Dharmesh Shah

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Why Venture Capitalists Avoid Innovation: They Like Making Money

By Dharmesh Shah on February 18, 2010

The following is a guest post from Andy Singleton, the founder of Assemba.  Assembla provides online workspaces for distributed software teams, and helps many startups build their products. 

Any given innovation is much more likely to fail than to succeed.  Innovation as a whole may even be unprofitable for the innovators.  Fortunately, we keep doing it, because in economic terms, innovations are durable (they last forever) and non-rivalrous (anybody can use them), so over the long term, society benefits a lot from the successful innovations.  As a society, we look for ways to get around the fact that innovation is generally unprofitable.  We subsidize innovation.  We honor it.onstartups piggy bank slots

A recent conversation has me wondering anew about the question of whether venture capitalists actually further the process of innovation.  They claim to be in the business of innovation, but they also talk constantly, often in the same paragraph, about how much they want to avoid innovation.

In this latest conversation, the VC said "We look for companies with a product and a proven business model."  This should should sound familiar to you. I wish I could run a video montage of the pictures in my head of VC's saying how much they want to avoid innovation.  Surely you would laugh.  If you ask VC's what they look for, they use words like "traction", "proven business model", "reference customers", and "invest in marketing" or “sales and marketing”.  This in itself is a big step forward from "We invest in teams that have done it before" (Greylock partner, 90's), or "We look for the second time around" (Sigma partner, 90's).  It doesn't take a genius to understand what they are saying.  As much as possible, they want to avoid all innovation (stuff that’s not proven).  It’s risky and unprofitable.

VC behavior subsequent to making an investment is also revealing.  After looking at hundreds of deals, and falling in love with one particular business plan, and persuading other investors and partners that it's great, VC's generally don't support subsequent changes to the business plan.  A self-funded entrepreneur is constantly making major course corrections, to the point of driving his colleagues crazy.  VC's will deny this, but a VC investment is basically a ballistic missile launch, without course corrections.  They are likely to just shut down the funding, or even to continue investing a lot of money in a concept that is clearly not creating the forecast level of excitement.

In my recent conversation, the VC partner went over the top by saying "We want to invest in companies that own code and have protectable IP", and then going on give the example of SpringSource - a service company working with un-owned open source code.
Are these people as idiotic as they sound?  Far from it.  They are some of the smartest, most observant, and most successful business people you will meet.  They have learned the hard way that innovation is more likely to fail than to succeed, and that the best way to make money is to latch on to a product that people already like. Even with this filter, and their cleverness and experience, and funding one in 100 opportunities, they still have a hard time making money in the current environment.  Investors that stray from the established formulas of the VC business (2 and 20 on fees, 5 year fund cycles, "growth capital" for sales and marketing) - are often punished with poor returns.

Note the cruel irony here.  In the VC business, a business that claims (with heartfelt feeling) to be devoted to furthering innovation, innovation is deadly.  It is the least innovative firms that succeed.  Successful firms may excel in a number of areas, but innovation isn't one of them.

So if innovation is actually risky and unprofitable, where does this leave us?  It rolls the clock back 80 years to Joseph Schumpeter's observation that entrepreneurs are driven by "animal spirits" rather than money.  Being a professional economist, he actually said, "Hedonistically, therefore, the conduct which we usually observe in individuals of our type would be irrational."  He also claimed that profit maximizing, utilitarian theory is "unsurpassed in its baldness, shallowness, and its radical lack of understanding for everything that moves man and holds together society."

Limited partners are utilitarians, and they don't invest in irrational animal spirits.

I think that this has some bearing on public policy.  Do we really want to be offering big tax breaks to VC's - the carried interest deduction - if it isn't going to get us the innovation which they have wrapped around themselves like a flag?

It also might have some bearing on the VC business itself.  VC returns in the last decade are negative.  VC partners are making less money now.  Many limited partners are not going to reinvest on the old model going forward.  VC's also have a diminishing reputation in the entrepreneurial community.  They have a strong incentive to get rid of an innovative entrepreneur and just wash out his stock - which they often do.  Suddenly, the old models aren't working for anyone.

And, maybe innovation is coming.  There has been a burst of micro-venture initiatives that invest small amount of money at the earliest stage.  That's a dangerous place for an investor (angel investors are incredibly brave) because one of the tenents of the old rigid VC model is that follow-on investors will usually try to squeeze out the early investors.  Maybe this indicates that innovation is happening throughout the investor chain. I also recall a conversation with a partner at General Catalyst, one of the more successful new VC firms, about their practice of "home cooking", or creating their own companies.  The speaker dismissed the appeal as "zero pre" (translation: our interest is purely economic, in that we get a better deal if we pay a $0 pre-money valuation) but I think something deeper is going on.

Is it possible that, once in a while, the VC business should look to innovation, for real?


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9 Quick Tips Learned While Raising $33 Million In Venture Capital

By Dharmesh Shah on February 8, 2010

As the market improves, my guess is that many of you will likely be thinking about raising funding for your company.  With my latest startup, I’m now a venture-backed startup founder (I’ve raised $33 million in three rounds of capital for my marketing software company).  So, I’ve got some direct experience with the process.  Several of the companies I’m an angel investor in or otherwise involved with have also been in the fund-raising process.  So, along the way, I’ve learned a few things, and I’d like to share them with you.onstartups cash pile


There’s already lots of great content on the web about raising capital and understanding deal terms.  My favorite is the content on Venture Hacks (a must read, if you’re raising capital).  But, I figured it wouldn’t hurt to share some of the “lessons learned” from my own experiences.  Some of these you’ve probably heard before, but one or two will likely be new to you. 

And, a quick note before we jump in:  I’m doing a FREE live webinar with my co-founder at HubSpot, Brian Halligan this Wednesday, February 10th at 1 p.m. ET.  The title is “Money, Marketing and Management with HubSpot’s Founders”.  The idea is to share a bunch of practical tips we’ve learned while building HubSpot (including some insider stuff gleaned from raising $33 million in VC).  If you’re intereted in this article, you’ll probably like the webinar.  If you can’t make this specific time, you can still register and we’ll send you an email with a link to the recorded version. Oh, and did I mention, it’s free? 

Sign-up for: Money, Marketing and Management (aka “Stuff we learned about startups that you’ll probably find useful”)

Ok, back to our article.

Insights From Raising $33 Million In Venture Capital

1.  Get the first round right:  The terms of your Series A deal are very important. Not just because of the impact on that first round, but because many of those same terms are likely to carry through to future rounds.  It’s tempting to concede on some important terms because you’re thinking “well, that’s just life…and it doesn’t seem like that big of a deal.”  Try to resist that temptation.  One of the things I’ve learned is that when negotiating the term-sheet for your Series B or Series C round, the “base” terms (the starting point of negotiations) is whatever terms were in your Series A.  So, if you agree to some non-favorable terms on the “A” round, you’re not just paying the price for that concession in this round, you’re likely going to continue to pay in future rounds as well.  Factor that in. 

2.  Avoid valuation infatuation:  Entrepreneurs often become obsessed with the pre-money valuation on the deal.  Though this is certainly an important element of the transaction there are other factors at play that have significant impact on the raw direct economics of the transaction including the employee stock option pool (and who pays for it). If you get close to finalizing a deal, it is imperative that you have a spreadsheet that helps you understand the economics of the deal.  You should read Jeff Bussgang’s article on the topic.  It is worth your time.

3.  Raise more than you need:  Regardless of how much capital you raise, chances are, you’re going to have wished you raised a little bit more (or perhaps even a lot more).  Within reason, if you have access to capital and the terms are decent, raise more than you think you need.  Don’t get hung up on dilution.  To help you overcome this fear of too much dilution, build yourself a simple spreadsheet that models the actual financial impact to your person bottom-line based on various outcome scenarios.  What you will likely find is that if things go really well and your startup is the spectacular success it deserves to be, the extra dilution is not going to change things all that much.  And, if things go really poorly, it won’t matter either (because those extra common shares aren’t going to make you money).  You might be thinking “I’ll just raise the additional capital in a future round, at a much higher valuation” — which is somewhat right.  But, what you should keep in mind is the transactional cost of the additional round.  Raising a venture-round is a very time consuming process and when your bank balance is getting low, you’re going to really want to just keep working on the business instead of shifting focus back to the funding game.  In short:  If you have the ability to raise a slightly larger round, and the terms are reasoanble, you should probably go ahead and take the extra money.

4.  Know what “market” is:  It’s possible that you’ll encounter some not so favorable terms during your VC negotiation — terms that are not that common.  It’s also possible that your potential investor is just pushing on the edges a little bit to see what they can get away with.  You need to know which terms are actually rare/uncommon.  Your strongest line of defense against weird, non-favorable terms is a line that goes something like “that’s not market”.  This is sophisticated VC-speak for “what you’re asking for isn’t very common in VC deals right now.”  This line of defense has two advantages:  1) it works  2) it demonstrates your savviness. To figure out what the common deal terms are now, track down the report that one of the larger law firms that does a lot of startup transactions publishes periodically.  The report usually includes (among other things), what percentage of transactions have specific deal terms (like participating preferred).

5.  Orchestration is important:  Try to keep the interested parties moving along at as close to the same pace as possible.  You don’t want to get a term-sheet from one VC and have had the first meeting with others.  Orchestration is not easy, but it’s important.  The reason is that to really get great VC terms in a round, the single largest contributing factor is competition.  If you can get two or more VCs competing to invest in your company, you’ll get much better terms.  As it turns out, this is not easy to do because to really get credible competition going, you’re going to need to have several VCs at the “termsheet” stage of the conversations.  If one VC delivers a termsheet to you, but you still haven’t had the second (or third or fourth) meeting with some of the others, it’s going to be tough to get that competing termsheet.  Meanwhile, the VC that gave you the first termsheet is going to be “anxious” for you to accept.  This anxiousness could manifest as simple “prodding” or as an out-right “exploding termsheet” (i.e. a termsheet with a deadline).  So, try to keep your conversations moving forward with several VCs are a similar pace.  The good news is that nothing accelerates the process of other VCs more than knowing that you’ve already gotten a termsheet.  Once you get that first termsheet, you’re likely to get more as the VCs try to jostle for position. 

6.  Beware deal fatigue:  Even in good times, fund-raising is an arduous process.  Be prepared for yet another round of meetings, yet another level of due diligence and yet another round of negotiations.  Don’t try to sprint to the finish line and be exhausted when you get there — you may have another lap to go.  And, it might be the most important lap.  Much like any large negotiation, there are often relatively important deal terms that get finalized in the final stages of the deal.  You need to maintain your energy so that you don’t just give-in on some of these seemingly unimportant “details”.

7.  Don’t Use Your Uncle Larry As Your Lawyer:  As entrepreneurs, it’s not often that we need to engage legal counsel.  In fact, if this is your first startup, it’s possible you’ve never actually hired a lawyer before.  If you’re raising venture capital — you need a lawyer.  And, your uncle Larry who helped you out with that lease agreement last year is not good enough.  You need a lawyer that has done many venture financing deals before.  This is a high stakes game.  VCs are super-smart and they negotiate financing deals all the time.  They do this for a living, you don’t.  You need someone that has competency in this area.  A great lawyer understands the nuances of this game both from the perspective of which deal terms are important, what “market” is (#4 above) and when to stay firm and when to concede.  I’ll say this one more time for effect:  You need great counsel that has tons of startup financing experience.  Don’t be penny wise and pound foolish on this.  Oh, and by the way, you might want to know that you’re likely going to pay for the legal fees of the VC as well (it comes out of the funding round).  I’m not sure why this is, and I don’t like it one bit, but it’s common practice. 

8.  Partner personalities matter:  Yes, ideally you’ll be raise funding from a top-tier fund that’s a great brand.  But, what’s more important is that you fundamentally like the VC partner that is investing in you.  This is a long-term relationship and life is short.  You might part ways with one or key team members along the way (which is never fun), but your venture investor will almost certainly be with you until the very, very end.  If you have the luxury of choice, you should put strong weight on the person you take money from, not just the firm and not just the deal-terms.  I followed my own advice on this in our funding rounds.  We had higher offers than the deal(s) we took, but we solved for the best overall deal and the best partner. 

9.  Switching Partners Is Hard, Do Your Homework:  It’s likely that in the early stages of your VC process, you’ll get introduced to a particular partner at a firm.  Usually, this is based on what area that partner invests in (i.e. which one you “fit” with).  But, in many larger firms, there might be more than one partner that could conceivably do your deal.  Or, you might get bucketed wrong (because your startup straddles a couple of areas of intest for the firm).  If that’s the case, you need to work hard to figure out who the best partner would be (from your perspective) and try to connect with that partner as early in the process as possible.  Once conversations begin in earnest, it’s very, very hard to switch to a different partner within the firm. 

So, what do you think?  Are you going through the arduous process of raising venture capital now?  Or, have you been through the pain before?  Any of this stuff ring true?  Would love to read your thoughts and experiences in the comment.  Oh, and if you have questions you’d like me to address my upcoming webinar (which will spend a fair amount of time on funding), leave them as a comment.  I’ll pick a few and address them.  Thanks.

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