Thoughts on Components

October 1, 2012

Looking over my past investments, I am struck by how much harder it is to develop a company that is selling components to OEM’s rather than a product to the end market. I have had two companies pivot to making the product that they were initially just enabling others to make – one did it in time and it is working great, the other did not succeed (and went out of business a few years ago).

Why are component companies harder?  Several reasons: OEM’s are tough negotiators (low margins), the markets are often smaller (lower exit value) and you are constantly at risk of being swapped out (higher risk to revenues = financing risk). Also, a component company struggles to build a brand that the end customer recognizes (and if they can, it can be very expensive to do so). Maybe most importantly, you don’t get the direct connection to the end customer that is needed to understand when to make the right decisions about what is important about your product, what benefits are key, how the product really needs to improve. If a company is not well connected to the end buyer, can end up being (mis)guided into pursuing technical improvements rather than customer benefit improvements and they are not always the same thing.

Don’t “GO TO MEETING”

December 6, 2011

Lately, I’ve had a board meeting and several pitches done via GO TO MEETING. I hate it. Are entrepreneurs concerned about the possibility of their presentation being emailed around (which we would not do without asking anyway)? Or are they not want me to page ahead?  My feeling is that GTM takes the excitement out of learning something new, eliminates my ability to page forward or back to see if something will be covered later or to check a number that was presented earlier. It relegates the audience to a movie watching experience rather than an interactive discussion and my concern, when GTM is used in a pitch, is that it may indicate a larger misunderstanding: that investors are passive and should be reported to rather than collaborated with.

Let your presentations be a bit more freeform when you are pitching and leave the VC with the feeling that you have had a conversation rather than a lecture.  Sure, you risk the VC being distracted and reading a different slide than the one you are on but that’s because the VC thinks it is more interesting than the one you are on – knowing that is valuable.

I’ve been hearing from multiple sources about Intellectual Ventures going into universities, gathering a group of faculty researchers to “brainstorm” and file patents on their ideas. It is very troubling that universities would consider working with patent trolls. I suspect that the universities are going to be surprised when the so called Intellectual’s lay claim to IP that the university would have otherwise owned as a result of the natural course of research. The Intellectual Ventures line will, of course, be that, by protecting the IP, they will encourage development of the technology but the truth is that they will not do anything like what a real venture firm will do to move the technology to the market, create jobs, make the world a better place. The patent trolls would rather extract money from the hard work of others.

I had two things happen recently that made me think more about how a board is perceived by the employees of a venture funded company, specifically the non-CEO managers:

First:  After I learned about a portfolio company crisis that had been brewing for months (about 12!), I asked the company’s managers “why didn’t you tell me about this problem?”.   What I got back was “well, we just did as we were told”, “you were the board, we had to be careful in telling you things”,  and “we were instructed by the CEO not to talk to you”.  I am still scratching my head at these answers…it’s 180 degress from the way I want a management team to think.

Second:  Around the same time, I visited a portfolio company without advanced warning just because I was in the neighborhood with some extra time.  The team there was totally stressed that a board member visit might mean something bad…  I guess I can understand the reaction, many times the only time some company employees see the board is when they come in for board meetings or to fire someone, shut the company down, etc.  That’s not the case at all here, I just wanted to drop in and see how things were going and the CEO had told me to stop in if I found myself with a little extra time that day.  Plus I enjoy working with this team and wanted to see how I could possibly be helpful.

These two interactions got me thinking about how perceptions of what the board (of directors) is and what it wants might interfere with really beneficial information flow and interactions.  Specifically:

  • The VC directors are not there to simply evaluate how their investment is doing.  They should be a resource and to help the company with skills and relationships that might not be in the company normally.  In other words, make the board work for you (and everyone work for the shareholders).  VC’s actually want to be asked to help with problems, find resources, etc.
  • The directors do not want to funnel all communications through the CEO.  We absolutely want to have open discussions with the team.  Just lay it out there…the good, the bad and the ugly.  CEO’s will not succeed if they create barriers between the directors their team or, worse, create some fear of the board (“we can’t tell them that because they would pull our funding”).
  • Some members of the board will understand the company and nuances of strategy faster than others.  Everyone should recognize this and work to keep all the board members up to speed, not by managing information but by proactively educating.  The fact is that some directors will not really pay attention until there is a crisis, even if the team is being fully transparent.  CEO’s have to actively educate and manage those board members because they can become loose cannons if surprised (because they panic when the company is under stress).
  • The board is not exclusively focused on objective financial measures.  Companies can grow in value (or potential value) by building a great team.  Yes, ultimately it needs to translate to revenues and profits but in the early stages, a good director is also focused on team development.  Board members sometimes  fail to attend to this though and leave it to the CEO.  I let this issue go for far too long with one company that failed to build out a complete team and the team fell apart at the same time that it landed the first big customers.
  • Directors do not always agree with each other on strategy – that’s OK as long as a decision is made and everyone stacks hands and moves forward together.  Because a startup almost always has to pivot once it understand the customer needs, it is natural that there is an ongoing dialog about where that pivot point is. The non-director management of the company should learn to value a range of opinions from the board just like it values a range of ideas from the employees.

This idea of open communication is easier to say than to do.  A manager can’t really call the board and say that the CEO is wrong – it breaches trust.  What I think teams should do is to separate the people from the problem and focus on bringing issues forward.  The CEO needs to create a culture where, if a manager is concerned about a problem, this concern gets exposed to the board.  It isn’t really that much harder than having the managers speak their minds in the board meetings (where most of the senior managers of the company should participate).

What I plan to try with my next company is having an explicit policy from day 1 where (1) every new employee gets some explanation of what the board is and how it can be used as a resource, (2) board members are expected to pop in and chat with any employee, and (3) every board member will visit, at least by phone, at least once a quarter, with every C and V level executive to get an unrehearsed view of the company  status.  The goal is not only to help the directors better understand how the company is doing and head off problems but also to find out where the directors can be a valuable resource for the company.  Some of my companies already operate this way (because of the culture set up by the CEO) and my observation is that they are more likely to stay out of the ditch and, if they end up there, are more likely to have everyone pulling together to get back on the road.

The Solyndra blame game is in full swing.  The company, having previously filed an S-1 to go public and taken over $500 Million in US government (USG) loan guarantees, filed for bankruptcy last week presumably losing all or most of the investor equity capital as well as the USG backed debt.  Given the nature of the risk here, I think it is fair to say that USG has been acting as a VC.

Good VC’s know that they won’t get every call right.  Hey, I sold a bunch of Apple stock after they failed with the Newton.  Similarly, sometimes we are wrong about investments and sometimes we are right, sometimes wildly so.  That’s why VC’s, including USG, build a portfolio.

Should the USG be making what are essentially VC investments?  Personally, I think not, for the obvious reasons.  But a public flogging on “why the USG lost this money” misses the point and shows is that the armchair quarterbacks in congress don’t understand the first thing about startups, venture capital, technology entrepreneurship.  For instance, this week, a congressman said, basically, “how can you be wrong after doing nine months of diligence?”  A VC knows that the ones that fail always looks stupid in hindsight.  To you and to everyone else.  VC’s also know that there is no amount of diligence that will guarantee success.  If it were only that easy we wouldn’t have had to bail out a bunch of smart investment bankers for buying mortgages at the wrong time.

For the record, here is what I suspect where the real mistakes by USG (based on the limited information out there so far):

  • This is just a guess but I suspect that the Dept. of Energy felt safe going in behind brand name investors.  However, the availability of such large amounts of non-recourse debt may encourage those VCs to take riskier investments, partially because the leverage will increase returns but also because it usually comes in after most of the venture capital so the “pot odds” drive a rational investor to stay at the table.
  • Manufacture of a commodity product is probably not where we should spend USG capital.  Alarms go off in my head when management tells us that they will be profitable when they get to massive scale.  As a nation, we need a race to low cost on low margin manufacturing like we need a hole in the head.  Solyndra would have been pulled overseas eventually even if it had initially succeeded.
  • The DOE/USG should have set public expectations for a J-curve (i.e., losses show up early, making the fund look like a bad idea but winners take more time to build value).  The DOE Loan Guarantee portfolio is $36 Billion so the Solyndra loss is less than 2% of the portfolio.   I realize that being debt guarantee, the portfolio will not “make it up on the winners” like a regular VC fund would hope to do but, if the outcome metric is more businesses and more jobs, there is plenty of opportunity for a net positive outcome to the loan program.

Regardless of how you feel about USG engaging in direct venture capital or whether the USG portfolio “returns” the investment, Solyndra is just one failure in a high risk venture fund.   The same thing happens with failed designs for military aircraft but we generally perceive that, over a portfolio of projects, these expenses provide “returns” to the country.  Get over it.

Question: Should Universities put money into startups to bridge the so-called “valley of death”?  I hear that more and more lately.

Answer: It is a terrible idea.  However, there is a way for the university to spend far less and create more.

Let me explain. Universities are frustrated…there is all of this “research and nobody is commercializing it”  and “if VC’s won’t do it then we should invest”.  Unfortunately, the simple solution, invest in our own startups, is a recipe for financial losses.  Picking startup winners and helping them succeed is just not the core competency of universities (and looking at the numbers, it isn’t the core competency of many VC funds either).  Also, as I have said before, there is a tendency to over estimate how many really commercializable technologies are sitting around at one time.

What a university CAN be good at is creating a culture where there are more opportunities for commercializable research to be generated and to have a shot at commercialization.  In fact, if you look at the success  of the Rice Alliance, it can stimulate much more than the commercialization of university research – it can have a huge impact on the local startup ecosystem at a very low cost.

So, I think that having the university act to select and finance startups is not such a good idea but spending money on mentoring entrepreneurial faculty, helping them refine their story and their target market or technology and connect with the business and investment community is absolutely worthwhile.  Mentoring and connecting the university with the business community go hand in hand. It is not expensive, the university can have a lot of shots on goal and, if there is a strike out on a particular technology, the experience still gets into the university, the business community gets engaged …all for the benefit of the next deal.  This approach is highly leveraged with sustainable benefits versus the rifle shot model where the university spins out a company, puts money into it, hires a CEO and hopes for the best.