A Guide For A Future Venture Investor

Formation of New Ventures – Final December 6, 2007

Jules Maltz

My Last Lecture in S353: A Guide for a Future Venture Investor Although the focus of Formation of New Ventures is on building and managing an entrepreneurial company from the CEO’s perspective, I am struck by the number of lessons that I learned that are also relevant for a future venture capitalist. As I contemplate a job next year investing in private technology companies, I have tried to summarize these key lessons on both venture deal evaluation and board management to serve me as a guide throughout my career.

Venture Deal Evaluation Evaluating the attractiveness of an investment from a venture capitalist’s perspective is analogous to evaluating the prospects of starting a company from an entrepreneur’s position. Similar to an entrepreneur, a venture investor should focus primarily on two attributes: a) the authenticity of the idea; and b) the total available (and serviceable) market. However, in contrast to an entrepreneur, the venture capitalist should also assess the motivations of the management and look for teams who are willing to take high-risk, high-return strategies. An analysis of these three lessons is provided below: •

Authenticity:

As we studied the various cases, there was a clear pattern in that the

“authentic” companies (i.e. companies founded by entrepreneurs with direct experience in the problem or a natural capability to solve it) were noticeably more successful than nonauthentic businesses. In McAfee, for example, John McAfee is ideally positioned to establish his company because of his understanding of viruses and his experience operating electronic bulletin board systems. When he reads an article about a rumored computer virus, he immediately understands the implications and how he could distribute software to prevent

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Formation of New Ventures – Final December 6, 2007 these viruses.

Jules Maltz

Similarly, Vinod Kholsa’s idea for Sun Microsystems grew out of his

realization that Daisy was spending 80% of its resources building computer hardware because nothing existed in the market. Recognizing this need for standard workstation hardware, Kholsa recruited Andy Bechtolsheim, the foremost expert in designing workstations. In contrast to these successful founders, entrepreneurs without authentic ideas often struggled to clearly address the market need. While David Roberts and Brian Axe had some prior general business knowledge, they launched Zaplet based only on a personal bad experience scheduling a vacation (rather than a true understanding of the email coordination needs of consumers and enterprises).

Because these entrepreneurs weren’t uniquely

positioned or capable to address the opportunity, the company struggled to find its product market fit. •

Market Size: In addition to authenticity, venture investors should also look for businesses with large current, or future, available and serviceable markets. While an authentic entrepreneur (the “jockey”) is core to the success of a company, there is no substitute for a product uniquely positioned to address a large market (the “horse”). McAfee, for example, recognized that every PC would ultimately need virus protection software. His distribution strategy of using the bulletin board systems allowed him to take a large share in the serviceable market of network-enabled PCs, and eventually grow into the total available market of all computers. The venture investors backing XenSource also focused on the market opportunity in virtualization. While XenSource was clearly behind VMware in its share of the serviceable market, only 5% of all severs were virtualized, creating a large “green field” opportunity for the company. Furthermore, Sequoia Capital, in its fund XI offering memorandum, explicitly states that it focuses on markets that are, or have the

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Formation of New Ventures – Final December 6, 2007 potential to grow to, over $500M.

Jules Maltz By consistently backing companies that are addressing

large markets, venture investors can avoid mediocre outcomes, and, hopefully, achieve premium returns. •

Attract High-Risk, High-Return Entrepreneurs: Finally, venture investors should attract riskloving entrepreneurs who are willing to take large gambles to achieve massive returns. As Andy Rachleff illustrated through the “coin flipping exercise” (i.e. at what dollar amount would you stop flipping a coin if you had a 50% chance of making 10x your money and a 50% chance of losing it all) the typical entrepreneur is significantly more risk averse in betting his/her company than the average venture investor (since the investor has a diversified portfolio). To encourage the venture fund’s potential for high-return outcomes, investors should look for entrepreneurs who have an unusual tolerance for risk. Vinod Kholsa demonstrated this quality when he left Daisy, which had already achieved some success, to start Sun Microsystems. Kholsa’s goal in founding Sun was “to take on IBM and DEC,” the two largest mainframe players, and beat them in their primary businesses. Interestingly, as Sequoia’s offering memorandum notes, many of the most successful entrepreneurs who demonstrate this risk-loving quality are immigrants. Leaving one’s home country demonstrates that an individual is willing to take a large risk for a high return.

Venture Board Management In addition to analyzing the company formation process, the class also focused on the dynamics surrounding a private company’s Board of Directors. While many of the cases centered on dealing with the Board from the management’s perspective, there were several lessons in how a good venture director should work with the CEO. Specifically, a venture investor should

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remember that the Board relationship with the CEO: a) starts with the term sheet; b) should be challenging, yet supportive; and c) may come into conflict with the interests of the venture fund. •

Relationship Starts With The Term Sheet: While a venture investor typically does not join a company’s Board of Directors until after his or her fund has made an investment, the investor’s relationship with the CEO starts well before the first Board meeting. For many directors, the CEO’s conduct during the term sheet negotiation process serves as a good indication of the CEO’s future behavior in dealing with the Board. In Hotmail, for example, Sabeer Bhatia used the threat of a fictitious angel financing to convince Steve Jurvetson to pay an unusually high price in the initial financing round. Although the company ended up with a successful outcome, Bhatia’s behavior in negotiating the term sheet created a lack of trust between both parties. This mistrust continued after Jurvetson joined the Board and into the future financing rounds, placing the company in unnecessary risk. In contrast, John McAfee’s conduct in working together with Jeff Chambers from TA Associates to structure a fair deal fostered a more productive relationship between the two parties that ultimately resulted in a better managed company. In addition to analyzing the CEO’s behavior during the financing, venture investors should also behave in a way that encourages trust with the entrepreneur. By placing the “gun in the entrepreneur’s hand” and letting the entrepreneur determine what terms are fair, a venture investor can create a strong bond with the CEO and assess whether the entrepreneur is also trustworthy.

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Challenge and Support the CEO: Once the investment has been made, a venture capitalist’s primary role as a director is to serve as a “sounding board” to the CEO. As the article “Forming and Working with the Board” mentions, the best Board directors give “independent, informed advice to management and challenge the CEO, rather than acting as

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a rubber stamp.” Because a venture investor has often backed numerous companies, he or she can provide guidance that can help the CEO navigate through a difficult situation. At the same time, however, venture directors must be careful not to “direct” the activities of the company. For example, in Zaplet, Vinod Kholsa, as a Kleiner Perkins director, drove the company to create five disparate business units. While this was, in part, due to the frothy capital-raising environment in late 1999, it eventually led to a major company restructuring and the ultimate demise of the business. Instead of directing management, Board members should empower the CEO, who needs to be responsible for the actions of the company (and the eventual outcomes).

This system allows the Board to effectively evaluate the

performance of the CEO and assess whether future management changes are necessary. •

Recognize and Manage Potential Conflicts of Interest: Finally, it’s important that an investor recognize and address his or her dual role as a fiduciary of the company and as a partner of a venture fund. Because of this dual role, there may be potential conflict of interests when an investor might prefer to push for a higher-risk, higher-return outcome, even though it is not in the company’s best interest. For example, in the Conectics case, Kleiner Perkins may have preferred that the company restart a Phase III trial for Relaxin, rather than focus on the safer dermatology business. A director should avoid these conflicts by always voting in the best interest of the company as a Board director (even if this conflicts with how the investor’s firm is voting as a shareholder). Additionally, a venture director should abstain from votes where there is a clear conflict of interest and/or seek to involve independent directors to provide an unbiased perspective.

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