Many pundits and economists observe that we are in the midst of the greatest financial crisis since the Great Depression.  What they haven't fully yet processed is that we are in the midst of the greatest wave of government intervention in business since the New Deal.  Across massive, diverse industries such as energy, health care and life sciences, financial services and automotive — to name just a few — we are embarking on arguably the most business-focused, activist US government in history. 

I moderated a very timely panel yesterday at the MIT VC Conference on the new role of government in business in general, and entrepreneurship in particular.  MIT is one of the central cradles of American innovation and entrepreneurship.  The fact that they asked me to focus on this theme is clearly a signal that entrepreneurs are focused on better understanding the New World Order of government as the "third wheel" in the VC-entrepreneur equation.

Joining me on the panel were a group of four very talented leaders whose careers have spanned both sectors.  In effect, these four were uniquely experienced at "seeing both sides" of the private sector-public sector partnership:

• Dan O'Connell, Massachusetts Secretary of Economy and Housing under Governor Patrick.
• Ranch Kimball, former Massachusetts Secretary of Economy and Housing under Governor Romney and now CEO of the Joslin Diabetes Center.
• Phil Giudice, Massachusetts Commissioner of Energy and former SVP at EnerNOC.
• Paul Afonso, former chairman of the Department of Telecommunications and Energy under Governor Romney and now a partner at Brown Rudnick.

A few themes/observations that were shared:

• Dan O'Connell observed that, at least in Massachusetts, when government leaders say, "We're from the government and we're here to help," it's not the old Ronald Reagan punchline.  Instead, it's an earnest attempt at striking a helpful partnership with the Patrick administration — led by a governor who himself was a former business leader.  He also pointed out that business leaders need to appreciate that government's involvement in business has a different goal:  local job creation, not capital return, requiring some compromises on both sides when embarking on collaboration.
• Phil Giudice observed that from his recent visits to Washington DC this last week, it is clear that the Obama administration is preparing for a massive, long-term, strategic effort around energy independence from which billions of dollars will flow.  Phil led the passage in MA of a landmark Energy Bill in partnership with business leaders from the New England Clean Energy Council (Flybridge Capital is a sponsor and member of the council).
• Ranch Kimball expressed his belief that NIH funding will grow again and that MA is incredibly well positioned for the surge in private and public life sciences spending that will flow to MA, citing with pride the extraordinary talent in Massachusetts (and not just in Cambridge and Boston, Dan noted, but throughout Worcester, Lowell, Springfield and elsewhere).
• Paul Afonso observed that when business wants something out of government (a growing trend as there is more that is being "given"), they need to not just send their lobbyists with their hands out, but rather encouraged CEOs to get to know government leaders when they don't need anything so help lay the groundwork for collaboration.

Massachusetts has pioneered many of the initiatives in teaming business and government (health care reform, life sciences and clean energy being three salient recent examples).  It will be fascinating to watch the new administration embrace, copy and adapt some of these initiatives over the next few months, and perhaps take them further still.

Everyone in the VC business is looking hard at their fund reserves right now.  Very hard.

That's because the two key assumptions regarding how much money a portfolio company would require from start to finish (the exit) have changed:  (1) the length of time before exit; and (2) the number of portfolio companies that would attract outside capital to lead follow-on financing rounds.

The new planning assumpion VC fund CFOs and senior partners are embracing is that each portfolio company's exit forecast should be pushed out two to three years and, further, funds should assume that inside rounds will be the prevailing method for raising additional capital within the portfolio.  For the strongest portfolio companies, it will be a privilege to close a flat round with an outsider.  In other words, "flat is the new up".

Let me first "pull back the camera" for a minute and explain how VCs think about "reserves".  When a VC invests in a company, they set aside "reserve capital" for follow-on rounds of financing.  For example, if a VC invests $5 million in a round of financing, they pencil in an additional, say, $10 million of capital that they set aside in their fund for the company to cover additional rounds of capital in the years.  They calculate this number based on their assumptions of total capital required before exit and the amount of that capital they will be responsible for — as opposed to other investors who may be investing alongside them.  So, if you assume the company will require $40 million in total capital before exit, then other investors will need to be found to put in the additional $25 million (i.e., above and beyond the initial VC's $5 million plus $10 million in reserve).  Reserves become an important number because VCs need to plan their entire fund structure around them.  If a $400 million VC fund makes 20 investments of $10 million each (for a total of $200 million in capital out the door) and then sets aside $10 million for each investment in follow-on capital (for a total of $200 million in reserves), then when investment #21 walks in the door, they need to have a new fund raised to invest out of – the previous fund is "tapped out". 

When things were going well, VCs could comfortably assume their portfolio companies would achieve their exits 4-6 years after investment and would assume that the good companies would attract outside investors and higher and higher prices.  For the last five years, it was not atypical for a high-quality Series A company that raised an initial round of capital priced at, say, $5 million on a $5 million pre-money valuation to hit a few important milestones (e.g., hire the team, build an initial prototype, identify a few initial customers) and they expect to raise a Series B at a meaningful step-up from their $10 million post-money valuation from the Series A – say, $10 million on $15-20 million pre.

Today, those financings are simply not happening.  Series A prices have come down a bit, but the initial management team needs some reasonable ownership level to stay committed.  Where prices are really getting hammered in the VC-backed world is in Series B and Series C rounds.  Outside of a few notable, and particularly promising exceptions, almost no one is paying up for pre-revenue companies never mind fast growth revenue companies.  If you have a high quality company and it can simply attract outside capital at the same price as the previous round, it's a great outcome.  Hence, flat is the new up. 

Now, back to the reserves analysis.  If your exit timing assumption is pushed back 2-3 years, then you need to raise more like $50-60 million, not $40 million.  And if you thought you could attract most of that from outsiders, you are mistaken.  VC funds need to plan to shoulder a larger part of the load.  So now you're looking at needing $20 million in reserve capital rather than $10 million.  Across one or two companies, a fund can sustain this level of replan.  Across the entire portfolio, it's a bigger problem.  Remember my example of the $400 million fund above with 20 portfolio companies?  If all 20 double their reserves, the fund is way underwater.  And woe to the portfolio company whose VC fund gets tapped out too soon.  It's a bit like pension funds for…er…auto makers.  If the VC fund has under-reserved for the portfolio companies, then everyone gets squeezed.

Entrepreneurs need to get up to speed on this important issue that's echoing through the halls of VC firms and engage their VC partners in open dialog about their reserves.  I've suggested to each of my CEOs that they systematically poll their investors and directly ask, "what do you have reserved for us in your fund?" so that there is no confusion on this point. 

There is no shame for VCs in changing the planning assumptions underlying their funds.  The tragedy would be if VCs don't do it quickly in light of the new facts on the ground – and, in turn, if entrepreneurs aren't aware of the issue early enough to make the necessary adjustments to preserve the value creation opportunity in their companies.

As John Maynard Keynes famously observed when flip-flopping on an important economic policy matter, "When the facts change, I change my mind – what do you do sir?"

Alan Blinder (former vice chairman of the Federal Reserve) is one of my favorite economists.  His book, Hard Heads, Soft Hearts, outlines a compelling philosophy in economic policy – whereby a tough-minded, analytical approach is applied to solve difficult social issues.

Thus, I read his recent NY Sunday Times article on the central role that trust plays in capitalism with great interest.  "The new president's most fundamental job," he writes, "is to restore the people's confidence that the economy will perform — for them".

Translating this mantra to the start-up world is a thought-provoking exercise.  Do the principals in the start-up economy — the entrepreneur and the VC — trust each other?  In these economic times, tensions can flare over strategy, burn rate and performance.  Tough conversations and arguments over tough issues is natural, but if there isn't a foundation of trust between these two parties, the start-up ecosystem fails, just as our markets fail.

Trust often breaks down in the VC-entrepreneur relationship when either side senses that the other isn't being straight with them.  The telltale signs for a VC to not trust the entrepreneur is when they see an entrepreneur:

• Get more defensive during tough times, rather than more transparent.
• Avoid confronting tough issues, rather than forcefully raising them early and often.
• Blame poor performance on others, rather than embrace accountability.
• Focus on their own situation and wealth equation, rather than focus on shareholder value.

On the flip side, the entrepreneur worries that their VC isn't being straight with them when they see a VC:

• Disengage in the details during tough times, rather than engage more vigorously.
• Be a pollyana when things aren't going well, rather than providing realistic assessments and tough feedback on performance.
• Seek to apply general formulas (e.g., let's implement the Sequoia Manifesto!), rather than cater their response to the specific situation.
• Focus on their VC fund's situation and agenda, rather than the portfolio company's.

Successful corporate chieftans turned philosophers, such as Jack Welch (GE) and Bill George (Medtronic), have identified authenticity as the key success factor to leaders.  I would suggest entrepreneurs VCs (not often necessarily thought of as leaders!) face a similar standard.  If your VC or entrepreneur can't pass the "Authentic Leadership" test, you are in trouble.  Bill George points out authentic leaders are those that:

• Are true to themselves and their beliefs.
• More concerned with serving others than their own personal success or recognition.

• Engender trust and develop geniune connections with others.

Restoring trust in our economy and government for Americans and the broader world community is a monumental task for President-elect Obama.  We VCs have the (admitedly smaller but still critical) task of navigating these tough times by demonstrating to our two major customers – our entrepreneur and our investors – that we are worthy of their trust.

Earlier this year, I wrote a blog about how to prepare for the financing process, focusing in particular on follow-on financings.  Some readers have pointed out to me that I left out a very key element of the due diligence process:  what the process itself reveals about the nature of the entrepreneur to the VC.  Many entrepreneurs I know underestimate the importance of their small and large actions during due diligence and the signals their behavior send to the VCs.  In truth, the due diligence process itself is a gauntlet that tests the entrepreneur and informs the VC about their mettle and whether they have the character and skills to build a great company.

VCs don’t typically enter a true due diligence process until after the 2nd or 3rd meeting.  That’s when they start talking to experts in the field, customers, management team members, conducting technical reviews and combing through financial models.  Broadly speaking, there are three stages to the process:

1) Sniffing around.  During the “sniffing around” phase, the VC has decided they like the company enough to make it one of their top 3-5 “new deal” priorities, spending proactive time on the company squeezed in alongside the time they spend on their portfolio.  This typically involves the following activities:

• Conducting follow-up meetings with the team to identify and probe on the key issues
• Putting the team in front of “friends of the firm” who have expertise and can provide insight into the opportunity
• Making 3-5 reference calls with analysts, customers or management team members to get an initial read.

In addition to the substantive questions around market size, competitive advantage, technology and team qualifications, the VC will ask themselves a few key questions about the entrepreneur during this phase:

• Is the entrepreneur defensive when I probe on important questions or are they thoughtful, earnest, insightful and authentic in their answers?
• Is the entrepreneur on top of the details of the business or do they appear to be flying by the seat of their pants?
• Has the entrepreneur done their homework about the market and really researched deeply the customer need and competitive set or do they appear naïve and uninformed about the challenges ahead?

2) Digging deep.  During the next phase, the lead VC partner has decided to make the company a top 1 or 2 priority and begins thinking deeply about the company and the opportunity during shower time and drive time.  For the VC, this typically involves the following activities:

• Briefing their partners in some detail on the pros and cons of the investment opportunity and the important financial terms of the deal
• Mapping out a detailed due diligence plan to probe on the key diligence issues and risks
• Exposing some if not all of their partners to the company to get other informed opinions around the table
• Making 15-20 reference calls with customers, management team references, perhaps even competitors and others who can provide insight into the market

During this process, the VC will ask themselves the following questions about the entrepreneur:

• Are they open in revealing customer references and management team references or are they hesitant and defensive?
• Do they provide thoughtful, detailed responses to the key diligence questions promptly or do they appear to take the posture that the VC simply “doesn’t get it”?
• Does good news and momentum continue to build as the process wanes on or do they seem frozen in time?

3) Making the case and negotiating the deal.  Once the lead VC has decided he or she is convinced, they now have the obligation to convince their partners, or “make the case”.  The entrepreneur must answer whatever the hot buttons of the other partners are as well as make it through the dreaded Monday morning partners meeting, where the fate of the deal is decided based on their performance in a tight 60 minute presentation.  In parallel, the lead VC partner will typically be negotiating the main business terms of the deal with the entrepreneur.  Again, you learn a lot from someone during this process.  In particular:

• Is the entrepreneur cool, thoughtful and confident in how they present to the partnership or do they seem nervous and anxious in a “step up” moment?
• Is the entrepreneur persuasive and mature in making the case for their important business points during negotiations or do they seem immature and irrational as they make their arguments?
• Is the entrepreneur quick to pick up on sophisticated deal terms by bringing in good advisors or do they seem commercially naïve and unable or unwilling to bring in helpful expertise?
• Finally, do you complete the process and still say to yourself:  “I’m excited to do business with this person and jump into the roller coaster with them for the next 5-7 years” or “boy am I glad that’s done, I can’t wait to get to the next deal!”?

In these trying economic times, entrepreneur should expect that the due diligence process will become more rigorous.  Further, the competitive power has shifted to the sources of capital (i.e., VCs), which means deals will likely move slower and more deliberately than in the past.  Remember, the deal isn’t done until the money is wired and the VC will be evaluating you and your actions all along the way. 

Every start-up board is having the same conversation these last few weeks:  how will this economic crisis affect us and what should we do in our own business?

We had our annual investor meeting this week and warned our investors that it was going to get ugly over the next year or two (surprisingly, they indicated that some of their other VC investors had sounded positively pollyanna during this annual season).  For all the reasons I described in my recent blog, "Short-Term Bear, Long-Term Bull", we remain a fan of the start-up economy in the long run.  That said, CEOs need to take swift action to make sure they survive to see the long run.  For as economist John Maynard Keynes observed, "In the long run, we are all dead."

My partner, David Aronoff, wrote a good blog outlining what CEOs should be doing to ensure survival.  TechCrunch reports a similar note that angel investor Ron Conway has sent out to his portfolio companies.  GigaOm reports that Sequoia Capital called an all-hands, emergency meeting with its portfolio CEOs to walk through a recommended plan of action.  I have received copies of emails from a few other funds alerting their CEOs with similar messages.  Take action now.  Don't dither.  Cut costs, cut projects, raise incremental capital, be proactive and plan for the worst.

If you don't, you might be watching Kenesyian economic policy being implemented from the vantage point of six feet under.

Every year, Microsoft bigwigs trek down to Silicon Valley and brief the VC community on their view of the world and plans for the future.  They are kind enough to invite East Coast VCs, not just locals, and so I flew out last week to partake in the annual event alongisde a few hundred of my VC brethren.  Just as when I had attended the event in the past, the highlight was Steve Ballmer's address.

I personally think Steve Ballmer is the CEO of the century.  When he joined college buddy, Bill, the company's revenues were $2.5m.  This year, they crossed $60 billion.  Yet, when you meet him in person, he remains incredibly down-to-earth and accessible.  I remember a few years ago he gave out his email address.  For fun, I sent him an email.  I was stunned when he replied right back.  I love watching him speak as he is full of fire and brimstone, but also very insightful.

A few of the highlights from this year's discussion:

• Ballmer claims he thinks of himself like a VC (ok, he was probably playing to the crowd a bit) - and tries to have a similar mindset as he makes decisions to prioritize and direct their $9 billion R&D budget.
• He couldn't have been more bullish about the tech industry (which, he pointed out, feels as if it's in a different world than the CNBC crowd we've all been watching lately) – very excited about all the innovations in cloud computing, mobile, search, the enterprise and elsewhere.
• Interestingly, he identified his top competitors as Google, Apple and Linux.  Secondary foes included IBM, Oracle, Amazon and SAP.  It goes to show how consumer focused Microsoft has become that two of their top three competitors are essentially consumer companies and brands.  Amazingly, almost all of these companies are doing well – in large part thanks to innovation and global expansion.
• He admitted that they screwed up the Yahoo acquisition but vowed to get better at such transactions.  With their recent issuance of debt, clearly there is more to come.
• In times like these, Ballmer indicated, he wants to be the guy with his foot pushing hardest on the pedal, implying that some of his competition might be thinkig of letting up due to the economic situation.

Microsoft clearly remains a force to be reckoned with, particularly with an executive as talented as Ballmer at the helm.

One of my closest friends is Andrew Janower of Charlesbank Capital.  His eight year old daughter, Samantha, has a brain tumor, and AJ has created a non-profit to find a cure called the Pediatric Low Grade Astrocytoma Foundation.  Their story was recently featured in the WSJ.

American Express has named the foundation one of the finalists its considering providing a $2.5 million grant to.  They will make their decisions on September 29th based on cardmembers' votes.

If you are a card member, please take two minutes to VOTE (no donation required, just a click).  Here's what you do:

1. Go to http://www.membersproject.com/project/view/NN934A

2. Scroll down to "Vote for this Project" (located under the video/photo window)

3. Click on "Vote for this Project"

4. Click on "Log In"

5. Log in using either your American Express Card number* or your on-line account information

6. After logging in, you should have returned to the Project Brain Child description page –
http://www.membersproject.com/project/view/NN934A

7. Scroll down AGAIN and click on "Vote for this Project"

8. You're done!

Thanks for your consideration!

I don't need to repeat the facts behind last week's financial turbulence – from Lehman Brothers to Merrill Lynch to AIG and beyond.  To paraphrase Jon Stewart, it's a good thing the audience can't see me cry during the commercial breaks.  Beyond the obvious coverage in the Wall Street Journal, Business Week, The Economist and the Financial Times, a few of the sites I've found insightful are  Seeking Alpha and the Prudent Bear.

Watching the carnage on Wall Street has been a spectator sport for most of us in the VC and start-up community.  The rough going our investment banking cousins are experiencing has caused us to put down our popcorn and soft drinks and ask ourselves:  how am I impacted?  What will all this mean to the entrepreneurial economy?

In the dozens of meetings and conversations I've had with entrepreneurs and VCs this last week, it is clear that everyone is shell-shocked at the macro level, but surprisingly sanguine on the micro level.  "Our traffic numbers keep going up and up," pointed out one B2C CEO, shaking his head in disbelief.  "Our portfolio is basically not affected," claimed one VC with a tinge of hubris.

Yet everyone is clearly affected, it's just a matter of degree.  Henry McCance, one of history's great venture capitalists and chairman of Greylock, was quoted by my partners (three of whom are ex-Greylock) as saying in the midst of the 1998 Long Term Capital crash (which some say was worse than the 1987 market crash), "We know our portfolio is down 30%, we just don't know where".

But it's better to be down 30% than 300%.  In truth, most early-stage companies are not that affected by the stock market gyrations or even a general recession.  Yes, some consumer-based "if you build it, they will come" businesses will be more susceptible to the inevitable pullback in advertising spend.  But most venture-backed start-ups are technology-driven with deep Intellectual Property (IP).  If the technology works, value is created.  With only a few customer proof points, a few million of revenue can be generated from scratch and even more value can be created.  The holding period for early-stage start-ups is typically 6-8 years, and so an episodic recession shouldn't materially affect long-term value creation, so long as follow-on financing is available.  One VC observed that his partnership had done an analysis and realized that, "we have 20 companies in our portfolio seeking follow-on financing this year.  They'll nearly all get done, but none of them will be meaningfully up rounds.  Instead, there will be many flat and down rounds ahead".

But the VC and entrepreneurial community went through a far rougher period only a few years ago and most firms are run by executives who remember those times and remember the prudent actions required:  cust costs, but don't cut to the bone; raise more capital than your plans suggest you need to cover the dry period; in general, increase fund reserves and assume longer holding periods; with employees and investors, set expectations for patience and long-term business building rather than quick hits and quick flips. 

Further, I would observe that many of the macro-trends that the entrepreneurial economy is based on remain very positive.  For example, I would argue that the following trends are inevitable:

• The $600 billion advertising industry will shift to online (particularly search) and mobile – an area that is still growing north of 20% per year.
• Advances in nanotechnology and materials science will yield valuable medical technologies and devices – with health care spending still 18% of GDP, this is a big sector of the economy ripe for innvoation and value creation.
• Advances in energy technology will yield profitable new approaches in solar, wind, LEDs, batteries, and numerous other renewables – revolutionizing this massive industry (see Tom Friedman's inspiring NYTimes magzine:  "The Power of Green").
• Globalization (reported thoughtfully in a special report in this week's Economist) continues to accelerate, making it easier for young companies to attract capital and deploy resources in the most efficient locations, irrespective of geographical barriers.

At the same time that these macro-trends are bubbling along, the fundamentals of the start-up ecosystem remain strong — seasoned (and novice!) entrepreneurs are enthusiastically tackling these issues.  Venture capital funding remains plentiful – almost everyone in the industry will tell you there is still too much money chasing too few ideas (good for entrepreneurs, but more challenging for individual fund returns!).  The ecosystem has modest dependency on the debt markets, inflation or commodity prices.

For all these reasons, although I am a short-term bear (yes, it will continue to be an ugly year or two for the global macroeconomy), I remain a long-term bull when it comes to the entrepreneurial economy and the potential for start-ups to impact the world and create value.

The role of a Chief Technology Officer (CTO) in a company is an incredibly critical, but poorly understood one.  Unless a member of the founding team is a strong technology visionary that occupies that role, many start-ups neglect the position.  Instead, they assume the CIO or VP of Engineering can be responsible for setting technology strategy as well as delivering on it – an impossible burden even for the most talented technology manager.  Within our portfolio, I have always been an advocate of separating the two positions:  an internally-facing VP of Engineering or CIO, who is responsible for delivering the goods on time and on budget on an operational, quarterly and annual basis; and an externally-facing CTO, who is looking over the horizon to set strategic direction and establish the priorities of where to invest taking into account how the world will look in 3-5 years.

Therefore, I read Lotus founder, Mitch Kapor’s call for the next President to hire a CTO for America in MIT’s Technology Review with great interest.  Historically, America has never had a CTO.  The President’s Science Advisory Committee, which had great prominence when it was first established in 1957 during America’s “Sputnik moment” under Presidents Eisenhower, has had little influence and visibility since Nixon abolished the committee in 1973 and it returned under President Ford in a weakened form.  Yet technology strategy and policy permeates so many of the critical issues the country faces today:  from energy policy to defense, from education to homeland security and obviously the big elephant in the room in any budget debate – health care.

During Bill Clinton’s 1992 campaign, his campaign manager James Carville famously drummed home the mantra, “It’s the Economy, Stupid”.  After taking office, President Clinton elevated the Council of Economic Advisors chairman to a cabinet-level position and appointed the highly respected Wall Street heavyweight, Bob Rubin (who later became Treasury Secretary and arguably one of the most influential stewards of our economy in recent memory).

With a nod to Thomas Friedman, I might submit that an appropriate election theme this time around may be “The World is Flat, Stupid”.  More and more of America’s success in the global competitive environment depends on our knowledge economy and government is playing a large role in shaping this.  For example, ethanol subsidies appear to be a narrow and short-sighted way to spend billions of tax-payer money, yet they persist because no credible voice provides Congress and the cabinet with an authoritative technology perspective.

No matter who wins in November, I hope they bring with them to Washington the technology version of Bob Rubin to help steer our course.  Our needs seem more urgent than the mere challenge of putting a man on the moon.

Everyone said the 2008 summer doldrums were going to result in the worst exit environment since the Internet bubble crashed.  After the first half of the year produced one of the worst 6 months for VC-backed IPOs in recent history, the anemic results were bound to trickle down into the M&A market during the slow summer months.

I spent the last few weeks in Israel (pleasure, not business) and so left a pile of non-urgent emails from PE Week, VentureWire, etc. in the “post-vacation” reading folder.  After reading through them in one sitting (something I don't recommend trying at home), I was surprised to piece together the data.  To my surprise, there have been a good number of summer exits, providing some optimism during an otherwise grim economic picture as we head "Back to School".

It appears that high-quality corporate buyers are still trolling for acquisitions and opening up their pocket books where start-ups with traction can be found.  Here’s my accounting of the situation (blend of public and private data):

• SBA Communications acquires Optasite for $430m
• Microsoft acquires DATAllegro for $240m
• Cisco acquires PostPath for $215m
• Nuance acquires SNAPin for $180m
• Belden acquires Trapeze for $133m
• Comcast acquires Daily Candy for $125m
• Cisco acquires Pure Networks for $120m
• BT acquires Ribbit for $105m
• Monster acquires Trovix for $72.5m
• Publicis acquires Performix for undisclosed amount, but likely north of $100m

This isn’t to say that many VC-backed companies aren’t affected by the economic environment – of course they are.  As a VC mentor of mine once said – when the NASDAQ is down 30%, I know I’m down 30%, I just don’t know where!  That said, it was nice to see a few glimmers of light in the dark tunnel of 2008.  Perhaps we'll see more of the same between now and year-end?