Monday, March 10, 2008

VC Industry Focus to Shift?

These are tough days for venture capitalists - and tech entrepreneurs. For every YouTube and Facebook, there a hundred other VC funded businesses that are just limping along. Heck, some might even be skipping along (generating revenue, perhaps even profitable) but it doesn't much matter. The is precious little 'liquidity' - the life blood of a heathy start up environment. The IPO window is almost shut for all but the most impressive companies. Wall Street wants to see revenues of somewhere in the $100 million range, and profitablity, to seriously consider a company for a pubic offering. Even then, with the dramatic downturn in tech valuations, there are few buyers for these nascent tech company shares. Certain industries, telecom, semiconductors and enterprise software are particularly difficult to attract Wall Street interest. There is a sense in these sectors that the best days are passed. While not true, Wall Street bias are hard to overcome.

Many investors - and founders - have been in their companies for 6, 7, even 8+ years. They are finding that it is not enough to build a solid revenue generating company. And those of us in the start up world know how terrifically difficult that is. No, revenues and profits are not enough. The public markets must also be in an accomodating mood. With tech valuations at signifcantly depressed levels, even the M&A market is in a slump. Acquirors like to use their generous market caps to buy smaller companies. When their market caps shrink, so does their acquisition currency - and their nerve.

So where will this take us? One effect of the long tech slump (going on 8 years) is a greater openness on the part of traditional tech VCs to consider investments in alternative industries. Clean tech is clearly one such example. But there are others. VCs are now investing in such non tech spaces as store front retail, apparel and even consumer products. Where this winds up is anyones guess. But I believe a growing percentage of venture dollars will find their way to non traditional industries. Should this trend gain traction, Silicon Valley itself may become less relevant over time. To be sure, it will likely remain the largest base of VC investment. It just won't dominate as it historically has. That is not necessarily a bad thing. Southern California entrepreneurship has a lot more to offer than just technology centric businesses.

Tuesday, March 4, 2008

Do 4 Year Vesting Schedules Still Make Sense?

Four year vesting is one of the sacred cows of Silicon Valley. It is a birth right. A practice that can not be questioned. The persistence of this labor friendly term in start up comp plans would make the Teamsters Union proud. When it comes to pay packages in Silicon Valley, everything is negotiable EXCEPT the length of stock option vesting. That has to be 4 years. But does this make any sense? On balance, I don't think so. At least not any more.

During the dot com glory days, it was possible for a venture backed company to be formed and go public in 4 years or even less. Of course, many of these businesses were woefully unprepared for public market scrutiny and subsequently failed. But the idea of a 4 year vesting schedule was palatable when a start up could reasonably expect to be pubic in that period of time. Those days are long gone. It takes closer to 7 or even 8 years for a successful company today to go from launch to IPO. So what happens to all of those employees who are fully vested at the 4 year mark? That is an issue many VCs and boards, Clearstone Venture Partners included, are wrestling with.

If an employee's stock is fully vested, what is her motivation to remain in the company from a financial perspective? The answer is not much. She would quite likely be better off going to a new company and receiving a fresh grant of stock options. In another 4 years, she will have twice as many options as she would have had if she had stayed at the first company for the entire 8 years. She will also enjoy some portfolio diversification by having a financial interest in two different start ups. So the value of 4 year vesting makes a lot of sense for the employees. But what about for the company?

Most venture backed companies create option pools of 20% to 25% of the total shares outstanding. The hope is that these pools will be sufficient - plus or minus 5% - for all of the employee stock option grants from inception to IPO. But imagine a scenario where most of the early employees leave after 4 years. Those people will need to be replaced. And those replacements will need new option grants. So essentially the company is paying twice for the same position. And the situation can get quite odd. I have seen companies in which the collective stock holdings of FORMER employees exceeds the amount of stock held by current employees. Hard to see how a situation like that can be good for the current employees (who are creating value for those that have left) and the non employee shareholders. Eventually, if enough employees leave at the 4 year mark, a company has no choice but to augment the option pool in order to back fill the vacated positions. These new stock grants dilute the ownership percentage of every other stockholder - from VC to founder to employee. In summary, 4 year vesting is not a very attractve compensation structure for start ups given the current IPO time line.

What to do about this conumdrum is far from obvious. Ideally, from a company's perspective, stock options would only vest when a liquidity event occurs (wheher IPO or acquisition). If that takes 10 years, so be it. There are a number of drawbacks to this approach from the employees perspective so such a solution is not practical. However, I do believe that 5 or even 6 year vesting should become the vesting standard. As the holding period for venture backed companies elongates, I believe there will be more and more board room dicsussions about what is fair and reasonable with regard to stock option vesting. It was not that long ago when 5 year vesting was the norm, and getting back to that would be a good first step.

Stock Market Slide Effecting Start Up Valuations

Early stage VCs typically say that the ebbs and flows of the stock market don't effect the valuations they pay in start up financings. That may be true. At the formation stage, when a start up is little more than a business plan and a few dedicated engineers, there are a host of other factors that influence valuations more so than PE multiples of public companies. VCs tend to put greater weight on the potential market size of the product being built, the reputations of the founders and the number of existing competitors than they do on swings (positive or negative) in the NASDAQ index.

So to some extent, entrepreneurs and VCs can comfortably ignore the chaos of currency fluctuations, interest rate changes and other macro finanicial shifts. The operative phase here is 'to some extent'. You see, unless a company only plans on raising one early stage funding round, it must eventually seek capital from a different cast of characters: the later stage or 'growth capital' providers. And guess what? These firms most definitely do look at public stock market valuations as a measure of how to price a private company.

Just six months ago, many companies in traditional venture backed industries (enterprise networking, wireless and storage to name a few) were trading at attractive PE and revenue multiples. For instance, in the enterprise networking space, companies like Riverbed, Aruba and Isilon were trading at better than 10 times sales. With valuations in these sectors now down 50% to 75% from their highs, later stage funds are becoming much more careful when it comes to valuing private businesses. In fact, if a VC backed company raised a Series B or C round in the past year, there is a good chance the NEXT round will be flat or possibly below the previous financing. The justification for these more conservative valuations? NASDAQ. Or rather, what has happened to tech heavy NASDAQ in the past few months. A growth fund wants to invest in a company that it can reasonably see going public in the next 12 to 24 months. No fund wants to face a situation in which the last private round valuation is ABOVE the expected IPO filing range. So what are they doing? These funds are being much more conservative in how they value the companies they invest in. And keep in mind, in January and February 2008, over 2 times the number of new issues were pulled than successfully completed their IPOs. So not only are valutions dropping but the bar to go public is being raised dramatically.

The tightening of valuations for later stage financings (particulary the mezzanine or last round before going public) is having a cascading effect on the pricing for earlier rounds. Whereas just a few months ago it was possible to get a 3X step up in valuation from the Series A to the Series B round, it is now more likely that the step up will be 1 to 1.5X.

Two observations fall out of this. First, as long as the public markets are under pressure, expect venture valuations to hold or decline, particularly in later stage financings. Second, as a CEO or founder, take a hard look at what you are planning on achieving with the most recent capital you raised. If the business achieves everything you promised to your most recent investor, does that justify a substantial increase in the valuation of the business when it comes time to raise the next round? If you have doubts, take another look at where the capital is being spent. This is what Clearstone is doing with its portfolio companies. Its a dynamic world and even the best laid plans have to be questioned.

Sunday, March 2, 2008

The Tyranny of Revenue Projections

What a senseless exercise we have all gotten ourselves into. I am talking about revenue projections for start-ups. These 'mandatory' projections that are supposed to be included in all powerpoint pitches to VCs. I know that I am part of the problem here, as I too expect to see a revenue projection from the management team when presenting its business to Clearstone. And yet, it does seem rather silly. I may be in the minority in saying this (but I do not think that I am): NONE of the 2 dozen start-ups I have funded over the years has ever hit its first or second year revenue target. Some have done much better, some have done much worse, but none have gotten to the desireable 95% accuracy rate I would like them to hit.

The reasons for this terrible track record are quite obvious. Who the heck knows how a product will sell before it is even in the market? How long is the sales cycle? What ASP will the market accept? No one knows at the beginning. It is all assumption laden guesswork. So, why do we even bother with revenue projections until we have some bonafide sales data to build upon?

I think I know the answer. It is about signaling. Signaling what? When an entrepreneur shows a revenue projection of what the business will do in year 3, she is sending a message about how big of an idea she is pursuing. The specific number is not so important as is the growth rate year over year and the order of magnitude. The problem comes up when we (the VCs, the board, future investors), start holding the management team accountible to a specific number. "Why did you only do $5M last year when your plan was to do $7M" is a common type of question asked of early stage companies. A proper, albeit politically incorrect answer, might be "who the hell knows why?. We pulled that original number out of a hat 2 years ago before we had even launched out product. The fact that we even got that close is a miracle". Of course, that would be considered an inappropriate response since it is not based on some analystical foundation. But it is more truthful than a lot of answers that I hear entrepreneurs give.

In my next posting, I will provide some guidance on what I think a start up should do when presenting revenue forecasts.

What Do VCs Read

What do VCs read? That is a question that comes up now and then when I am meeting with enterpreneurs. What they are really asking, I think, is "where do VCs get their inspiration about a deal or market space". In my opinion, most of what inspires a VC to get excited about a market comes from rumor, hear say and general media publications. I really don't know a lot of VCs who scour market research reports to confirm growth rates in a new industry or peruse 10Ks to confirm the gross margins of a market leading company. This is one of the reasons so many venture backed deals are flawed from the start. They get funded by VCs who have little more than a superficial understanding of the underlying trends in the industry.

I mentioned that VCs tend to read a lot of general media publications (WSJ, NYT, Forbes, Fortune, ect). In fact, I am amazed at how well read most VCs are about what is gaining traction in popular culture. Getting a mention in one of these periodicals is an excellent way to stoke demand in your business from the investment community.

There is a flip side to all of this, however. When a narrative starts building about an industry being troubled, VCs get skittish, even when that narrative is based on specious arguments. I believe this is one of the reasons the dot com tech crash was so immediate and severe. In late 2000, every mainstream publication in America was breathlessly reporting how the Internet sector was essentially one great big fraud. When Paypal came to Clearstone in 2000 looking for funding, many other VCs simply could not get past the fact that it was a 'dot com'. If it was an Internet company, it couldn't be valuable. The funny thing was that Paypal was actually showing great adoption patterns. But in the end, most VCs were too busy reading Forbes about the stupidity of Internet business models to stop and assess the attractive financials of that business.

Let me offer this observation. If you are starting a company in an industry that is not well understood - 'below the radar' - in venture capital venacular, then you have an uphill battle on your hands. Getting a VC educated about your market space is no easy task. What can you do to improve your odds of getting funded? For starters, provide the VC with as much market data as possible about the trends unfolding in your market. This sounds obvious, but a lot of entrepreneurs believe that VCs are either already well versed about their particular market or that they have the internal resources to quickly find out. The truth is, most VCs have a long list of things they need to get educated about - given the variety of deals that they look at - and the easier you can make it for him or her to get up to speed, the better your chances of getting funded.

Saturday, February 23, 2008

How to Design an Effective Bonus Plan

There was a time when pre-IPO companies didn't have bonus plans. Generally, such businesses are still unprofitable and no one is interested in increasing the burn rate through bonus payouts. No more. Most of my pre-IPO companies today offer bonus plans to at least some of the management team. I have even warmed to this idea - having previoulsy been alarmed at the thought of paying bonuses while the company burned cash.

So, what are the key ingredients of an effective bonus plan? This question is one that I have wrestled with over a number of years as a board member and chairman of numerous compensation committees. Based on experience, I have learned that a bonus system should incorporate 5 specific elements to in order to be an effective motivator. I discuss these below.

My philosopy of bonuses is straightforward. A person's paycheck is for his or her regular work. The paycheck should suffice as appropriate compensation for someone who performs as expected. If she performs her duties as requested, and does an adequate job in that effort, then the paycheck is her reward.

A bonus, on the other hand, is a reward for doing something more and it has a two fold objective. It is, foremost, compensation for work performed at a level above what is expected. But it is also a tool. A very effective tool I might add. It allows a CEO to put a spot light on a specific objective that must be accomplished in a particular time period. Achieve that objective, and you will be rewarded with cash or stock remuneration. It is this aspect of the bonus that I like best. People can be motivated by money. If you want to motivate a person to achieve a certain objective, put a price tag on what it is worth to you. When an employee hears "get that system installed and operational in one quarter and you will earn $20,000 in bonus money", that tends to focus his mind on making sure it happens.

Now, onto the elements that must be incorporated in any bonus plan to maximize its effectiveness.

Timely - This means quarterly, not annually. An annual bonus simply takes to long to bear fruit. Also, consider the challenge of laying out a specific set of objectives in January that will still be relevant to the company in December. Not very likely. The quarterly bonus has one more attractive dimension. It gives the management team and the board a reason to evalute people on a frequent basis - and adjust priorities as needed. That is extremely valuable.

Meaningful - The reward being offered has to be a motivator. What that majic dollar or stock grant amount is depends on a lot of factors. Just make sure the bonus matters.

Predictable - The best bonus plans are ones in which a person can easily calculate what he is going to earn. This means emphasizing objective measures of performance. I hate subjective standards when it comes to bonus plans. Making an employee guess what he might earn is not a motivator. Lay it out in with simple math. To that end, the components of the bonus calculation should include no more than 3 variables. For instance, a VP of Operations might be bonused on 3 measurements: COGS, product shippments and customer satisfaction results. I have seen too many bonus plans with 15 + factors driving the bonus award. That is too many. It makes it nearly impossible for the employee to quickly assess how his contribution to a given task will affect his bonus. And ultimataly, you want him thinking that way. You want to influence how he spends his time. When an employee must make the inevitable trade-off between doing one thing versus another, you want the information provided by the bonus to guide his efforts.

Consistent - The structure and mechanics of the bonus plan should be remain consistent over time (as much as possible). This means that things like the payout frequency (quarterly), the bonus amount (% of salary for instance) and the number of variables in the bonus (2 or 3 is best) should remain constant. What can change - and likely should - is the specific activity or result that the bonus will be based on. For instance, the VP of Engineering may have her bonus for Q2 based 50% on the delivery of a certain product and 50% on hiring objectives. The next quarter, all of her bonus might be based on opening an offshore development center by a certain date. It is fine to change the specific activity being bonused, what should not change (at least not often)is the method by which a bonus is calculated and paid.

Fair - The purpose of a bonus is to motivate certain behavior to obtain certain results. So it makes a lot of sense to ensure that the employee can actually influence the results she is being bonused on! That is what I call fair. Seems obvious but it doesn't happen often enough. In my opinion, "group goals" suck! Remember what the bonus is for. It is to communicate to the employee what you - the CEO or board - find important and to motivate him to achieve certain results that you desire. This requires a bonus scheme that he can influence.

My final advice. As you put together your bonus plan, ask yourself, is the reward being offered Timely, Meaningful, Predictable, Consistent and Fair. If so, you probably have the makings of a bonus plan that will drive the results you are looking for.


Google's Lurking Problem....

Yes, even Google has problems. Some are well discussed - like its difficulties in trying to break into the hand held market - and some are not. All great companies follow an arc of some sort. They rise to prominence. They become the status quo. Eventually, they fade as someone else invents a better approach to solving the same problem.

Generally, it is only in hindsight that you can see where the troubles began for a business. Generally, but not always. Occassionally, a serious problem is hiding in plain sight. What problem am I referring to with respect to Google? Project managment. Specifically, the thousands of projects being undertaken by Google employees without proper corporate oversight of which ones makes sense and which ones don't.

Google has proven itself competent at monetizing search results. Nothing more. Even the idea of exactly how to do that, of course, didn't orginate with Google. That idea came from Bill Gross, who started (later renamed Overture and acquired by Yahoo). That is it. Google has a great pay per click business but no where has it shown itself exceedingly capable at inventing other billion dollar ideas. Which isn't to say it isn't trying. It is just going about it all wrong.

Google prides itself on its management edict that 20% of an employee's time is his (or hers) to do with as desired. The hope is that these bright and motivated workers will come upon a big new idea for Google to exploit. Fine in principal but not in practice. Consider that for all of Google's impressive revenue growth quarter over quarter, over 95% of its revenues still come from one source: Adsense. Yet, massive investment in money and time is being spent on thousands of other initiatives. What happens when its base business slows? My prediction? A radical wake up call to all of the employees who today consider it their right to explore projects willy nilly without regard to their realistic revenue potential. When that day comes, the culture of Google will have to change. Business discipline and accountiblity will become the new watch words. The strain this will put on the organization will be immense. Reeling in a loose culture and creating a layer of cold analysis is never welcome by line workers. At Google, it will be down right despised.

Now, aside from increased management oversight (which will come from where in a company that has never had any?), what do you think the impact will be when subsidized cafeteria, dry cleaning and car washes get eliminated.

Were I on the Google board, working on establishing a durable culture would be my top priority.....