A new model for investing in "social"

I had the pleasure of sitting on a panel last night sponsored by GoodCompany Ventures, a very interesting shop that helps entrepreneurs with a "social investing" (but not necessarily a non-profit) mission get their start with advice, mentoring, and sometimes capital. I sat on the panel with some outstanding thinkers including Jacquie Novogratz (Acumen Fund), Fred Wilson (USV), Jacob Gray (Murex Investments) and Scott Edward Anderson (The Green Skeptic). I had never spoken on the topic of "social investing" before and, quite frankly, didn't exactly know what it meant except I that generally thought of the term as pejorative from an investment perspective. Social investing? This means not really generating attractive returns, right? Well, after last night's discussion and thoughts that came to me on-the-fly during the debate I have a very different perspective on what this burgeoning asset class really means, and how it has the potential to change the world in an array of positive ways.

First of all "social investing" is a really dumb term. If you're going after conventional for-profit investors the social moniker will kill the pitch every single time. Fred Wilson raised an interesting point about the difference between short-term and long-term profit maximization. He is personally willing to take the long view on building an attractive, sustainable business even if its goal isn't maximization of short-term profits (read: Etsy). And, in fact, he cites personal examples of companies that have been short-term profit maximizers that flamed out because of unhealthy business practices. But I think the issue is more fundamental than that. Many of the companies being incubated by GoodCompany or funded by Jacquie's Acumen Fund wouldn't make the grade even on the terms Fred laid out. It's not strictly a short-term/long-term issue. It's an issue of how you define capital and return.  

My hypothesis is that we need a whole new regime for quantifying the value of businesses that have goals other than strictly financial profit. We need hard numbers - real metrics - to demonstrate the value of initiatives that create value for society beyond the payment of staff and the generation of profits for shareholders. For instance, Jacquie brought up the example of a company Acumen funded that provides treated mosquito netting for families in Africa. These nets provide people from getting malaria, saving enormous amounts of money on acute health care and work time lost, while insuring economic productivity among the youth for their lifetimes that otherwise could have been cut short by infection and disease. These benefits are able to be quantified: we have the economic data to do the crunching, and the econometric modeling techniques at our disposal to quantify the ROI of these investments. But the "R" - the return - isn't simply financial profit: it's economic utility, real benefits being enjoyed by society. These are the terms we should be used to define the benefits of this kind of investing - this asset class - which really does need to be viewed as an asset class separate and distinct from businesses principally focused on financial returns.

So if the appropriate measure is economic utility (which encompasses both financial and social profits), how should these businesses and initiatives be funded? I would argue that it should tap into capital from two key sources: Government and funds that have traditionally gone toward conventional philanthropy. Fishing around in the traditional for-profit pond is a waste of time: utility in this sphere is generally uni-dimensional - profits first and last. Let's be honest. Investing in this asset class has the potential to generate traditional financial returns, but they are tenuous. And if this is the benchmark by which capital is allocated among projects, many critical projects will go unfunded because the measure is wrong. So if we can all shed the stigma of "social investing" and acknowledge that you can still "invest" and "do philanthropy" at the same time, I think it would go a long way towards improving the messaging of this vitally important asset class. I see this approach as addressing the capital allocation problem among philanthropies. By taking a disciplined, numbers-based approach to quantifying cumulative benefits, it will become increasingly clear which businesses with a social mission should attract investment capital and which should not. It will no longer simply be a marketing issue, but one grounded in logic and reason. Will some projects go unfunded that would otherwise have attracted capital because of its PR? Yes. But will many more important projects get done that otherwise would have gone unnoticed because they might have a low Q score but massive economic utility? For sure.

These are only my initial thoughts on this topic. I will definitely be applying more mental cycles to these incredibly important issues. I'm looking forward to both stimulating and participating in this critical dialogue.

Does being a VC mean "trying to change the world?"

My friend Chris Dixon just wrote an interesting post titled It's not East Coast vs West Coast, it's about making more places like the Valley. It is very interesting and provocative, and as with all Chris's posts, it's a must-read. However, it honestly rubbed me the wrong way and prompted me to write the following comment:

Chris, I think it comes down to what being a VC really means. You seem to equate the VC mission with "making things that change the world." I believe this is a narrow and potentially dangerous definition, and actually highlights one of the biggest problems with the Silicon Valley venture scene. It also, in my experience, doesn't reflect the true dynamics of how large-scale West Coast VC works, which is a lot less sexy and entrepreneur-friendly than you indicate.

Should a good VC be working to fund ideas that change the world? Yes. Should they also be looking to back young companies working on important problems that are, say, built on top of something else and very useful but not transformational? I'd say so. There are lots of start-ups of value that will never be the next Google, Twitter, Microsoft or Apple, but that doesn't mean they shouldn't be funded and nurtured as any start-up should. If one were to apply the "change the world" mission to venture investing, the amount of capital being invested in such companies (or even that should be invested in such companies) is probably less than 20%. To me the key is making sure that those 20% or so get the requisite support and time to thrive from their venture backers, which is the much bigger issue at hand.

I'd like to think that I back worthwhile start-ups and am very entrepreneur-friendly without all that negative financial engineering you ascribe to certain East Coast VCs, but do most of my portfolio companies have a chance to change the world? Not in the way I define changing the world. And personally, I'm ok with this. I'm helping to create useful products, create jobs, and foster entrepreneurial excitement and possibilities. This is what venture investing means to me.

As it relates to large West Coast VCs, many of these firms are structurally bound to trying to change the world because they need those kinds of wins to return their funds. This doesn't make them paragons of virtue; it makes them rational. But buying this series of far out-of-the-money call options has an ugly dark side as well: if companies don't appear to have the potential to change the world (read: sell for $1 billion+, go public, etc.), they often get squashed and orphaned since they are no longer worth the VCs time. Now I'm painting with a broad brush here but you get the point. Does this dynamic help create a favorable entrepreneurial culture? Is this approach really making the world a better place? Not to me. Plenty of companies that would have made it on the East Coast will fail on the West Coast precisely because of the need to hit home runs to the exclusions of singles, doubles and triples.

Chris, I certainly agree that those investors who are heavily focused on metrics and traction are noxious and ill-placed as seed stage investors (they are really Series B, C and D investors). However, I would say that entrepreneurs who combine vision with pragmatism are more attractive to me than entrepreneurs who simply have vision. Might this pragmatism keep the starry-eyed entrepreneur from changing the world, and only building a really large, successful company? Yes. Is this necessarily an indictment on the NY VC reputation of wanting to understand plans for commercialization even in pre-revenue companies? I don't think so.

Thanks for penning this, Chris. You've raised some really important points that warrant discussion.

Roger

These were my $.02. I'd be interested in your thoughts, too.

Thoughts on Taking Venture Money

My (highly intelligent and experienced) friend Chris Dixon just posted on the importance of VC brands. He makes many good points and you should read his perspective. But the issue Chris raises begs a more fundamental question: whether or not to take venture money, and if so, from whom?

There are many variables that come into play. Are you a seasoned and successful entrepreneur? Do you have a functioning product with demonstrable traction? Does your team include a strong founder-technologist with a strong reputation? Taking venture money early is simply not an option for many, if not most, start-ups. If you are a guy like Chris who has already made top institutional investors money (Bessemer, General Catalyst) from a prior start-up (SiteAdvisor, sold to McAfee after 14 months), getting venture backing for your next company (Hunch) is not much of a struggle. But this is the exception and not the rule. And while raising money as a seasoned and successful serial entrepreneur from legacy backers isn't difficult, it is generally a wasteful time-suck pursuing venture money early in the game. This is not the same as "Don't talk to VCs." Absolutely not! VCs are invaluable sources of input, contacts, and pitching experience for the new entrepreneur. These are opportunities not to be missed. But to spend enormous amounts of time trying to raise first-round money from venture investors is almost always a mistake.

So where to go? Strategic angels. Small venture firms and "super angels." Entities, be they firms or individuals, whose charter is to take pre-revenue risk at a fair price and help these nascent companies succeed. At the seed stage it is critical, absolutely critical, to build the right investment syndicate. Getting money from mom, dad and friends is ok, but is not going to deliver the value-added of a strong seed-stage syndicate of professionals who may be tough on valuation, but bring a discipline and culture of support to the venture. Angels and small firms, just like brand-name VCs, can be due diligenced fairly easily. There are a finite number of these people and firms, and they can be tracked down through either VCs, online research or smart networking quite easily. But as is the same with venture firms, warm introductions are critical to getting the right meetings and being taken seriously. Fair or not, reality is that the best of these investors get bombarded with deals, and need to impose filters to effectively manage inbound traffic. And the most powerful filter is receiving a deal from a trusted source. So if you are a start-up seeking seed funding, I'd create my target list of angels and small firms/super angels and work my rolodex like hell to get the right introductions. Otherwise, you are fighting an uphill battle.

Let's say that you've gotten that seed funding, something in the $250K-$1.5MM range, that has helped you prove out the business model, win early customers and generate some revenue traction. And let's say that you are in a capital-efficient business, where you don't need $20MM to ramp growth, but something in the $2-$5MM range. While it may make sense to take more money down the line, this amount is likely sufficient to build a very valuable business at scale (but perhaps not the $100MM+ business that we all dream of). Where should you get this Series A money? The "big brand" firms with huge pools of capital? Medium-sized firms? Small firms? Not an easy question, with virtually countless permutations. That said, t I do think there are three factors all entrepreneurs should keep in mind when making this decision.

1. Size of fund
2. Deal partner
3. Domain expertise

Size of fund: In general, the larger the fund, the larger the required exit in order for an investment to be worthwhile. A fund with assets north of $500MM is going to be hard-pressed to invest $3-$5MM in a company and be ok with an exit less than $100MM, assuming they own 20% of the company. The payoff simply doesn't move the meter. They want to "lean hard" (e.g., put more money into and shoot for a mega-exit) on winners, because nominal dollar returns to pay back the fund are critical. This is where alignment of motives breaks down. ROI is not the measure, it's dollars returned. This creates a problem for entrepreneurs who may want to accept the $60-$70MM exit (which, incidentally, is many times more likely to occur than the multi-hundred million dollar exit), but where the VCs have a blocking position and can force such a deal to be turned down. So it's important to understand that taking money from large, "brand name" firms (and the two generally go hand-in-hand) often means that you are "going for it" - no sub-$100MM exit for you. It will either be a home run or you'll be stuck for a long, long time. As long as you go in eyes wide open, then ok. But this is a material barrier to those running capital efficient businesses who want to preserve the optionality of exiting across an array of scenarios.

Deal partner: As mentioned above, having the right deal partner is critical, regardless of whether you are talking about the seed round, the A round, B round or beyond. A strong deal partner can help materially de-risk a business through sound mentoring, prudent board leadership and valuable connections. The brand of the deal partner is far more important than the brand of the firm. While having a brand name firm might help in future fund-raisings (unless they choose not to invest - then you're screwed), it pales in importance to a great deal partner. Deal partners become great because of what they do, not who they work for, so raising the next round with a great partner, even if they're not at one of the "elite" firms, does not in my experience represent a barrier to fund raising. And if the deal partner has good chemistry and a positive attitude towards working with the first-money in seed investors, so much the better. Then everyone can be pulling in the same direction. It is a powerful combination.

Domain expertise: An extension of the deal partner concept. Certain firms have experience at certain things. Those firms most active in your space and close to the end-users you want to sell to should be the highest on your hit list. They have the benefit of "pattern recognition," having lots of data about firms like yours, how they might stumble and ways in which the growth plan can be better executed. They are also likely to have great contacts on the recruiting front, absolutely essential to building a Series A company in rapid growth mode. And while your deal partner is the one you work with most closely, having others in their firm able to help out with introductions, occasionally sit in on strategic Board sessions and to identify key recruits will prove invaluable over time.

While there are always exceptions, these are the factors I've found most important in helping entrepreneurs achieve their business and strategic goals. Good luck, and be careful out there.

The Peter Lynch of Consumer Internet is.....

Fred Wilson. Why this just hit me today I do not know, but after thinking about it I know it to be true.

I was having a conversation with a very good guy from MTV Digital today, Michael Bloom, and we got to talking about the NYC investment scene. Invariably the conversation winds around to Fred and his partners at Union Square Ventures, and as I always do I mention how I could never invest the way Fred does. This generally centers around the way Fred is able to invest in platforms that often generate massive audience and upside but which is not at all visible from the outset (del.icio.us, Twitter, etc.). Lacking such vision, I generally focus on businesses that have clear paths to revenue, require far less capital than platforms, are generally more B2B and less B2C (with some notable exceptions) and which generate valuable data and/or metadata that can be repurposed and reused to generate additional revenue streams. This has always been my rap.

Michael, astutely, says "Well, it seems that Fred invests in stuff he likes to use himself." Now, it isn't that I haven't thought of this before but I've generally thought about it in more clinical terms, e.g., Fred sees something cool, tries it out, posts it on his blog, gets a ton of feedback, does additional homework and makes a decision. But after thinking about the lion's share of his investments, I think Michael is right. I think he really does eat his own cooking and invests very close to home, e.g., in companies that do stuff and make things that he himself likes. This is a much more elegant way to contextualize the differences in mine and Fred's investing styles. He is a consumer geek and a gadget freak and his investments display this passion. I am a data geek with a quant background and most of my investments display this passion.

In short, Fred is the Peter Lynch of consumer internet investing. Invest close to home. Invest in things you understand. Invest in things you have passion for. And invest in things you use in your everyday life. It certainly worked for Peter. And now it is working for Fred.

Government Stimulus and the Venture Industry: It's Not the Bankroll, But the Chip Size

What is the optimal size at which to do real venture capital, the kind of investing that nurtures tomorrow's Googles, Amazons, Ciscos and Microsofts, as well as the loads of applications and technologies that add real value to existing companies and customers? The answer to this question has undoubtedly changed over time, as the cost of enabling technologies has plummeted and massively scalable businesses can be built for a fraction of the cost of even 10 years ago. But still the debate rages on, particularly given the problems of the large-scale branded venture players and worries over a sharp drop in the availability of start-up capital. The topic has recently bled into the political arena, with President Obama's tech-friendly bias and the hundreds of billions of dollars going towards programs many feel will lack real job-creation power. Perhaps a portion of these funds can be intelligently deployed across the venture capital arena?

My friend Matt Harris, his partner Bo Peabody (both Managing General Partners of Village Ventures) and I have been talking about the right way to scale the venture business for quite some time. The issue: while the most attractive risk-adjusted returns are available at the early-stage end of the venture continuum, and it arguably hold the promise of creating more and better jobs than at any other stage, it is very hard for institutions to access this asset class due to scalability problems (read: can't deploy enough capital in a single fund to be material). Therefore, when problem-solvers think of throwing big dollars at venture industry, they immediately migrate to the larger, later-stage venture firms. The problem is, as Matt explains below, simply providing large firms with more dollars isn't going to facilitate more and better job creating, higher returning investments. The solution required is more complex and textured than that.

While Matt doesn't have a blog, he frequently has terrific thoughts and powerful ideas, and this is one of those times. While we were all struck by Tom Friedman's recent Op-Ed in the New York Times about deploying big stimulus dollars into venture capital, Matt put thumbs to Blackberry and came up with the following thoughts:

Tom Friedman recently advanced a proposal to deploy $20B in $1B chunks to the country's leading VCs, to spur investment in start-ups.  The problem with Tom's plan isn't that injecting $20B into the entrepreneurial economy is a bad idea, it's that giving it out in billion dollar chunks merely exacerbates the problem, which is that managing large funds drives VCs away from being early stage company creators, and towards being financiers.  VC firms only have so many talented check-writers, who are typically pretty fully employed investing in 2-3 companies per year.  If you give those firms more money, they can't (or won't) make more investments; they will make larger investments.  As a result, their deals will be less likely to be raw, early stage, potentially game changing start-ups, and more likely to be expansion stage companies who might otherwise raise debt capital in healthier times.

Most thoughtful amendments to Tom's plan have involved using the capital to subsidize seed and angel investing, which can be interpreted as VCs wanting more "prepped" deal flow, in that angels and seed funds tend to be feeders to established vc funds ... This is not a bad thing. But it may not solve the entire problem.  One area of inefficiency in the venture business is the paucity of funds with between $50MM and $150MM under management.  Because of the large size of most Limited Partners, they want to invest a minimum of $20-30MM in the funds they invest in.  But most of them aren't allowed to constitute more than 10% of any fund.  So by definition, they can't invest in funds with under $200MM under management.  This makes raising modest sized funds challenging, and as a result the % of VC funds of this size has dropped. In the 1990s, 42% of funds raised were between $50MM and $150MM. Since 2000, only 23% have been in that range.  This is despite relatively clear data that funds in this size range outperform; in fact, they have out-performed larger funds by almost 25% over the past 18 years (data: Cambridge Associates). Of course, it's also more profitable for the VC to raise a larger fund, but it's hard to blame them for failing to resist this temptation when their own LPs are asking them to grow.

A productive application of government funding to the world of entrepreneurial finance requires a nuanced understanding of where the inefficiencies are.  While I agree that angels could use some incentive to be more active, I also think that there is no replacement for a focused and sophisticated venture investor.  It probably comes as no surprise that some of the most talented young GPs would rather have their own small, focused fund than be in the way back seat of a larger fund, where carried interest has the feel of a mythical animal. Government funding, thoughtfully applied as an anchor Limited Partner in funds managed by these young stars, could spur entrepreneurship in one of our country's least innovative sectors:  the venture capital industry itself.

Heresy? I think not. Matt touches on several themes I've written about for a long time, and places it in the context of the current debate around how to best stimulate economic growth. I think these ideas and others raised on this blog warrant some serious consideration. Given the impact a small allocation of the stimulus budget could have on creating vibrant new businesses, increasing our economic efficiency and laying the foundation for strong economic growth, I think it is a no-brainer. But brains are needed to make sure the capital gets to the right place - the early-stage end of the venture capital industry.

The Straight Deal on Angel Investing Today

Today's New York Times' article Angels Flee From Tech Start-ups is more an indication of poor reporting than it is on the state of angel investing in today's environment. One could argue that today's environment has made for better, more effective angel investing, since lots of "dabblers" have been scared away while the "professionals" (full-time angels, small venture funds, etc.) are seeing an increasing number of high-quality deals. Are fewer companies getting funded by angels? Of course. Should all the companies that had previously been funded by angels, many of them dabblers, gotten funded? Definitely not. So is value creation in the early-stage space really being inhibited by a dearth of angel investment? I don't think so.

Bottom line, if you have a strong, technical founder, a solid business plan, a market either ripe for disruption or fertile for rapid growth and some early traction, you can get a business funded. Clearly there are a lot of variables at play, but deals are getting done and don't let the morose people in mainstream media tell you otherwise. As discussed previously, the venture industry IS broken; but this doesn't mean that true early-stage investing is broken. In fact, it is arguably the place to be. The combination of fewer players seeing more and better deals together with falling valuations makes this a good time to place some intelligent bets, IMHO.

Let me take this analysis one step further: angel investors and small VCs often like to build strong syndicates, including those people who are strategic and can open doors, provide advice, and generally de-risk the business plan. Larger venture firms frequently like to control funding rounds themselves, often limiting their ability to get the best people involved who may only be willing to invest $50k but can add hundreds of thousand if not millions of dollars of value through their active participation. This is the way I approach the business, as do many of the people I work with who lead financing rounds of, say, $500k-$1.5 million.

So all is not lost if you are a start-up and need angel financing. But take heed: it is super competitive out there. And if you are unable to stand out from the crowd along the key dimensions mentioned above, then this is not the market for you. Wait for the next up-cycle, when all the dabblers come out of the woodwork and are wiling to try their hand at early-stage investing once again.

Early Stage vs. Later Stage Investing: Risks and Rewards

This has been a topic du jour. Seed stage investing is too risky, with valuations coming down the risk/reward is better in later stage companies, etc. Part of this is due to more seasoned companies - those that have done A and B rounds and are generating revenues - either seeking additional runway to achieve profitability or profitable companies seeking a "rainy day" cushion. But another impetus for this are VCs who have capital to deploy but want to do so in less risky enterprises. Clearly there is a big question mark around exits - few M&A exits are happening and the IPO market is closed indefinitely, raising concerns about funding seed stage companies with little track record and even fewer revenues.

So I am trying to separate out the risk/reward decision from the "I don't want to take much more risk" decision. Given the sharp decline in seed stage valuations (at least that's what I'm seeing), the risk/reward calculus for great companies looks pretty compelling. As long as they are funded with, say, two years of capital, and that this capital is designed to help them get to breakeven and hopefully beyond, AND the deal is done at an attractive valuation, how does this stack up with an A or B round supplement done flat to the last round? I'd say pretty well. While certainly the risks of the seed stage investments are higher, I'd argue that the potential returns more than compensate given the valuations currently available, even for great start-ups. But hey, this is only one man's view.

One thing is for sure - there is a dearth of start-up capital out there. The pendulum has swung far in the other direction relative to 2006-2007, when start-ups were often getting crazy valuations based on a powerpoint and some good ideas. And it will continue swinging even farther away from rationality, IMHO. This is why I believe true venture investing will be one of the top performing assets classes over the next 36 months - Vintage 2009-2011 deals. Time will tell, but I'm putting my money where my mouth is.

Companies In the News

In recent days some of my companies have done some pretty cool stuff. Given the general malaise I wanted to share a few rays of sunshine:

Buddy Media: Buddy Media has been on a tear, both in terms of performance (read: closing deals) and contributing to the social media ecosystem. First, Mike Lazerow and team came out with a white paper concerning what advertisers needs to know about social apps. Then they announced a strategic relationship with VivaKi that got great coverage in Adweek and other industry venues. Finally, SAI came out with a piece referencing Buddy Media's rapid growth during Q4 2008, which wasn't exactly the greatest time to be selling to agencies and the big brands. Bottom line, while times are tough and getting tougher, the the upside in helping advertisers deliver value to customers via the social nets is a greenfield opportunity. Advertisers are looking to spend scarce ad dollars more efficiently, and Buddy Media is one of the companies helping to show them the way.

BlogTalkRadio: BTR recently came out with a new site design and added a host of new features to enhance hte experience for both content creators and listeners. Alan Levy and team also published a detailed road map of new features and functionality to help make sure users get the most out of the BTR platform. Usage stats are skyrocketing, as new hosts are finding BTR an easy, effective means for communicating with their followers, getting a message out or promoting a product or service. In its short life BTR has moved beyond the podcast to faciliate real-time, streaming dialogue from any phone line; it has altered the paradigm for Internet radio and spoken communication online.

Stocktwits: Howard Lindzon presented at this week's NY Tech Meetup in front of a packed house at IAC. I'd say that his presentation - in essence, letting the application run live while talking about the company's strategy and plans - was a success. It is hard not to be excited about the company's progress. We will shortly be coming out with added functionality to make the user experience even better, and a variety of value-added services as well. There will be much more to say soon, but it was exciting to see the response at the Meetup dedicated to "Built on top of Twitter" applications from an often-cynical crowd.

There are other things going in the portfolio - financings that are closing, new product releases, etc. - that I can't comment on now. But I think it is safe to say that the early-stage business is still alive and kicking, with perhaps some of the best investment opportunities over the past several years. So as I'm watching the public markets plunge on awful economic news, fraud and global violence, I am thankful that our little corner of the world is still doing ok.

The Pyramid Principle: Venture Investment in a Capital-Efficient World

Large venture firms are in trouble. The combination of too many dollars to deploy coupled with the rapidly declining costs of starting companies has largely rendered their models obsolete. While there are exceptions, e.g., Cleantech, most venture-stage companies require very little money to prove their viability, often less than $2 million (made up of an angel round or an angel plus a "light" Series A round from a small venture firm). So where does this leave the big firms running assets of, say $250 million and above? Either relegated to a dwindling number of later-stage deals where large amounts of capital are required or a concentration of capital-intensive sectors such as Cleantech and Biotech. As either a GP or an LP of these funds, this is not where I'd want to be.

But all is not lost for these funds, if they are willing to adapt and if their LPs are able to wake up and shake off their hidebound ways of thinking about venture investing. It will require a change in staffing, due diligence methods and capital allocation. Big stuff to be sure, but essential if the legacy leaders of venture want to stay relevant and on the cutting edge. The way forward is what I'm calling the Pyramid Principle. It contemplates a three-tiered approach to venture investing, but through a structure that is almost the inverse of what larger venture firms are doing today.

The base of the pyramid - where firms will spend the lion's share of their time - will be in true early-stage venture investment. It will involve leading rounds that are as small as $250,000 and up to $2 million. It will also include incubation, which will pair a small, high-performance, tightly-knit group of agile developers that can churn out rapid prototypes of entrepreneurs' ideas. The base is a bubbling cauldron of deals, experiments and innovation. Where will the ideas come from? Either internally by looking at gaps and trends across the investment portfolio, bringing on Entrepreneurs-in-Residence that have specific ideas they'd like to work on or by being approached by an entrepreneur with a compelling idea but would benefit from the structure of working within a venture firm. The goal of investments in the base is to assess viability, e.g., whether the product or platform can demonstrate commercial relevance and traction. I would expect the staffing of the base to be with wicked smart, young-ish entrepreneurs, who want to step back from working on a single idea and to develop their chops as investors. The more experienced venture professionals, the Mentors, could provide advice and counsel to these up-and-comers and, in the process, get mentored themselves in bleeding edge technologies, business models and development methods. Entrepreneurs would get carry for both bringing in deals and working with companies, and Mentors would get carry for bringing in deals, advising the Entrepreneurs and directly working with some of the young companies. Some companies out of the base will be sold early, generating super-high ROIs but not large absolute dollars. If it turns out that growth will either cost too much or take too long to achieve, then it might make sense to take the money and run. That will be ok under this model. It will require a culture that pushes rapid assessment and admission of mistakes, rewards innovation and compensates heavily for successes that can be broadly applied. Most large venture firms find this activity too time-consuming and capital inefficient to warrant much attention. In the future I believe that getting the base right will be the key to success in the large-scale venture field.

The middle of the pyramid - where less time but more capital will be deployed - will be in B-round  growth capital investments. These source of these growth-stage investments will largely emerge from the base, in companies that require $2-$5 million to aggressively go-to-market. Money will go towards bulked-up engineering and operations teams, key management roles and creation of a sales and account management infrastructure. This has been a very competitive stage in the venture world for the past 3-5 years, where plenty of funds are happy to write checks for $5 million to help a company grow. The problem is, there will be fewer of these companies requiring fewer dollars as bandwidth and storage costs approach zero, yet these larger VCs are traditionally reliant on these deals and even later-stage investments to put their bulging LP commitments to work. By cultivating and nurturing companies in the base, the new-age VC can hang onto their winners and build a strong stable of growth-stage companies in their portfolio.

The top of the pyramid - with a small number of deals consuming large amounts of capital - will be in C and D-round growth acceleration investments. These will be for those companies that are runaway successes which can benefit from large ($10-$100 million) investments to rapidly achieve scale and dominate the space. They will be graduates from the base and middle of the pyramid, and will have been nurtured from inception to explosion within the firm. These investments represent "venture firm nirvana" - winners that have been on the books from the beginning with the ability to put progressively larger dollars to work throughout its life cycle. This enables those C and D round returns to be augmented by cheap A and B round valuations, creating the optimal mix of ROI and capital consumption.

I imagine that making these changes will be very difficult for most large venture firms, as it requires an internal culture change and a different team coupled with an external shift in messaging. It may be that a number of brand-name VCs go into run-off mode, taking their chips off the table over time and focusing their efforts elsewhere. Perhaps some of these firms could segregate their businesses into a run-off book and a new fund, with the LP commitments at a fraction of their levels in the heyday. Maybe we'll see yesterday's $1 billion fund as today's $200 million fund, with a number of $75-$150 million funds started by the venture stars of the late 1990s/early 2000s. This would be a good thing for everybody except the old-line venture firm GPs, who will no longer be collecting management fees on mega-asset pools that are no longer necessary. That's ok; they'll get over it. But if the major VC players want to remain relevant and in the game, they will need to dramatically scale back assets and modify their approach to the investing business.

Climate Update: Early Stage Investing

I've been collecting a lot of data about attitudes and behaviors towards early stage investing in today's tumultuous and uncertain market environment. Whether you happen to be an investor or an entrepreneur, an angel or a venture capitalist, you are going through a disciplined re-assessment of what you should be doing and how you should be doing it. One thing is for certain: few people are operating in the ways they did only a few short months ago. Aside from dozens of meetings with entrepreneurs and VCs, I attended a NextNY event last night that was all about how young companies should be coping with today's uncertainty. David Kidder of Clickable and Matt Blumberg of Return Path both had some sage advice, from the perspective of business builders that have been around since well before the bubble and crash and have been challenged to adapt to hard times.

Venture Capitalists: Uniformly more conservative, but many are still in business

As seems to be the case with many industries, I am seeing a barbell emerge in early stage investing. Many of the larger funds ($100 million+) I know and work with are pulling in their horns, focusing largely on current portfolio companies and reserving cash for supporting those that warrant additional investment. I recently had a deal where a term sheet was pulled by a premier VC; this is not something I could have imagined back in the summer. There is definitely a sense of hunkering down and being all over their management teams, asking for stepped-up financial reporting, cost cutting plans and hiring freezes. But in general, there doesn't appear to be much of an appetite to do new early stage deals. They are preparing for a nuclear winter where exits are few and far between, the IPO market is closed and times to exit could be extended from 3-5 years to 8-10 years and beyond.

Smaller funds, while certainly applying the same discipline to their existing portfolio companies, in general appear more sanguine about the opportunities that exist. They have fewer companies to deal with than larger funds, often have plenty of dry powder (both financially and managerially) to both support existing companies and to deploy in new deals and are seeing more deal flow than ever. So while they are clearly raising the bar for investment and competition for VC capital is intensifying, many view the current malaise as a chance to invest in great businesses at attractive prices, such that 7-10 years down the road they will look back and say: "Vintage 2008/09 deals were some of the best deals we've ever done."

All VCs, whether large or small, are saying that current cash should be husbanded, with the goal that it should be sufficient to support the business until cash flow breakeven. One of the big dilemmas is how to best support successful, growing early stage businesses that are not yet cash flow breakeven. My friend Fred just shared some interesting thoughts on the topic, citing Tom Evslin's post where he utters a common sensical but important line for people in freak-out mode to remember: "In the end you will succeed because of what you DO spend your money on." Surely time is right.

Though I've generally applied this concept to Wall Street it is certainly applicable to early stage companies: LIQUIDITY CREATES OPTIONALITY. That means having the chance to accelerate growth in the face of weakened competitors, to step up advertising and promotion when others can't afford such expenditures and to hire key talent at better prices to shorten release cycles or to sell more aggressively. The best VCs are helping their companies to balance the twin goals of liquidity preservation and growth, a balancing act that is not easy but essential for supporting the development of world-class businesses. VCs have got to be front-line risk managers. Risk managers aren't just for Wall Street any more.

Angels: Shaking out

The prevailing tone in the market is that angels who "dabble," e.g., aren't professional angels or "super angels" as I've referred to them in the past, are generally shell-shocked and backing away. They neither want to put capital in new deals nor likely have the stomach to participate in pay-to-play recapitalizations that will inevitably come about during 2009 as the cash crunch really takes its toll. We are in the early innings of what will be a very challenging time for companies funded in the past 1-3 years, those in need of capital that are not yet near cash flow breakeven but who have businesses worth supporting. Now I wasn't around in the 2001-2003 period doing early stage investing and don't have first-hand knowledge of the angel landscape that existed, but based upon conversations with Fred Wilson and others it seems that the super angel had not yet emerged.

Today, conversely, I know lots of people like me, refugees from big tech and big media with knowledge and cash or micro-cap funds (>$25 million) that are not only still in the game, but operating with much the same attitude as the smaller VCs discussed above. What this means for the entrepreneur is that it will surely be harder to put together those "friends and family" rounds, as the dad next door who was willing to toss in $50k in April is licking his wounds from his equity portfolio dropping by 30%. But while the competitive environment for capital has intensified the money is there, it just happens to be in fewer, more concentrated hands. And I'm not sure this capital was even available in the wake of the early 2000s downturn. So that is the good news.

Entrepreneurs: Be relevant, be focused, be a cash hog

David and Matt had some priceless lines last night that I will seek to recall, gems for the entrepreneur who is wondering how to best position their business both to the market and the investment community:

D. Kidder: Be in the jet stream; don't be at the edge. Get in the middle of "directional optimism."

What David was saying is to avoid being a feature, an add-on. Be right in the middle, be relevant. Be something that squarely addresses a client problem. Don't be afraid to go for it. Because if you don't, you will not succeed.

D. Kidder: Get your product into customers hands ASAP - NO SCIENCE PROJECTS - and with total transparency.

In essence, don't be afraid to look stupid, don't be afraid if it breaks. Be honest with a client as to where you are and what you are trying to accomplish. Take their feedback seriously. Rapidly iterate on the product. And get it back out in front of them. Use rapid iteration to FIND THAT CUSTOMER.

M. Blumberg: Overcommunicate with your team in times of turmoil. Whether the company is big or small, it doesn't matter. The leader needs to be a calming influence - and helps keep good employees in their seats.

Matt shared some stories of entrepreneurs he knows that did both very good and very bad jobs of communicating with their teams when times were tough. Those that did share a lot often found that team members came up with solutions better than the CEO, and were "pre-socialized," helping to allay a CEOs fear of having to fire people, cut salaries, etc.

D. Kidder: Listen to customers and data. They are the two keys.

While David acknowledged the value of his Board and other smart people in his orbit, at the end of the day the ultimate guideposts of progress are customer feedback and data around usage. Little else matters.

D. Kidder: Be and "AND" culture

In short, always be raising money until you never have to raise it again, and build product at the same time. Those who say raising money is a distraction to building product just don't get it. You have to do both AND do them well. It's all about the AND. 

The Key Take-aways

• Cash for start-ups is out there, but principally from the smaller VCs and super angels

• Fewer players actively doing early stage means greater competition for cash, so plans have to be sharp, relevant and highly cash efficient

• Cash is king, but you've got to spend cash to be king someday

• While the VC and economic weather is stormy and is likely to be so for quite some time, businesses are still being created, innovation is alive and well and businesses are getting funded. It is just that everybody is having a harder time. That's all.