In that 1984 classic, Revenge of the Nerds, a group of outcasts and misfits fight back against their better-looking, "cool" rivals, ultimately winning the girls and glory.

I was reminded of the movie over breakfast this morning with the CEO of one of the major ad agencies.  Just as you'd expect a high-powered agency executive to be, he was smooth, smart, suave and urbane.  But his industry is under siege from the Nerds.  On one side, he has techno-media companies like Google, Yahoo and MSN using technology and data to eat into the traditional ad agency value chain.  On the other side, he has advertisers like P&G, Ford and Coca Cola demanding more sophisticated targeting and effectiveness for their incremental ad dollars – no longer accepting the old way of doing business over a three martini lunch.  The stakes are getting higher:  Think Equity estimates the global online advertising market will be north of $40 billion in 2009 and still growing at 15-20% per annum while TV remains flat and radio and newspapers suffer.

And so Madison Avenue's chic "Mad Men" are under siege.  And the Nerds seem to be winning.

But the cool guys are fighting back.  If you can't beat 'em, join 'em.

They are buying technology companies (witness WPP's acquisition of 24×7 and Publicis' acquisition of Digitas) and embracing the digital world in spades.  This CEO, for example, talked to me about three Nerd-like priorities:  striking the right technology partnerships (typically with start-ups, like the new one I'm funding in this space), hiring the right in-house technical resources, and wresting control of the data from the publishers.

This final point struck me as a very intersting one.  Ad Age reported this week on the gauntlet that has been thrown down by GroupM, WPP's major media buying organization.  The agencies are wising up to the value of the data in online advertising and are trying to regain control over it.  In many cases, the data can be more valuable than the actual served ad itself.  Thus, Group M and other agencies are changing their contracts to tighten up the ownership of the data and prevent ad networks, publishers and the techno-media firms to use the data for their own profit purposes.
Soon, agencies may disaggregate buying media from buying data – in other words, there may be data insertion orders placed right next to media insertion orders.  This would put a specific price and explicit rights control on the data.

But the cultural change required is perhaps the most difficult one for these large ad agencies.  How will the agencies compete for great technical talent and recruit and retain innovative entrepreneurs?  Will they be able to outsource some of the technical capabilities that their clients are demanding (e.g., with the likes of digitalArbor)?  And who will win in this battle to own all this incredible data being collected on consumer behavior?

If I remember correctly, the Nerds won in the first movie, as well as in Revene of the Nerds II.  Maybe Madison Avenue needs to make a third sequel:  "Revenge of the Mad Men".

Billed as "Silicon Valley meets Madison Avenue", today's AlwaysOn conference in NYC was somewhat reassuring.  Attendence was up from previous years and attendees were there to do business – raise money, look for deals, develop partnerships.

A few highlights:

• Ad Networks 3.0:  panelists argued that there remained a huge opportunity, despite investor fatigue in yet another ad network.  Elizabeth Blair, CEO of Brand.net, pointed out that although 30% of direct response advertising dollars had already moved online, only 5% of brand dollars had made the shift, despite consumer reporting that they spend 40% of their time online.  That said, there was clamoring for some way to use data to improve CPMs, particularly for non-premium inventory.
• Mobile Advertising:  panelists laid out the case for why the iPhone was transformational for mobile advertising and that early trials suggest mobile advertising actually works.  That said, they were realistic about the slow growth ahead as mobile works its way into the marketing mix, particularly as a component in cross-platform campaigns.
• Brian Wieser of Magna gave a great keynote, providing overwhelming data to suggest TV isn't dead yet.  "TV dwarfs other media in reach and frequency," he argued.  The data was compelling.  For example, 97% of adults 18-49 turn on the television every week, the same as 10 years ago, and viewing hours is actually growing, now standing at 500 billion person hours (side note:  who the heck is watching 4 hours of TV / day??  That's the AVERAGE consumption!).  Further, even if online video grows at a rate of 35% (roughly the current rate), TV will still represent 100x more hours in 2011!  A sobering view in the world of, as Wieser put it, "Web 2.0%".
• Online Advertising:  Jeff Lanctot, Chief Strategy officer at Razorfish, predicted flat spending, lower CPMs, and argued that the "print dollars turning into digital pennies" simply was not working for publishers.  Perhaps massive publisher consolidation will rebalance supply and demand, but unlikely.
• Smartphone:  this panel was simply an hour long raving lovefest for the iPhone.  Favorite iPhone apps mentioned ranged from the sublime (Amazon, Pandora) to the ridiculous (iFart, iThrow, iFu Kung Fu).  Eric Litman, CEO of Medialets, amusingly pointed out that there are 20 million Windows Mobile devices, but application discovery is such an awful experience that the download rates are a fraction of the iPhones.
• VC Outlook:  Jonathan Miller (Velocity, ex-CEO AOL), Woody Benson (Prism) and I did a panel on the VC outlook.  We tried to provide a balanced view – I think we were all relatively balanced as short-term bears, but long-term bulls.  As Woody pointed out, "You can't do what I do unless you're an optimist.  Otherwise, you'd jump out the window!"

But the real highlight of the day for me personally was closing the New York Stock Exchange (NYSE) – an honor that Tony Perkins was kind enough to make available to me.  Lucky for me the market was up today (Tony quipped that he should change the name of the conference to Always Up)!

I recently read Malcolm Gladwell’s new book, Outliers, with great interest and delight. Gladwell is a fantastic author:  always thought-provoking on human behavior and a quick, entertaining read.  But I confess this book did not resonate with me or strike me as relevant for the VC-entrepreneur dance in the same way his previous book, Blink, did (see:  VCs Blink).  It was intellectually interesting, but not professionally illimunating.

Instead, I have been even more taken by another book, which also analyzes human behavior in a thought-provoking way called Sway. Written by Ori and Rom Brafman, Sway was recommended to me by my friend and co-investor Howard Morgan at First Round Capital.  It is a fascinating analysis of why human beings naturally fall into irrational behavior.  The book has very relevant implications for venture capitalists and entrepreneurs, particularly in today’s environment, as VCs are likely to allow irrational behavior to seep into their portfolio management decisions in the coming years.

Sway points to three central psychological tendencies that cause human beings to behave irrationally, despite the preponderance of facts pointing in another direction.  The first is loss aversion, defined as our tendency to go to great lengths to avoid possible loss – even when it means taking outsized risks relative to the actual loss impact.  The second is value attribution, where we imbue a person with certain qualities based on our initial impressions (or desired impressions!).  And the third is the diagnosis bias, where we allow our initial assessment of a person or situation cloud any further judgment and, in effect, cause us to filter out any contradictory data.

As I look back on the good and bad investment decisions that we have made as a partnership, I see each of these three tendencies factoring into our discussions.  It is not uncommon for a polished, confident entrepreneur to benefit from value attribution, when in fact a deeper analysis of their skills and previous experiences as a result of exhaustive reference checking will reveal a very different prognosis.  We have tried to be more cognizant of identifying these tendencies in the partnership as we contemplate our future investment decisions with our (relatively) new fund.

As I look forward to managing the portfolio during the challenging times that we all face, I can see where loss aversion, in particular, holds sway in a VC partnership. Human beings prefer to avoid a loss, even if that loss is more costly than the price of continuing forward. One of the dangers in the coming years for the VC business is whether VCs are going to continue supporting companies in order to avoid admitting defeat and taking losses. In many partnerships, the culture may naturally encourage covering things up.  Many VC partners are eager to brag about their portfolio successes, but slow to admit when they have made mistakes or when they are in the midst of dealing with a poorly performing portfolio company. Further, partnerships as a whole are going to be loathe to admit problems and failures with their investors, the Limited Partners.  Without any malice, portfolio “cover ups” will be common throughout 2009 and 2010.

Loss aversion will thus cause VCs to throw good money after bad in 2009 and 2010.  Loss aversion will also cause VCs to report overly optimistic quarterly valuations.  I would estimate that many portfolios have valuations that are overstated by 20-30%.  And, as I have discussed before (see:  "Why 'Flat is the New Up' and VC Funds Are Under-Reserved"), it is also the reason why I think many VC firms are grossly under-reserved.  These factors will be exacerbated by most portfolio companies failing to attract outside financings in the coming years and VCs, loathe to admit losses, continuing to support them well beyond the length that a rational investor would.

To be clear, it is not only VCs who are induced into irrational behavior due to loss aversion. Entrepreneurs clearly suffer from this tendency as well, particularly when it comes to hiring and firing key executives. How often have you heard an entrepreneur say that they should have acted 6-12 months earlier in firing an employee that was not working out?  The reason – loss aversion. Entrepreneurs are loathed to admit their own hiring mistakes and are fearful of the impact and magnitude of losing even a poorly performing team member. I know I certainly fell into this trap when I was an entrepreneur, and I see it is repeated time and time again.

Thus, I think the lessons of Sway are ones that all VCs and entrepreneurs would benefit tremendously from when evaluating how they make decisions. In an upcoming blog I might dive into the question of value attribution and the diagnosis bias, which are also a thought-provoking concepts that drive irrational behavior in VC partnerships.  One entrepreneur identified another book for consideration on this topic called Predictably Irrational by Dan Ariely, which I have not yet read.

What are other examples can folks think of that fall into these irrational categories?

One of our portfolio companies is raising money this year.  It's a great company, run by a great CEO, and it will get funded in a competitive process.  The CEO was briefing our partnership the other day and listed the firms he is talking to.  In another start-up a number of years ago, he had been backed by an unnamed firm in Boston, led by an unnamed partner, and made them money.  "Why aren't you going back to [insert name] at [insert firm]?" I asked innocently.  "Life's too short," he replies pointedly, "to work with assholes."

At a time when there is likely to be some shakeout in the VC industry, a question that perplexes me is:  Why do asshole VCs continue to survive?

Now don't get me wrong, I don't think the VC business is unique in its profile or behavior.  According to the NVCA, there are 700 or so VC firms and 8,000 industry professionals (including associates, principals, etc).  The vast majority of these folks are decent people.  There are always a few bad apples in every barrel and an industry with type A, competitive people operating with very high stakes is likely to have its fair share.  Talk to any entrepreneur who has gone through an extensive fundraising process and they will eagerly share some their favorite, colorful horror stories.  So why do these VCs continue to succeed?  Why isn't there a stronger, self-correcting feedback loop?

Here's the logic thread:  the best entrepreneurs have choices, particularly those that have been successful before.  They typically seek out the top VCs who are both smart/successful/value-add/relevant AND who are respectful/decent/good to work with (you can see my BCG roots coming through in the imaginary 2×2 matrix).  Even if a VC is charming during the courting process, with minimal effort, reputations can be investigated and references carefully checked as to how they behave when things don't go according to plan.  So why is it that Asshole VCs are able to persist?  Shouldn't the best entrepreneurs avoid working with them and therefore shouldn't they be less successful over time?

One of my VC friends from Silicon Valley suggested one explanation:  "Entrepreneurs get blinded by firm reputations and look past individual reputations.  They don't do their due diligence on partners and check references carefully on the individual board member."

"If I were an entrepreneur given the choice between banging my head against a cinderblock wall for a year or taking money from [unnamed partner from unnamed firm]," observes one VC friend, "I'd opt for the cinderblock wall."

Ouch.  With fewer financing choices for entrepreneurs likely in 2009, I hope they aren't faced with that sort of painful choice!

I dodged the snowflakes and made the trek out to Sin City for this year's Consumer Electronics Show (CES).  Although attendence was down, it is still an insanely large audience of 130,000 attendees and 2,700 companies.  CEA head Gary Shapiro reported in his keynote that industy sales were up over 5% and that 2009 will be flat or slightly down.  Not bad if true.  His speech, by the way, was as much a political speech as it was an industry overview, further underscoring the importance of government activities in business affairs in the coming years.  Two areas he hammered on were immigration policy ("expand H1B visas") and shooting down the ridiculous union-sponsored "card check" law (every large company business leader I have spoken to in the last 6 months is apoplectic over this bill and view it as a litmus test for Obama's centrist economic policies).

Tom Hanks appeared with Sony CEO Howard Stringer to pump Sony products and were very funny.  But by far the funniest line of the day was heard from the very dour and serious head of Intel Capital.  Seeking to assuage the nervous entrepreneurs amongst the portfolio companies that were in attendence at his networking lunch reception, he assured them, "We [Intel Capital] intend to continue forward and be very supportive of your down rounds this year".  Ouch.  He was probably just grumpy from the miserable results Intel announced to Wall Street the day before, with an unheard of 23% forecasted drop in revenue.  That wasn't so funny.

Also not so funny were the general buzz and complaints bemoaning the lack of innovation.  The next generation of flat screen displays and Blu Ray devices just isn't that exciting any more.  Further, I was shocked at how empty the casinos were.  I can see why the casino moguls are sweating it right now.  The consumer electronics industry may be in for a stagnant year, but coming off a record year that would be a victory.  But one look at all the frozen cranes up and down the strip is all you need to know that Sin City is in for a tough run in 2009 and 2010.  But Intel Capital will be happy to invest in their down rounds.

Among my holiday reading this year was Alan Greenspan's biography cum economic analysis, "The Age of Turbulence".  In retrospect, the book's publishing date of mid-2007 preceded almost precisely the unravelling of the housing market in mid-2007 that eventually led to 2008 becoming the year of the largest market crash since the Great Depression.  The book is thus a fascinating glimpse into Greenspan's brain on the eve of the crash.

In short, the erstwhile "Maestro" (as Bob Woodward tagged him in his 2000 book) clearly "missed it".  One quote that really jumped out at me:  "I was aware that the loosening of morgage credit terms for subprime borrowers increased financial risk, and that subsizdized home ownership initiatives distort market outcomes.  But I believed then, as now, that the benefits of broadened home ownership are worth the risk."  Ouch.

To get a glimpse of his current views, read his guest article in The Economist.  At the end of the article, he points out that, to date, there has been $7 trillion in global sovereign credit pumped into the system ($1 trilion presumably from the US, which doesn't include the additional $1 trillion stimulus planned).  This staggering amount of money is going to have to be inflationary at some point.  With US Treasuries at 0%, it appears the market is more worried about deflation.  But many economic commentators are very worried about inflation in years 3-10 (today's WSJ had a good range of interviews with some of them, so called "Doomsayers").  Greenspan himself points to long-term inflationary risk as "the rate of flow of new workers to competitive labor markets will eventually slow, and as a result, disinflationary pressure should start to lift".

So my big prediction for 2009 is that we will begin the year nervous about deflation, and end the year nervous about inflation returning.  Interest rates will need to go up again in 2010 and 2011 to choke off the inflationary stimulus. 

What impact all this will have on venture capital and entrepreneurship, I'm still sorting out.  One thing is true, venture capitalists and entrepreneurs are operating at a very different end of the economic spectrum, creating new products and services that never existed and thereby creating value.  Hence, I remain a long-term bull about entrepreneurial prospects.  As Greenspan points in one section that really resonated with me:  "[The 1990s] technology boom came along and changed everything.  It made America's freewheeling, entrepreneurial, so-what-if-you-fail business culture the envy of the world."  I guess I'll keep that photo of me and Alan on my desk after all…

My firm, Flybridge Capital Partners, launched a new program last week that was inspired by Scott Kirsner's blog post earlier this year on the tragedy of Massachusetts students not remaining in the state after they graduate.  Scott called to task some of the industry associations who, in theory, should be welcoming to students but, in practice, create barriers by charging them for attending the critical industry events that would help weave them into the business community.

We call the program, "Stay in MA" and it's a student scholarship program that allows students who want to attend industry events with participating associations (and nearly every major "innovation economy" association is participating in the program) to attend these events for free.

To learn more, check out www.stayinma.com.  And thanks to all the associations who are participating!

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.