Last post, I shared my observations from the recent Microsoft VC conference hosted by Steve Ballmer in Silicon Valley (BTW:  what an amazing young entrepreneur turned mega-executive and company-builder; he has my vote for CEO of the century so far – and I’m not just trying to suck up so that I can sell any of our companies to Microsoft!).  I included in that post an observation that the enterprise software business model is dead and VCs are really shying away from these deals.

The corollary is that consumer is hot again in the VC community.  E-commerce version 2, the digital home, online advetising, social networking and finding the next Google — all are themes that VCs up and down Route 128 and Silicon Valley are chasing.  As a result, experienced enterprise software investors are trying to convert themselves into consumer VCs.  Literally every VC I talk to in Boston is asking themselves:  "How do I reinvent myself as an enterprise IT guy/gal into a consumer VC?"

And so the obvious contrarian thing to ask is:  is there a consumer VC bubble coming?  Just as Gary Rivlin of the NY Times observes the phenomenon of "VC Tourists" in his recent Sunday Business Section Article So You Want To Be A Venture Capitalist, I might argue there are "Consumer VC Tourists" now jumping into areas where they have little to no background and are therefore bound to lose lots of money.  Fast.  I confess to being personally biased on this one.  At Upromise (college savings loyalty program I co-founded in early 2000), we raised over $100M and spent much of it on marketing to acquire the now 6+ million member households.  I saw first-hand how quickly money can fly out the door in a VC-backed consumer play and I’m worried that it’s happening again.  And, yes, I still worry that we in Boston still have a thin talent pool for successfully executing such businesses.

There’s some emerging data to support the "consumer bubble" theory.  VentureOne recently reported that in 2003, there were 183 consumer deals and $1.2 billion invested.  In 2004, it jumped to 246 deals and $2.1 billion invested.  I would be surprised if 2005 didn’t continue the trend.  Most worrying, this month’s featured event at Harvard Business School Club of Boston is, you guessed it, "Emerging Trends in Consumer Technologies".  Uh oh.  Anytime HBS jumps on a bandwagon, you know it’s the top of the curve.  Maybe the contrarian thing to do is plow back into enterprise IT!

I’m in Mountain View, CA today attending Microsoft’s annual VC Conference.  Every year, Steve Ballmer and crew come down from Redmond and expose 100 VCs to their upcoming plans.  The buzz points in the audience this year include:

• The enterprise software business model is dead.  This is refrain many VCs are mumbling to each other lately.  Price pressure is incredibly intense between open source, Microsoft moving up the stack, vendor consolidation, IT buying wariness, the ASP model, overfunding in interesting sectors and many other factors.  It used to be that you could build a profitable enterprise software company at the $15-20M threshold.  But with today’s pricing pressures and high cost of sale, it seems to have jumped to $40M, and it’s harder to reach that threshold quickly.  VC appetite for standard enterprise software appears to be dwindling to nothing.
• LAMP cost of ownership vs. Microsoft is a myth.  This is a new acronymn that I learned today.  It stands for Linux, Apache, MySQL and PHP – all open source components that are eating away at Microsoft’s value chain.  Microsoft firmly believes that they are right on the facts and losing a perception battle with their core developer community – and need to fix this, fast.
• Microsoft is no longer the Big Bad Wolf.  Believe it or not, Microsoft feels downright warm and fuzzy lately to a VC.  It used to be that VCs would complain that investing is software is dumb because Microsoft will simply build it and give it away for free.  Nowadays, you hear much less of that.  The law of large numbers has settled into Redmond’s decisions.  If a business is less than $1 billion in platform revenue potential, it’s not interesting enough to warrant Microsoft’s attention.  Therefore, there are plenty of multi-hundred million dollar software segments that Microsoft is thrilled to help young companies build (on top of their platform, of course).  Also, Microsoft’s IP strategy is now all about aggressive cross-licensing rather than offensive litigation.  This company has really grown up over the years.

Ballmer’s keynote over breakfast is today, so we’ll see if anything new comes out of that.  Last year, he spent much time trying to convince us (and himself!) that Microsoft would catch up with and crush Google.  One year later, they seem to have slipped farther behind!

How do VCs make investment decisions, personnel decisions and work through other critical issues?  Well, first you need to understand VC economics before the murky decision-making process can be teased out.

So what’s the VC business model?  Raise a fund, get paid 2.0-2.5% annually in fees to manage that fund, and make investments that you hope will generate capital gains.  When those returns are generated, the VC funds typically get 20-25% of "carried interest" or "carry" in the capital gains.

Let’s walk through a simple example.  Let’s say there’s a $150 million fund and the VCs are getting 2% in annual fees and 20% in carried interest.  Then, the firm takes in $3.0 million in annual revenue.  If the fund returns 2x the capital, or $300 million, over the 10-year life of the fund, then $150 million is considered capital gains and the VCs get 20% of that amount, or $30 million, to be divided up between the partners according to who has how much of the carried interest.  If the fund doesn’t generate any capital gains, the VCs get nothing beyond their salaries paid out of the annual revenue.  Once the VC is finished investing their fund, they need to raise another fund from Limited Partners (LPs), typically universitiy endowments, pension funds, fund of funds, wealthy families or corporations.

Why does this help shed light on VC decision-making?

Because decisions within a firm typically get made depending on who has the most carry, not based on title, as you would assume coming from a real company (VP Sales – oh, I guess they sell…).  Partner or General Partner titles can be misleading.  A 29 year-old, green General Partner may have a tiny sliver of carry as compared to the 50 year-old General Partner who’s been a successful investor for 20 years.  Guess whose opinion matters more?

In VC firms where the carry is divided unevenly, decision-making is typically unevenly made.  VC firms where cary is divided evenly are more consensus-driven.

So, if you find yourself pitching a VC firm and wondering how they’ll make their decision, there are a few important questions to get answers to while you’re fundraising:

1) Who is the partner who would serve as the deal champion?  Associates and Principals don’t typically have carry, so they can’t make investment decisions without a partner’s support.  Junior partners with small slivers of carry may need senior partners to closely oversee the diligence and decision-making process.

2) How long has that partner been with the VC firm?  Are they on an equal footing in terms of carried interest (i.e., ownership) to the other partners?  If not, they may not be able to "speak for the firm" when it’s time to make tough decisions about follow-on rounds and M&A transactions.  If so, they will still need to get to consensus, but it’s a very different dynamic when your "deal champion" isn’t a subordinate within the VC firm.

3) When is the last time that partner made an investment and what other deals are they working on?  If a partner is out of capacity, conventional wisdow nowadays suggests sitting on 8-10 boards at any given time is the max, then they are far less likely to take on a new project than if they have recently sold off or shut down a bunch of their portfolio.

4) Where is the VC fund in their fundraising cycle?  If they are at the tail end of a fund, they may be more selective in their investments…or more rash.  If their current fund is strong, they may be more willing to roll the dice with the final few investments in terms of risk/reward profile.  If their current fund is weak, they may need a few short-term, safer hits to make up for poor historical performance.

VCs are great at asking entrepreneurs dozens of probing questions about their state of affairs – so in theory turnabout should be fair play!