An Engineer's View of Venture Capitalists
Rodent of Unusual Size
Thu, 18 Jul 2002 10:49:39 -0400
Rodent of Unusual Size wrote:
> Is this old bits? If not, I'll repost with the actual
> content; don't want to waste bandwidth if it's old..
I'm told the content wasn't FoRKed, so here 'tis..
An Engineer's View of Venture Capitalists
By Nick Tredennick, with Brion Shimamoto,Dynamic Silicon
I first encountered venture capitalists (VCs) in 1987. Despite a bad
start, I caught the start-up bug. In the years since, I have worked
with more than 30 start-ups as founder, advisor, engineer, executive,
and board member. It's a lot more than that if you count all the times
I've tried to help "nerd" friends (engineers) connect with the "rich
guys" (VCs). Naturally, I've formed opinions along the way. Many books
and articles eulogize VCs. But here I want to present an engineer's
view of VCs. It may sound like I'm maligning VCs. That's not my
intent. And I'm not trying to change human nature. VCs know how to
deal with engineers, but engineers don't know how to deal with
VCs. VCs take advantage of this situation to maximize the return for
the venture fund's investors. Engineers are getting short-changed.
Fortunately, engineers are trained problem-solvers--I want to harness
that power. Engineers, armed with better information about how VCs
operate, can work for more equitable solutions. I'm not offering
detailed solutions--that would be a book. Rather, this is a wake-up
call for engineers.
My first experience with VCs was as an engineer starting a
microprocessor-design company; VCs were the gods of money. The other
founders and I told the VCs what we thought we could do and how long
it would take. We believed it; they believed it; we were all naive. I
had designed two microprocessors, had written a textbook on the topic,
and had taught at a well-known university. They thought I knew what I
was talking about. We landed money from premiere firms on Sand Hill
Road in Palo Alto, Calif. We told them a year; it took something like
seven years and it took major changes in strategy to get there.
I wasn't the CEO; I hired and managed the engineering teams that
eventually reached the goal. I wasn't there for the finish. I had a
run-in with the other founders, including the CEO, over how to manage
engineers. It was micromanagement versus laissez faire. (Their
attitude: "Turn your back on them and they'll sit on their hands." My
attitude: "Turn these particular engineers loose and they'll work
themselves to physical ruin.") We were in danger of losing good
engineers to morale problems. I suggested to the board that firing all
of the founders, including me, might solve the problem. A new team
might manage more consistently.
The board member from our largest VC firm invited me to his house in
Woodside for a chat about the morale problems. Acres, opulence,
wealth. We sat in leather chairs on a black marble floor. Behind him,
through the glass wall, I saw major excavation and construction work
going on up the hillside. "It's too bad someone is building a resort
hotel so close to your house," I said. "That's my new house," he
said. "This one will be torn down when that one's finished."
We talked about the situation at the start-up. I outlined my
concerns. I handed him a list of names. "Here's contact information
for some of the project engineers. The first four will tell you what I
have told you. The fifth will say the following things...." To his
credit, he interviewed the engineers. Also to his credit, he called to
tell me the result. "Everything you said is as you said it was." I
felt relief. I had struggled with a deteriorating situation for a year
and a half.
We agreed on the problem; we agreed on the circumstances--a solution
was on the way. They told me: "We think you should resign." I left;
the problems didn't.
Guide to venture capitalists
The VC connects wealthy investors to nerds. There are few
alternatives. You can self-fund by consulting and by setting aside
money for your venture. That doesn't work. You could go to friends and
family, but that risks friendships. You could find "angel" investors,
but that only delays going to VCs.
The VC community is a closed one. It caters to a restricted
audience. In fact, you don't get to meet a VC unless you have a
personal introduction. Don't send them your business plan unless the
VC has personally requested it.
VCs don't sign nondisclosure agreements.
That affords them protection if they like your ideas, but they want to
fund someone else to do them. At least two of my friends have had
their ideas stolen and funded separately. One case was blatant
theft--sections of the original business plan were crudely copied and
taped into the VC-sponsored plan. My friend sued and won a moral
victory and a little money. The start-up based on the stolen idea went
public and made lots of money for that start-up's VCs. Most
entrepreneurs don't have the time, the means, or the proof to sue. In
the second case, venture firm D sent its expert several times for
additional "due diligence" regarding the possible investment. My
friend got funding elsewhere, but D funded its expert with the same
VCs are sheep.
The electronics industry is driven by fads, just as the fashion and
toy industries are. The industry is periodically swept by programming
language fads: Forth, C++, Java, and so on. It's swept by design fads
such as RISC, VLIW, and network processors. It's even swept by
technical business fads such as the dot-coms. No area is immune. If
one big-name VC firm funds reconfigurable electronic blanket weavers,
the others follow. VCs either all fund something or none of them
will. If you ride the crest of a fad, you've a good chance of getting
funded. If you have an idea that's too new and too different, you will
struggle for funding.
VCs aren't technical.
Mostly, they aren't engineers--even the ones with engineering
degrees. An engineering degree is a starting point. If you design and
build things, you can become an engineer; if you work on your career,
you can become an executive or a venture capitalist. VCs in Silicon
Valley are as technically sophisticated as VCs come. As you get
geographically farther from technical-industry concentration,
investors become more finance-oriented and less technically-oriented.
Like all people, they dismiss what they don't understand, your novel
ideas, and they focus on what they know, usually irrelevant marketing
terms or growth predictions.
Experts aren't very good.
The VC will send at least one "expert" to evaluate your ideas. Don't
expect the expert to understand what you are doing. Suppose your idea
implements a cell phone. The VC will send an expert who may know all
there is to know about how cell phones have been built for the last 10
years. As long as your idea doesn't take you far from traditional
implementations, the expert will understand it. If you step too far
from tradition--say, with a novel approach using programmable logic
devices instead of digital signal processors--the expert will not
understand or appreciate your approach.
One company I worked with had an innovative idea for a firewall: build
it with programmable logic and it works at wire speed. Wire speed
meant no buffering, no data storage, and therefore no need for a
microprocessor or for an IP (Internet Protocol) address. Simple
installation, simple management, but so different that experts--even
those from programmable logic companies--didn't understand it. To
them, proposing a firewall without a microprocessor and an IP address
was like proposing a car without an engine. No funding. Back to work
at a big company. Worse for them; worse for us. The industry
loses. Progress is delayed.
VCs don't take risks.
VCs have a reputation as the gun-slinging risk-takers of the
electronics frontier. They're not. VCs collect money from rich people
to build their investment funds. Answering to their investors
contributes to a sheep mentality. It must be a good idea if a top-tier
fund invested in a similar business. VCs like to invest in pedigrees,
not in ideas. They are looking for a team or an idea that has made
money. Just as Hollywood would rather make a sequel than produce an
original movie, VCs look for a formula that has brought
success. They're not building long-lasting businesses; they're looking
to make many times the original investment after a few years.
When VCs build a venture fund, they charge the fund's investors a
management fee and a "carry." The carry, which is typically 20 to 30
percent, is the percent of the investors' profit that goes directly to
the VC. The VC, who gets a healthy chunk of any venture-fund profits,
may have no money in the fund. Even a small venture fund will be
invested across a dozen or so companies, spreading risk. Also, the VC,
as a board member, will collect stock options from each start-up the
fund invests in.
The rich investors take some risk, though their risk is spread across
the fund's investments. The real risk-takers are the entrepreneurial
engineers who invest time and brain power in a single start-up.
Venture funds are big.
Too big. If your idea needs a lot of money, say $100 million, then you
have a better chance of getting money than an idea that promises the
same rate of return for $1 million. The VCs running a $1 billion fund
don't have the time to manage one thousand $1 million investments. It
won't even be possible to manage two hundred $5 million
investments. It's better to have fewer, bigger investments. In such an
environment, if you need only $5 million, your idea will struggle for
VCs collect in "bake-offs" that are the VC's version of price
fixing. They discuss among themselves funding and "pricing" for
candidate start-ups. Pricing sets the number of shares and the value
of a share, and is typically expressed in a "term sheet" from the VC
to the start-up. VCs optimize locally. It wouldn't do for several of
them to fund, say, six companies in an industry wedge. Limiting the
options to two or three limits competition and makes the success of
the few more likely. The downside: limiting competition stifles
innovation and slows progress. As in nature, competitive environments
foster healthier organisms. Innovation is the beneficial gene mutation
to the current technology's DNA.
I attended a recent talk by a VC luminary, who gloated over the state
of the venture industry, after money for technology start-ups was
scarce. Here's my summary of the VC's view:
"A year ago there was too much money available, so there was too much
competition to fund good ideas. Valuations for pre-IPO (initial public
offering) start-ups were too high. Start-ups could get term sheets
from several venture firms and select the most favorable. Too many
ideas were getting funded. With too many rivals, markets might never
develop. The current market is much better. Valuations are reasonable
and, with few rivals in each sector, new markets will develop--as they
might not have with many rivals."
This is nonsense. Look, for example, at hard disks and floppy
disks. In the hard-disk business, there have been as many as 41 rivals
fighting for market share. Only three major manufacturers competed in
floppy disks. The hard disk has improved much faster technically; the
floppy disk is stagnant by comparison. I'm not talking about market
size or market opportunity (the hard-disk business versus the
floppy-disk business); I'm talking about rates of innovation.
VCs don't say no.
If the VC is interested, you can expect a call and, eventually, a
check. If the VC is not interested, you won't get an answer. Saying
"no" encourages you to look elsewhere--that's not good for the VC, who
prefers to have you hanging around rather than going elsewhere for
funding. Fads change; the herd turns; your proposal may look better
next year. In addition, the VC may want more due diligence from
you--to add your ideas to a different start-up's plan.
If VCs think you have few alternatives, they will string you along:
"I love the deal, but it'll take time to bring the other partners
"We need more time to get expert opinions."
"We're definitely going to fund you, but we're closing a $500 million
fund, and that's taking all our time."
"I'll call you Monday."
Once your alternatives are gone, they negotiate their terms.
VCs have pets.
The VC's version of a pet is the "executive in residence." Many
venture firms keep a cache of start-up executives on staff at $10 000
to $20 000 per month (a princely sum to an engineer, but just enough
to keep people in these circles out of the soup kitchens). Start-up
executives, loitering for an opportunity, may collect these fees from
more than one venture firm, since the position entails no more than
casual advising. These executives have "experience" in start-ups. When
you show your start-up to the VCs, they will grill you about the
"experience" of your executive team. It won't be good enough, but not
to worry, the VC supplies the necessary talent. You get a CEO. The CEO
replaces your friends with cronies.
The VCs' pets are like Hollywood's superstars. Just like Julia Roberts
and Tom Cruise, the superstar CEOs command big bucks and big
percentages (of equity)--driving up the cost of the start-up--but are
"worth it" because they give investors and VCs a sense of security.
Your idea, your work, their company.
The VC's CEO gets 10 percent of the company. VC-placed board members
get 1 percent each. Your entire technical team gets as much as 15
percent. Venture firms get the rest. Subsequent funding rounds lower
("dilute") the amount owned by the technical team. Venture firms
control the board seats. The VC on your board sits on 11 other
boards. Board members visit once a month or once a quarter, listen to
the start-up's executives, make demands, offer suggestions, and
collect personal stock options greater than all of the company's
engineers hold, with the possible exceptions of the chief technology
officer and the vice president of engineering. The VC's executives
control the company. You and the rest of the engineers do the work.
One company I know got a good valuation a year ago. Over the year, it
grew rapidly, developed its product, met or exceeded its milestones,
and spent its money according to plan. When it was time to get money
again, the funding environment had changed. Last year's main investor
wouldn't "price" the shares or "lead" the new funding round. The
"price" declares the number of shares and the valuation of the
company. Think of the company as a pie. It is a certain size
(valuation) and it is cut into a number of slices (shares). An
investor "leads" by offering a specific price for shares for a large
percentage of the next round. Other investors follow at the same
price. Even though the company's engineers had executed flawlessly,
the round came in at less than a third of last year's valuation.
As a part of closing this "down" round, the last year's investors
renegotiated the previous round, effectively saying, "Since this round
is lower, we must have overpaid in the last round. We want more equity
for the last investment." If there had been fraud by the entrepreneurs
instead of flawless execution, renegotiating the previous round might
have been reasonable. Imagine the opposite scenario: "In light of
market developments, it's obvious that your idea is worth much more
than we thought, so we're returning half the equity we took for last
year's funding." It's so ridiculously improbable that you can't read
it without laughing out loud. That we accept the converse highlights
the entrepreneur's weak position.
Values at variance
The VCs know money and they don't care about the technology; the
entrepreneurs know technology and they need money. Money knowledge
applies across all the start-ups; the technical knowledge is unique to
each. The VCs don't care about any single technology because they
spread their investments across the opportunities. Knowing money isn't
the same as knowing value. A year ago, VCs were lining up to give
money to Internet dog-food companies; this year, they wouldn't back an
inventor with a working Star Trek transporter.
It's financial; it's not technical or personal. To the VC, the
engineer and the ideas are commodities. The venture firm squeezes the
technical team because it can. VCs believe that they are exercising
their responsibility to maximize return for themselves and for the
Reducing the engineers' share of the pie is counterproductive,
however: they become demoralized; productivity suffers; eventually,
they leave. Engineers are not commodities. Replacing a chip designer
one year into a complex design delays the project six months while the
replacement engineer learns and then redesigns the work-in-progress.
VCs don't appreciate that the electronics revolution is built on the
backs and brains of engineers, not of executives. Moore's law and
engineering talent drive the electronics revolution. Tremendous market
pull for its products builds momentum. The pull is so great that the
revolution is indifferent to the talents and decisions of its
executives (legendary blundering causes only ripples), but it depends
on the talent and the work of its engineers. The engineers are the
creators of wealth; the VCs are the beneficiaries.
Fixing the problem
The engineers building the future deserve a fair equity share in the
value they create; today they don't get one. For them to get their
share, wealthy engineers must fund start-ups. And they don't have to
be Bill Gates to do so. "Qualified investors" can participate in
pre-IPO funding. This means your net worth (exclusive of your home)
must be at least a million dollars or you must meet minimum annual
income requirements. These days, the millionaire's club isn't all that
exclusive. Many engineers are qualified investors.
If you are a qualified investor, participate in start-ups as an
"angel" investor. An angel investor participates in early or "seed"
funding rounds. Don't do it with more money than you can afford to
lose, however, because it is risky. To change the situation I'm
describing, start-ups need your money and they need your advice. More
money and more start-ups bring faster progress and create more wealth.
Creating wealth isn't only about money; it's about quality of life and
it's about raising the standard of living for everyone (but that's
Engineers should band together to form venture funds. Start-ups need
more angel funding and they need better-organized angel funding. I'd
like to see a dozen or so $100 million venture funds run by
nerds. These nerd-based venture firms would work at the seed round and
at the next funding round (called the A round). They provide initial
funding and advice and they, with the benefit of professional
financial advice, represent their start-ups in future funding
negotiations with traditional venture firms.
Here's a third suggestion. I'd like to see an engineer-run start-up
whose goal is to raise $100 million in a public offering. The money
becomes a fund for sponsoring start-ups. It's a public venture firm
and it sells shares to raise money. Investing in start-ups wouldn't be
exclusively for rich people; anyone who could buy stock could be
investing in start-ups. Ideally, the public VC firm would be managed
and run by nerds with empathy for nerds in the start-ups.
I wanted to publicly thank more than a dozen people for help on this
essay, but they all said "NO!" None can afford to have the VCs find
out that they contributed.
Ken Coar, Sanagendamgagwedweinini http://Golux.Com/coar/
Author, developer, opinionist http://Apache-Server.Com/
"Millennium hand and shrimp!"