Venture Beyond with Trevor Loy

Venturing beyond the conventional wisdom about venture capital investing, entrepreneurship, flyfishing, and life.
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At Flywheel Ventures, we invest in entrepreneurs with solutions to the world’s greatest challenges in information technology and urban systems.  We often refer to our strategy for finding those entrepreneurs as “fishing where everyone else isn’t.”  While looking in non-traditional geographies is a component of that strategy, it also refers to our search in markets and technology sectors that other venture capital investors rarely pay attention to.   Very frequently, this strategy finds success in cities across the American West with vibrant creative cultures and strong university, corporation, or national laboratory R&D organizations.  Nearly all of Flywheel’s 40+ portfolio company investments have been made in such contexts, with over 2/3 of our investments specifically having origins in R&D organizations, and about 1/3 having explicit technology licensing agreements or equity ownership arrangements with those initial R&D development organizations where intellectual property (IP) was created.  Illustrative of our commitment to this investing formula are our recent investments in Tribogenics (a licensee and spin-out of UCLA), Lotus Leaf (a licensee and spin-out of the University of New Mexico), and TerraEchos (a spin-out of a predecessor entity’s R&D work funded by S&K Technologies).

Bridging the Technology Transfer Gap

Given our focus and experience in technology spin-out investments at Flywheel, then, the title of this post may seem odd.  Certainly, it is intentionally provocative.  However, it synthesizes a key lesson I have learned in this deep experience of entrepreneurs building companies at the intersection of global markets and technology commercialization.  That lesson is, quite simply, that technology commercialization is both misleadingly-named and vastly-overrated as a strategy for entrepreneurial success.  Instead, I believe that “people transfer,” not “technology transfer,” is a much more accurate descriptor for a successful approach.  Great companies are built by great entrepreneurs - period, full stop.

Now, it is certainly true that there are segments in which the “technology transfer” or “technology commercialization” strategy has merit, i.e. biotechnology or advanced materials science.  If someone in an R&D organization somewhere has truly developed a new pharmaceutical molecule that cures a specific form of cancer, a successful company can likely be built based on the exclusive license to that molecule, regardless of the entrepreneur strengths of the team.  Since Flywheel does not invest in life sciences-based companies or entrepreneurs, my expertise in that specific arena is limited.

However, in the areas of IT and urban systems where Flywheel does invest, I am generally in the camp of believing that IP is vastly overrated in general.  In the information technology arena, IP is not only useless but, in my view, actually detrimental.  There is a movement to eliminate patents on software completely and I am supportive of that movement: http://en.swpat.org/wiki/Software_patents_wiki:_home_page

None of this is to suggest that relationships with R&D organizations aren’t valuable to Flywheel or other VC investors.  Specifically with Flywheel, over 2/3 of our investments have had origins inside of R&D organizations.  Less than half of those, however, involved any sort of IP license agreement.  The more important value from our relationships with R&D organizations – from the Flywheel perspective – is getting to know the _people_ inside the technology R&D organizations.  While most will, by definition, not be commercially-viable entrepreneurs, there are always a handful who discover after some time in the non-commercial R&D world that the commercial world is where they passionately belong.  

This is also not to suggest that those technologists who decide to leave the safety and comfort of a non-commercial R&D setting to test the entrepreneurial waters will necessarily be the right CEO or other founding executive.  Often, they take a founding Chief Scientist, Chief Technology Officer, VP Engineering, or similar technical role, and hire more experienced entrepreneurial business managers for the CEO and other executive positions.  Also not infrequently, they may only take an entrepreneurial leave of absence for a year or two, working with the company in a technical advisory capacity to assist the transition from laboratory setting to commercial production.  All of these roles are quite legitimate and appropriate.

In the end, however, great companies are built by great entrepreneurial teams. As I have articulated in other posts, the quality of the entrepreneurial team is the most important criteria in my investment decision - and outweighs all other criteria put together.

As a result, then, in the IT and urban systems sectors where Flywheel invests, “technology transfer” or “technology commercialization” is at best an initial, baby step.  The initial technology or IP can serve as a useful organizing “seed crystal” around which a world-class entrepreneurial team self-organizes or is formed (often with our assistance).  However, any investment is ultimately going to be primarily based on the quality of that team, regardless of the initial technology.  Too often, the organizations charged with “technology commercialization” fail to realize this - or, more often, they are not provided the resources or scope of mission to implement this - and they are left wondering why their impressive collection of patent filings and IP assets seems to sit on proverbial shelves, gathering dust.  If, instead, they viewed (or were provided the resources and scope of mission to view) technology commercialization as only the first step in a broader “entrepreneurial team formation” process - and measured their success in these broader terms - I believe a lot more R&D would end up in the commercial marketplace.

So, while I purposely titled this post to be thought-provoking and controversial, by all means, there is tremendous value in investigating, protecting, and publicizing the technology and IP assets inside of R&D organizations.  That does provide a useful service, but it is only a starting point. The “commercialization” process is not done until a world-class entrepreneurial team has been formed - and, in most cases, it doesn’t even really start until the team formation.  Until the “people transfer” process is complete, the “technology transfer” or “technology commercialization process” will remain useless.

Oops! Road Sign

The only decisions an entrepreneur makes that truly matter in the long run are those that involve deciding who to trust.

Every other week or so, I am introduced to an entrepreneur who immediately sends me a non-disclosure agreement and asks me to sign the NDA before we talk further.  Among other signals, this indicates that the entrepreneur has failed do almost any homework on the process of raising venture capital investment, as the blogosphere is full of well-articulated posts about the process in general and about NDAs specifically.  In short, venture capitalists never sign NDAs.

My well-known VC industry colleague and prolific industry blogger Brad Feld summarizes this industry norm as follows:

Asking the venture capitalist to sign a nondisclosure agreement, or NDA… is a stupid idea perpetuated by lawyers. Most venture capitalists will not sign an NDA, so all you’re doing is putting up a barrier to get their attention and demonstrating your naivety.”

Despite the excellent treatment elsewhere in the VC blogosphere, many of the entrepreneurs that Flywheel encounters have not been exposed to these norms.  As a result, I occasionally find it useful to re-articulate the rationale here, so today I thought I would do so again.  Of course, this post does not constitute legal advice.

  • NDAs are a waste of the most precious resource for entrepreneurs and VC’s alike: our time.  Flywheel, like most VC firms, receives between 500 and 1,000 investment proposals every year.  In most years, we will invest in 3 to 6 of those proposals.  As a result, the initial stages of reviewing investments are best compared to the “triage” process in a hospital.  Executing an NDA for potential investments would be an enormous time sink.  First we would need to review the NDA.  Then, we would need to have our lawyer review the NDA and suggest any changes.  Then we would send those changes to the entrepreneur, who would need to review the proposed changes with the startup’s lawyer.  Even assuming minimal negotiation of changes, this process would easily consumer 2-4 hours of time and a few hundred dollars of expense.  Multiply that by 1,000 businesses per year, and we would be spending a significant chunk of our time and budget simply negotiating NDAs for the 994 to 997 businesses that we will not end up investing in.  Even worse, for nearly all of those businesses, we would spend far more time negotiating the terms of an NDA than we would giving feedback or advice to the entrepreneur.
  •  NDAs are unnecessary for initial discussions and review. A VC’s initial investment review is focused on whether a potential investment fits the firm’s stated criteria.  At Flywheel, we are looking for those entrepreneurs with the most urgently-needed solutions to the world’s most pressing problems.  At Flywheel, we are more specifically focused only on those entrepreneurs aiming to solve these global challenges within information technology and urban systems.  We don’t invest in life sciences, consumer-facing products, or project finance. We make our initial investments in an entrepreneurial company only in the first institutional capital round.  Finally, we focus our investments in those entrepreneurial companies with origins in the American West that are targeting a truly-global market opportunity. A large number of these entrepreneurs we meet are building exciting businesses, but don’t fit the criteria above.  Establishing that fact quickly saves both the entrepreneur and us a lot of time, and the information needed to assess whether a business fits the criteria above can easily be provided without an NDA.
  • Most entrepreneurial ideas are not very original: "Ideas are cheap and plentiful; market opportunities are rare and valuable."  Entrepreneurial ideas usually result from the intersection of customer trends, technological developments, and creative inspiration.  The first two of those elements are widely evident to knowledgeable observers and participants within a specific industry sector.  As a result, it is not unusual for many individual entrepreneurs or teams to independently  develop an idea in parallel with other individual entrepreneurs or teams who are working completely separately.  As Victor Hugo famously said, “an invasion of armies can be resisted, but not an idea whose time has come.”  As most VCs can attest, when an idea’s time has arrived, a lot of entrepreneurs separately and independently tend to “discover” the same idea at that time.  If we did sign NDAs with each one of them, and invested in one of them, the others would invariably but incorrectly perceive that the funded entrepreneur had “stolen” their idea — and potentially use an NDA as the basis for inappropriate legal action. While the VC firm or other entrepreneur would inevitably prevail once the facts were known to all parties, this would waste enormous, unnecessary time and expense for all parties in getting to that realization.
  • Asking for an NDA before an initial conversation demonstrates a lack of sales and “customer development” sophistication.  Sales and customer development skills often (usually?) trump technical advantage in entrepreneurial success.  One sign of basic sales and marketing skills in an entrepreneur is the evidence that the entrepreneur has spent time learning about the “customer” he or she is targeting - in this case, the VC investor.  If an entrepreneur has not taken the time to do a basic Internet search about the process of raising venture capital - which will always reveal the “norms” about asking for an NDA - this illustrates a deeper hole in the entrepreneur’s sales and marketing expertise.  Second, it demonstrates that the entrepreneur is either clueless or defiant of the well-established conventions of the process; neither bodes well for how a VC will assess that entrepreneur or develop trust in the relationship.  Finally, it demonstrates a lack of appreciation for the value of scarce time and money in the process, and may signal a broader lack of prioritization by the entrepreneur.
  • NDAs are rarely useful, even if they are signed.  Other than for protection of truly proprietary, technical information (such as a new molecule for pharmaceutical purposes, a new chemistry reaction for water treatment, or the formula for Coca-Cola(tm)), the information seemingly protected by NDAs can nearly always be discovered via other channels.   Many states increasingly do not enforce NDAs for “business methods” or other non-deeply-technical information.  Competitors with malicious intent can always find straightforward workarounds, and pursuing legal action to enforce an NDA requires the expenditure of capital that entrepreneurial firms almost never have available for such a purpose.  My advice to entrepreneurs is to consider that if a competitor can successfully beat an entrepreneurial company in the marketplace solely based on the “knowledge” gained from that entrepreneurial company, I would suggest that the entrepreneurial company’s customer relationships, recruiting ability, market execution, sales, fundraising, and product delivery skills are probably so weak that it would not have prevailed in the market even if it had not shared its “confidential” information.  Of all the bases for competitive advantage in a new and fast-growing market, confidentiality is near the bottom of the rankings.  For these reasons among others, NDAs are almost never enforced in the practical world, except in much larger contexts such as IPOs, acquisitions, large customer distribution deals, etc.
  • Asking for NDAs signals a cultural attitude toward secrecy that can inhibit later success.  The best entrepreneurs almost always succeed because they build better relationships with more open and collaborative sharing of information with customers, partners, investors, employees, suppliers, etc.  Entrepreneurship is a network-based process, and a culture of secrecy usually precludes success in a network.  Of course, this does not equate to widely and carelessly publishing every detail of one’s approach on the company’s website.  Rather, it argues for the cultivation of the most trusted relationships in the network(s) of highest relevance to the opportunity being pursued by the entrepreneur.  As Audrey MacLean, a serial entrepreneur and angel investor who was one of my early investors and mentors once put it, “The only decisions an entrepreneur makes that truly matter in the long run are those that involve deciding who to trust."  Accordingly, spend less time focusing on protecting your information via ineffective tools like NDAs, and more time building and cultivating networks of those people you can trust.
  • There are rare occasions when we will sign an NDA, but only relatively late in the process.  If and when we are considering an investment in entrepreneurial companies with a deeply-technical competitive advantage, we will sometimes delay our due diligence of that aspect of the business to the end of the process, and then execute an NDA surrounding the technical information at that point.  Typical situations might involve our verification of the performance of a new semiconductor chip design, the efficacy of the proprietary chemistry for a new water treatment process, or evaluation of the molecular structure of a new advanced material development.   Since VCs are rarely technical experts at these levels (even if we had been earlier in our careers), these situations usually involve hiring a third-party technical expert to assist us with the due diligence, and that person will also be bound by the NDA.  However, such situations are quite rare, and are always exceptions to the norms described above.

Entrepreneurs are my heroes.  Great entrepreneurs focus primarily on how to build businesses that delight their customers with amazing products and solutions.  Of course, building those businesses often requires financial capital, advice, and relationships in addition to great products and technology.  For many entrepreneurs, raising capital seems like a medieval labyrinth constructed by mischievous VC investors, for which secret tools and tricks are the key to success.  Like most professionals who hide behind jargon and mystique as a way of hopefully amplifying their power, venture capitalists often perpetuate the mysticism of the fundraising “pitch.”

Steve Jobs: People who know what they're talking about don't need PowerPoint.

Luckily, it needn’t be that way.  As it turns out, being an entrepreneur is highly correlated with being human.  And, as it turns out, pretty much all humans already know how to tell stories.  And, as it turns out, making a presentation to raise VC investment is really no different than any other form of storytelling.  

I wrote a long post in 2011 about how I evaluate entrepreneurial businesses, and how entrepreneurs can best use well-known methods of storytelling to present their businesses to me.   As a courtesy to both of us, please review that post before we discuss your business.  Whether you are a good fit with the way I evaluate investments or not, I wish you the best of success. Thank you for your courage in following the entrepreneurial path, and for creating your own story. 

bijan:

It’s not easy but there a number of ways to get into the venture capital business. Some grow up in it, paying their dues in an almost apprenticeship model then over the years they take on more and more responsibility at the firm as their experience grows.

Some are were experienced entrepreneurs…

informationarbitrage:

I’ve lived through bubbles. Lots of them. They are powerful, make a few extremely rich and many wondering what happened to their pocketbooks and their pride. What I’ve witnessed in the seed stage venture environment has not had these hallmarks. Sure, some prices for pre-revenue and often…

The U.S. government recently changed the rules for SBIR eligibility for companies with venture capital backing.  Read the changes here (the link is to a PDF).

It is important for entrepreneurs to understand the realities of the marketplace (investors will not sign general NDAs) and work with advisors to write cogent business plans that entice investors to take a close look at the company. Full disclosure issues, if any, can usually be resolved just before closing the deal.
Bill Payne, “No, I will not sign your non-disclosure agreement!” Full text is at http://gust.com/angel-investing/startup-blogs/2012/02/06/no-i-will-not-sign-your-non-disclosure-agreement/

Sunrise

In recent months and weeks, a number of reports and pundits have opined on the poor financial performance of venture capital funds over the last decade.  In general, their analysis is correct, although often lost in the media coverage has been the silver lining of the research, showing that smaller funds have continued to outperform larger funds.

To summarize the theme:  the VC industry exploded in the late 1990’s, enabling a record amount of capital and number of funds to be raised in 2000-2001.  Since most VC funds are structured for 10 years, that record amount of capital was deployed over the past decade.  And as anyone could have predicted, the oversupply of capital led to diminished returns.  That is Economics 101.

The main problem with the various analyses is a tendency to project the next 10 years based on the past 10 years.  Trends continue right up until they don’t.  The best returns in any investment asset class are typically made by those who invest precisely when everyone else has given up.  Capitulation is a buy signal.  Or as Baron Rothschild said more vividly in the 1800’s, “The time to buy is when there’s blood in the streets.”

The last 4 years have witnessed a record consolidation in the number of VC firms, and we are now entering the 5th year in which VC investments into companies have exceeded limited partner commitments of capital to VC funds.   As Herb Simon famously said, “Things that can’t go on forever, don’t.”  The financial market for VC investment is self-correcting, just like any other asset class; the challenge is that the long-term nature of VC funds (which, of course, is what gives the asset class its unique advantages) also acts as a damper on the VC industry’s cyclicality.  In many ways, we are just now seeing the disastrous impact on the VC industry of the dot-com and telecom bubble implosion from a decade ago.  The chickens are coming home to roost, so to speak.

In that context, as a contrarian-minded VC investor, I have tended to believe that the VC funds raised in this period will likely end up being historically strong performers.  The consumer Internet revolution, the mobile phone and tablet explosion, and the natural demographic rise of a new generation - with several billion more participants in the free market system - all portend enormous transformation and market opportunity.  Record amounts of angel investment and new providers of seed funding like Y Combinator and Techstars, coupled with lower-than-ever costs to start companies, have launched record numbers of new start-ups.  Eventually, the successful winners of the start-up tournament will move into the later bracket stages, where they will need traditional venture capital to scale.   The reduced availability of that capital will allow the remaining VCs to be more selective and rational in funding only the very best tournament finalists.

Recently Mark Suster wrote a similar blog post with the title “It’s Morning in Venture Capital” that more eloquently echoed my opinion:

Contrary to some press reporting, the boom in startups, the creation of accelerators and seed funds as well as the deserved popularity of AngelList do not signal doom for our industry. They are, in fact, great news for traditional venture capitalists. The most successful of these businesses will still need venture capital to scale their businesses.  They need a combination of capital and experience to separate from the rest of the pack – the low cost of starting a business means it is even more vital to become the market leader more quickly.”  

I highly recommend reading Mark’s lengthy but excellent post here.

Indeed, it is morning in venture capital investing.

Earlier today, the Financial Accounting Foundation (FAF) voted to establish a new Private Company Council (PCC):

The new group, the Private Company Council (PCC), will have two principal responsibilities. Based on criteria mutually developed and agreed to with the Financial Accounting Standards Board (FASB), the PCC will determine whether exceptions or modifications to existing nongovernmental U.S. Generally Accepted Accounting Principles (U.S. GAAP) are necessary to address the needs of users of private company financial statements. The PCC will identify, deliberate, and vote on any proposed changes, which will be subject to endorsement by the FASB and submitted for public comment before being incorporated into GAAP. The PCC also will serve as the primary advisory body to the FASB on the appropriate treatment for private companies for items under active consideration on the FASB’s technical agenda.

Congratulations to the board and staff of the National Venture Capital Association for its collaborative involvement with FAF and FASB to develop this new Council, which offers a real opportunity for improving the efficiency and efficacy of financial reporting for private companies. I had the honor of providing expert testimony to the leadership of FAF and FASB earlier this year, and am cautiously optimistic about the real impact the new PCC can have.

The full press release from FAF is here.

Scott Edward Walker has a nice post up at TechCrunch that covers the details of using convertible notes for seed financings:

One of the key advantages of issuing convertible notes is that the valuation issue is kicked down the road until the Series A round of financing – when there are a lot more data points and thus it’s much easier to value the startup (i.e., price the round).  Accordingly, the issuance of convertible notes disposes of the foregoing three problems.  Again, a convertible note is a loan (debt, not equity).  A valuation of the startup is thus unnecessary; and, if there is no valuation, there are no problems of dilution, taxes and option pricing.

Visit the entire post here.