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an inside look at the venture industry
venture capital confidential
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Mr. Burke: That goes to what we always tell the entrepreneurs: Focus on the VCs who have the expertise in what you're trying to do.

Mr. Wade: It's one of the key things that we look for.

Mr. Wilcox: Even so, it's unrealistic to expect most VCs to know your technology as well as you know it. You've been living that technology for years, presumably. They're going to get outside help. They can't know it as well as you do.

Ms. Burkett: And technology isn't the only thing. We're counting on our venture capital firms to build companies that are going to provide returns.

Mr. Wilcox: Technology is actually secondary. When we invest in funds, just like when funds look at entrepreneurs, they're looking first at the people, then, second, at the product or the technology. We do the same thing when we look at funds. We're more interested in the people

Mr. Burke: I have some questions on cards from the audience and some sent by email. Here’s one: What is your time horizon for profitability?

Mr. Biddle [Laughing]: Before we run out of money.

          Seriously, it's a difficult question. If you've got a company that's burning $30 million a year and co-investors who aren't particularly strong or haven't done a good job, the company needs to be profitable tomorrow or I'm going to lose all my money. If I have a strong syndicate and a company that's got a manageable burn rate, it could be three or four or five years.

          The thing we're trying to do in venture capital is build what I call a “magic box” where you put in a dollar, turn the crank, and two dollars come out. That's what we do. We invest before that box is built. Once the box is built and it works, you want to pour money into the machine because it works. I have companies and they can lose all the money they can raise because the model works. It varies.

Mr. Burke: During the rigorous due diligence process, what considerations or weightings are given to the strengths and weaknesses of the management staff, both from the company's standpoint and then when the LPs are looking at the funds?

Mr. Biddle: It depends on what they're trying to accomplish. There's usually two or three things that are the “secret sauce” in a deal that have to be pulled off. Those are the things we've got to focus on. If we have an inventor who has come up with something that's just over the top, we'll build a management team. If we have somebody with a pretty good idea and they haven't been top of their class in everything they've ever done, we're probably not going to make the investment. It depends what the secret sauce is. Most companies have a good idea, they've got an advantage, they've got a year. The management team is going to be the key.

Mr. Burke: From the LP’s perspective I would imagine there are fewer secret sauce ingredients. How would you view the management team?

Mr. Wilcox: For us, it's the people -- their character, honesty, integrity. Do they have some entrepreneurial scar tissue? That's important. Beyond the people, it's the track record. Do you have some exits you can show us?

Mr. Wade: One of the things that's important for us is whether this group has worked together previously. Is the track record such that they're not coming together in one cohesive unit for that present fund?

Ms. Burkett: In the process, we ask what they do to build management teams, and what their success record has been in building management teams or filling certain slots. Do they work with headhunters? Do they have good networks among the entrepreneurial community to fill those vacancies?

Q: I’m Ike Broaddus with GURU NETworks. We are a software company. We have products, customers, revenue, and we're looking to raise a number that seems to be somewhere in No Man's Land between the angels and the VCs. I'm wondering, do we pare down the business plan and go angel, or do we bulk it up and go for VCs? We're looking for $1-$1.5 million. What is the dividing line and has it changed in the last year or so?

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Ms. Burkett: I've heard the angels flew away.

Mr. Biddle: One of our investors has the expression: “The tourists have left.”

          If you've got $1 billion, it's not economic to make investments at that size. The numbers don't work to write a small check. However, you've got a lot of funds in the area with $50 million, $100 million, $200 million. We've invested as little as $50,000, and I want to be able to get $1 million to $5 million into the company over time.

          That's part of the reason why we're small. Our definition was: If 10X on a $1 million investment is immaterial to your returns, you can't make million dollar investments. With a $125 million fund, $10 million is material to me and my limited partners. We'll make $1 million dollar investments, just getting traction. It's fashionable compared to a couple of years ago, but it's not enough.

          In venture, most of the people who got rich in the computer industry were software people, and they couldn't raise any venture money. Before 1990, venture capitalists wouldn't touch software companies. They had to build it themselves and they ended up owning 30%-40% of their companies, whereas the hardware people, the Gene Amdahls of the world, ended up owning 2% of their companies because of the capital requirements. In a business like you're talking about, you should be able to grow the business and be profitable without me. I'm just gravy.

Q: Good morning. My name is Keith Bickel with The Bickel Group. Could you comment on this term that seems to have crept into the lexicon, “dry powder?” Everyone is talking about dry powder, meaning that there’s lots of capital sitting on the sidelines. From a limited partners’ point of view, is this becoming a bone of contention, particularly with respect to management fees since these guys are still paying themselves a nice, rich management fee without having deployed the capital? Is there enough capital leaving that it will be business as usual going forward in the next decade? Could we see another boomlet on the horizon because there's a ton of dry powder waiting to be put into businesses?

Mr. Burke: Before you answer that, does anyone have an idea of how much dry powder is actually out there on the sidelines?

Mr. Biddle: The number I see is $150 billion.

Mr. Bickel: So, it is emerging as a point of contention?

Ms. Burkett: It is.

Mr. Biddle: Let me address the dry powder issue, because the rules here have changed a little bit. Back in the 1980s when we had a meltdown like this in a much smaller industry, you hunkered down and found a rancher where you would put a quarter of a million dollars and the company stayed alive. Today, if you're burning $1 million, $2 million a month, there's no rancher who's going to finance that; it's got to be venture capital.

          The financings today are brutal. There's a router company in California that raised $150 million. My understanding is that this thing works and it's incredible. They just raised $100 million as a Series A at a $5 million valuation. The $150 million turned into $5 million dollars worth of common stock. The hot money who put up the $150 million, they're wiped out. The big franchise funds who put up a lot of that money, the new $100 million, they wiped themselves out, but now they own the whole company.

          In areas like communications, every financing that's being done today is a restart financing, so all the prior money gets wiped out. If there's another financing after this, that money will get wiped out. The last guy left is going to own the whole company. You can't do that without dry powder. We're not allowed to crossover invest.

          I've called 92% of my 1997 partnership. The fact that I have a lot of money, if you're in my '97 fund, means that I've got reserves for you, but I can't put $5 million or $10 million dollars into a deal. Each fund, when it runs out of money, is dead. They will be wiped out in future financings.  If I have the ability to threaten to write a check, to say, “The terms you're offering are ridiculous, I'm going to do it myself,” then I may not have to. The ability to write that check potentially can protect you in the future financing.

          There’s another side to this. If I wipe out the prior investors that includes the company’s management who are left with no incentive. That's terrible, so the management gets reloaded. In a lot of these companies -- maybe they raised $70 million of preference that we get first before the entrepreneur sees a nickel -- well, when the VCs get wiped out, the entrepreneur moves way up the food chain. As a result, these are good for the entrepreneurs, but they're terrible for the investor who ran out of money.

Q: I’m Bill Wakefield with Hypergrowth Advisors. It was mentioned earlier that a lot of VCs are going to have difficulty raising a future fund. What sort of due diligence should entrepreneurs do on the funds that they're targeting in order to make sure that the VC will be around in the future?

Ms. Burkett: You can go to their websites and find out a lot of information about them. Most of them will tell you the kinds of investors that stand behind them, and, if they have good, strong institutional investors, the chances are that they're going to hang in there with that fund.

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Mr. Biddle: You can also look at the co-investors in their deals. The really good investors in good companies usually have their pick of whom they want, and they'll pick the best groups. Look at the syndicates that they invest with. The fact that you can raise another fund, as I said before, is not going to save you, however, because you're in the last fund. The important thing you want to know is where you are in the fund. How much capital have they called? What are their reserves? Do they have dry powder for you? That's important.

Mr. Burke: A number of funds are affiliated with a strategic LP or partner with an interest in a particular space. How does this impact the decision by other LPs to invest and how does it impact the way those funds invest?

Ms. Burkett: For me, if I'm in a fund with a corporate or strategic partner, I have to be concerned about it because they have an agenda that's different from mine. Mine is a return agenda; I'm not looking for opportunities to broaden my base of business the way they are. The mix of limited partners that I am involved with makes a difference to me because of their agendas.

Mr. Wade: Historically, we haven't made very many investments in funds that have a strategic limited partner or some kind of strategic focus. I don't see where that would really be a good fit for us going forward.

Mr. Wilcox: We may be in a few funds that may have a few strategic limited partners, but I agree that they sometimes have a different agenda that may conflict with ours.

Mr. Burke: Jack, looking out 18 months, where do you see the bulk of the investment dollars going?

Mr. Biddle: Into Series A rounds and promising companies that have raised $100 million.

          Part of the problem with the business is that startups are built on the Fortune 1000. You can't make money selling to little guys or schools; you have to sell to Caterpillar and DuPont and Rockwell, and it's hard to do. A lot of VCs and a lot of entrepreneurs have forgotten who their customer is. They think their customer is Goldman Sachs, then Fidelity Funds for their IPO. That's not your customer. Your customer is Caterpillar. We should be investing in things that a $60,000-a-year programmer at Caterpillar will bet his job on. He’s willing to bet it on a startup if you can make his life better. People who have value propositions to the Fortune 1000 can build real companies, and, at the end of the day, if you have a real company, you will get paid. The focus is on real companies. What you're hearing about “traction, traction, traction,” is people remembering who the customer is, and showing that this guy at Caterpillar will bet his job on a startup. He is betting his job because there's no other employer in Peoria. It's not trivial. The investor is saying, “Prove it. Prove that the guy will bet his job.” Historically, the IBMs of the world were successful because people literally bet their jobs if a supplier went out of business. It has to be a heck of a value proposition for you personally to take that kind of chance.

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Mr. Burke: We've talked a lot about early stage companies. A couple of people in the audience want the panelists to comment on the opinion that VCs are not doing the best job in transitioning companies from early stage to later stage. Do you agree with that opinion?

Mr. Biddle: It's very true. VCs have different backgrounds, and some are very good at helping companies with systems and control in the later stage. The hardest thing in the business is knowing when to step on the gas, and that comes from experience.

          We focus on the early stage, and, as our companies get to be pretty big, other investors have come in who are probably better at that than we are and tend to take the lead. We have companies that are $100 million companies. That's a different animal than the two guys in the garage we backed earlier. We're not as active there as we were in the earlier stage because we're not as good at it.

Mr. Burke: From the LP’s perspective, you have the portfolio with early stage, later stage, and mezzanine funds. How does it break out for you, and how do you think through weighting the stages?

Mr. Wilcox: We see it as three stages -- early, expansion, and later stage -- and we try to weight each stage equally. Again, we watch them closely for style drift, because we don't want the early stage guys becoming expansion stage and we don't want the late stage becoming early stage.

Ms. Burkett: We overweight on the early stage with the theory that we're going to buy low and sell high. Historically, the later stage is where we started, but it has not been as successful for us of late, and a lot of my late stage funds are telling us that they're getting early stage pricing on their deals. I'm happy with the over-weighting on the early stage with less on the later stage because, in our portfolio, those are our bigger funds and they have more capital to put to work.

Mr. Wade: We have a balance, but, as of today, we're looking to underweight the later stage. If we were to add a new general partner it would be in the early stage because we think that's where the upside and the better opportunity would be.

Mr. Burke: One last question from the mail bag. How valuable are the intangibles from the LP perspective and how much of this is just a dollars game? How much do you pay attention to the funds and the people in the companies versus it just being a returns game?

Mr. Wade: It's very important to actively develop relationships with your general partners and to pay attention to what they're doing; specifically, to try and hone in on whether or not there is some kind of drift. When I get in a large setting like an annual meeting, I typically don't try to talk to the Jack Biddles of the firm, I talk to the senior associates, find out their insights, and see how things are going from that level. I enjoy the opportunity, and I think it's usually helpful.

          [Laughing] Jack, I shouldn't have told you that, but it's served me pretty well in the last couple of years.

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Mr. Burke: What do you hope to find out by talking to them?

Mr. Wade: What they're really doing, how things are actually working in the organization, and where they think the opportunities lie.

Ms. Burkett: The entrepreneurs are also important in that mix. They can tell you where the fund is going, how they're performing, and how their different investors are contributing to the growth and value of the company.

Mr. Burke: So you will actively seek out entrepreneurs who have been backed by the fund that you're looking to invest in?

Ms. Burkett: When they give me the chance, yes.

Mr. Burke: I'm curious. With a show of hands from the audience, how many of you have actually talked to the portfolio companies of a venture fund? A pretty small number. It's some due diligence that I want or should do.

          That’s all for us. Thank you, all.

Ms. MacPherson: I think it's interesting to look at the parallels between entrepreneurs who are looking for private equity funding and the funds that are looking for institutions to invest in them. Listening to the panel, I observed a number of similarities.

          Certainly, the LP’s perception about first-time funds is much like the way funds look at first-time entrepreneurs. They both look at focus, discipline, performance over time, the right people, market dynamics, and the competition.

          The entrepreneurs know that the rules have changed for them, and we heard today that the rules have also changed for the VCs. For both, cash is king. The entrepreneurs look as it as “runway;” the funds look at it as “dry powder.” They are two things that you don't want to run out of.

          Finally, the right people are so important for both. Whether it's  Jack trying to get the right LPs into his fund, or entrepreneurs getting the right VCs into their companies, it all turns out to be about the people.

          Thanks to our panel, and thank you all for coming. We look forward to seeing you at the next event.

[End]

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