to the company in question.  It turns out his firm had created an in-house tool to handle some of the functionality the startup was offering.  And while they were getting by with their proprietary solution, his shall we say "candid" assessment of how he felt about the internal program (that his team had to create, support, and enhance) told me all I needed to know about whether this was indeed a pain point - and a major account opportunity for the startup, whether we invested or not.

It has come to our attention that in certain parts of the world, the "How to Avoid a "No" from VCs" series, originally written for Seattle 2.0, is "not accessible."  Hopefully those same folks in far-off lands will not see the OVP blog as in any way subversive.  So, for the record, here is the multi-part series all in one place.

Where does VC money come from?

1. They put a rather small percentage of their total capital into private equity overall (which includes buyouts, etc.), and usually less than half of that into venture capital.  As an asset class, we are a very small piece of what they do every day.  So, while they invest in venture capital funds to try to get better returns than they can in public markets, and are ready to accept some added risk and illiquidity to do so, if we don't deliver they get more internal grief than the dollars involved probably justify.
2. They are judged internally on internal rate of return (IRR) in most cases.  A select few get judged also on multiples on capital (more about this another time).  But by being on the IRR clock, they care about not just how much we make, but how fast we get that cash back to them.  If you ever wonder why VCs seem to be impatient, here's a place to start.
3. In the venture capital asset class, those institutional investors have literally hundreds of funds to choose from.  And while we have all heard the mantra that "past performance is no guarantee of future results" we also know that most decisions by these folks are driven very strongly by what you last fund or two did, not how convincing your presentation is.

• VC funds receive cash from our investors in tranches.  We don't want the money all up front, because that would start the IRR clock ticking on all that money, most of which would be sitting in the bank earning meager interest.  However, we get to call the tranches as we need them (called a "capital call" in our parlance). So, we wait until either we have an investment coming up, or need money for our day-to-day operations, and then call an amount that matches our need.
• The money isn't exactly allocated over time, but we do plan on a spread of need in the following way.  We get a "management fee" on the total amount of committed cash - usually in the 2% area, and that covers our salaries, office rent, travel, etc.  We plan on that being available year after year over the 10 year life of the fund, although it usually tails off in later years, for reasons I won't detail here to keep this succinct.  Then there come the investments.  We tend to plan to average about one new investment per partner per year.  So for us, with 5 partners and a 5 year investing life, we target about 25 total investments per fund.  Of course, you entrepreneurs aren't quite so manageable, so some years (like 2008) we do more: 9 in our case.  Other years, we do fewer.  Every time we make a new investment, we allocate follow-on funds to that company, not withstanding the fact that all of you claim you'll only need one check!  :-) In fact, for every dollar we put in initially, we usually put $2 in "reserve".  Often, even that is not enough.
• When our companies are sold or go public we return those funds to the Limited Partners.  Initially, they get their money back in proportion to the amount invested by them and from our private contributions to the fund.  However, once we have paid back all their capital in (think of that as the total size of the fund), then we get what is called "carried interest" on the gain.  For most funds, that amounts to about 20% of the profits. 
• If there is no profit on an individual deal, such is life.  This is a high risk business we are in, and most individual projects fail. But, if we don't generate a profit on the whole portfolio of deals (see: bubble funds) then our Limited Partners get very cranky with us - as they should. But, beyond not investing in any future funds of ours, that is the extent of what can happen at that point.
• If a start-up doesn't perform in the expected time, but is still promising, we call it, "Normal". :-)  Not widely known fact, but of the 120 some-odd companies we've backed over 27 years, not one (that's right NONE) made their original business plan.  Yet, we've had the pleasure to grow some very successful enterprises that made our investors a lot of money.  This is why we reserve those extra dollars you don't think you'll need!
• VC firms and partners profit in essentially only one way.  It's what I call the Vidal Sassoon model, "If you don't look good, we don't look good." If our portfolio companies (in aggregate) return considerably more than what we paid in, then we look good.  You'll hear about how we like to make 10 times our money or better (this is true!). But, the reason we have to shoot for those numbers in each project is that usually we're wrong, and the company either loses money (often all of it) or doesn't make much.  So, to cover our losers, and our day-to-day expenses, we need our winners to be big winners.  A good venture fund will return to its investors somewhere north of 2x what they invested.  At 3x or better, everybody gets very excited.  Another way to think about this is a bogey over the S&P 500.  Most investors will tell you that if they can net 500 basis points (5%) or better over the S&P, compounded over the life of the fund, they are happy.

 Much more (6 articles) after the break....

I recently began writing as a guest blogger on Seattle 2.0. What I'm finding is, not surprisingly, that property has much broader readership than the OVP blog does, and so elicits more comments when I say something provocative. 

So, for the benefit of readers of this column, here's a link to my most recent post there.  It seemed to be useful, or irritating, or controversial depending on one's frame of reference. The title was "How to avoid a no from a VC - part 1, People" .

What is a CEO-a-thon?

Portfolio companies of OVP know (and perhaps dread) this annual event.  However, we look forward to it eagerly.  It comprises three days in the first quarter every year where we have every CEO of ours stand up and deliver a one hour summary of where they've been, where they are going, and why we should still feel great about our decision to invest. Every hour, on the hour, another one steps up to the podium. On one hand, there is nothing quite as exhilarating as seeing all these bright, motivated leaders wax passionately about their companies.  On the other, there may be no more high stakes event for these folks, post our initial investment.  

We know this is the most popular page on the OVP web site: Deals Missed

So, therefore rather than post this new information assuming loyal readers will stumble upon it, we figured we might as well put it up here on the blog, too - and let you enjoy watching us wring our hands, yet again.

Last week, OVP hosted what has become one of my favorite annual events – our 7th Annual OVP CEO Night.  It was great to be invited as a CEO in the early Accelerator days, and now great to host as the newbie partner at OVP.  This year, we had the added bonus of welcoming Adrian Hanauer, General Manager of the Sounders FC, as our special guest.

An interesting and unexpected speaker from a seemingly unrelated industry is one of the hallmarks of CEO Night.  Past speakers have included cycling legend Greg Lemond and famed restaurateur Tom Douglas.  Combined with creative themes for the food and beverages, this is what differentiates CEO Night from just any other networking event.

The University of Washington’s Computer Science and Engineering (CSE) department’s Affiliates Day is one of the most fun and rewarding days of the year for me as venture investor and geek.  It involves a showcase of projects and research areas by professors and students and is a festival of creativity, new ideas, and engaged smart people. It is a day my colleagues and I look forward to every year.

Last Thursday's meeting concluded with a panel on "The Changing Face of Venture Capital," moderated by UW's Ed Lazowska, who prompted us with a series of provocative questions. On the panel with me were Greg Gottesman of Madrona Venture Group, Ron Howell of WRF Capital, Bill McAleer of Voyager Capital, and Cam Myhrvold of Ignition Partners.

Many of us of a certain age can remember the game "20 Questions" - used largely by our parents to pass the time on long car rides.  One person thought of an object, and the others could ask up to 20 "yes or no" questions to guess what it was.  (You'll recall, the first question - not counted in the 20 - was "animal, vegetable or mineral?")

In figuring out what companies to invest in, venture capitalists are caught in their own game of 20 questions - usually built around the fundamental issue of, "If you build it, will they come?"  It turns out a key to playing this game successfully is not the number of questions you ask but how many potential customers you ask, and then the nature of the questions themselves.  For some reason, perhaps known to marketing gurus and/or statisticians, 20 is a magic number.  Once you've called and spoken with about 20 potential customers, especially if that list includes at least half not given to you by the prospective portfolio company, you've reached the point of diminishing returns.  Whatever you are going to learn from that process, you now know.

Now for one of the really tragic whispers emanating from an OVP partners meeting...

"Right team, wrong idea." 

We really agonize over this one. It doesn't happen all that often, but every once in a while we get this absolutely killer team in to present, with deep domain expertise in an exciting market.  And then, after they explain their business concept we say...

"Is that the best they can come up with?  What a shame!" (and then we shed a collective tear)

OK - for those regular readers of the G-B-U feature, as promised here is a "G" story.  Actually, it's two stories rolled into one.  Most of the time, the entrepreneurs we back act responsibly, ethically, and professionally.  So, it can be hard to decide where to draw the line, since there are too many "Good" stories to tell.

But, over the last six to nine months we've seen two CEOs do something very similar that strikes us as exceptionally "Good."  In both cases, she and he (one of each gender) came off a very successful quarter - yes, even in these turbulent times.  Both came to their respective Board meetings with the happy news that the company had grown nicely and had finally achieved that wonder of wonders - cash-flow breakeven!

So, what did they ask the Board for at that moment of happiness around the table?  More stock options?  Bigger bonuses? Perhaps a relaxation of the expense plan so they could hire more employees?

Ever wonder where those strange or seemingly onerous terms in a venture financing come from?  Well, you are about to find out, as part of our on-going series "entrepreneurs behaving badly." (For those who missed G-B-U part 1, feel free to go back and review the rationale of this series for context - and know that there are "Good" stories yet to come).

As with most lessons in life, the ones we learn the hard way stick with us the best.  And you would think that after over 25 years in the venture business, we must have seen it all and learned it all.  Not so!  What follows is an example in recent times of what we consider a "U" on the G-B-U scale - and one that actually caused a change in the agreements we strike with entrepreneurs going forward.

Stories of entrepreneurs behaving well, and badly

We’ve all heard the horrific tales of venture capitalists behaving badly. And while all of us who practice the profession would like to brush them off as sour grapes, we have to admit that sometimes they do hit close to home. See: VC Non-Admissions

However, so far, we haven’t seen any venture capitalists brave enough to point out that there is a corollary issue that only gets aired behind closed doors.

"Right idea, wrong team."

This is a tough one.  If you were listening in to our partner meeting after presenting your startup, what would you do? Well, the first thing might be to think hard about why we were feeling that way.

Does your team have deep domain expertise in the business you are starting?  If not, then we worry a great deal about what you don't know you don't know. (Or to paraphrase Will Rogers, "It ain't what you know that hurts you.  It's what you know that ain't so.")  

OK - so you've passed the test of "What do they do?" (see: Behind Closed Doors - PT 1).  Now comes the next set of words you don't want to hear with your ear pressed to the OVP conference room door...

 "Who cares?"

So, you think we're just being rude?  (Well, maybe)  But, in reality those words level a verdict on the startup as falling into one of two traps...   

"Invested in Venture Capital? You would have been better off in T-bills for the last 7-8 years."

"The technology advances we've seen in the last decade or two just won't be repeated in the next."

So, when were those quotes (or some just like them) put forth?

Do you ever wonder what REALLY happens around the venture capital  partners table once you, the entrepreneur, leave the room?  Well, it's time someone told you.  Hopefully, out of this you'll become more skilled at getting to "yes," or getting to "no" - but faster, or getting some value out of the experience.

The most dreaded words you can hear (if you had an ear pressed to the conference room door) are: "What do they do?"