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?

BusinessWeek asked me to write an article for them on entrepreneurship in their latest issue At Work.  You can read it here:  "Think Like a VC, Act Like an Entrepreneur".

It was fun for me to try to aim something at a more general business audience than my tyipcal entrepreneurial audience.

It was also very fun for me to see who they put on the cover of the issue:  Dwight Schrute, who has to be one of the funniest television characters ever.  While I was on vacation last week, I finished Season 3 of The Office and am looking forward to Season 4!

There is a controversy brewing in the world of government grant money to start-ups that is trickling into the VC community.  The Small Business Association (SBA) of the US government administers Small Business Innovation  Research (SBIR) and Small Business Technology Transfer (STTR) provides grants to small businesses (defined as fewer than 500 employees) to the tune of $2 billion per year.  This compares to $20-30 billion per year in VC money that flows to start-ups, so a meaningful figure in the entrepreneurial economy.

But the two worlds of VC-backed start-ups and SBIR grants have mixed like oil and water historically due to a key restriction in grant eligibility:  start-ups that are 51% or more owned by VCs do not qualify for SBIR or SBTR grants.  Thus, a young start-up in a field relevant to the government grant world has a conundrum when it considers taking VC money – it no longer will be eligible to receive non-dilutive government grants.

Many VCs argue this is a ridiculous exclusion that is fostering an adverse selection problem.  The economy is awash in VC money and so only the less promising start-ups aren’t getting it.  Instead, they get taxpayer-funded government money.  The most promising start-ups who can get VC money are not eligible for government money.  Hence, the government is serving as a funder of last resort to companies who the invisible hand of the market has rejected.
 
That may sound like an overly harsh view, but it is one that the NVCA (National Venture Capital Association) is arguing as they try to get the Senate and House to agree to loosen the restriction. Mark Hessen of the NVCA points out that “Venture capitalists have funded well over 90% of all the biotech firms in the United States”.  It is an interesting debate and the House and Senate are in the midst of it. 

I confess to being sympathetic to both views.  My father was an entrepreneur in the 1960s and 1970s who received government grant money to foster his innovations in the defense electronics community.  At the time, though, the VC community was miniscule compared to today.  In 1980, the VC industry comprised of under 100 firms with a mere $4 billion under management.  Today, there are 700 firms with over $250 billion under management.  It’s hard to argue that just because a firm is successful in attracting VC money, it is unworthy of government support.  The fact that SBIR applications have been dropping sharply in recent years (down 12%, 15% and 21% in FY’05, FY’06, FY’07) is a clear signal that something in the system needs to change.

Anyone following the open source phenomenon can’t help but be amazed at what appears to be volunteerism on a massive scale for corporate gain.  Almost every company in the world has some strands of open source code floating around their company.  Whether it is the Linux operating system, Apache web server, the IP protocol or database programs such as MySQL, open source software has permeated corporations around the globe.  According to one estimate from start-up Ohloh, there are 11,000 open source software projects going on right now in the world and 70,000 devleopers contributing to those projects for free.

Further, the impact and reach of open source extends far beyond businesses alone.  Mainstream consumers are participants in the open source phenomenon.  Wikipedia is the most obvious example, which attracts 683 million visitors annually to its over 2 million articles (source:  Wikipedia, of course) – all written by volunteers throughout the world.

Clearly there is an explanation that goes to the heart of human behavior and motivation as to why so many people are inspired to contribute so much for free.  Any reader of philosophers from David Hume to Adam Smith to Ayn Rand would point out that there must be some underlying selfish motivation involved.  Open source participants aren’t getting paid, yet they must be motivated in some part out of self-interest.  So what exactly is going on?

MySQL CEO Marten Mickos seems to have the answer.  In a recent WSJ interview, he observes, “Those who contribute to us are as selfish as anybody else…[They are motivated by] their desire to build a reputation for themselves…it gives them a feeling of usefulness in the world.” 

And I think therein lies the key insight.  Isn’t that what everyone wants?  To feel useful and recognized.  I would suggest that explanation is also at the heart of why entrepreneurship is such a powerful phenomenon.  The reward for the entrepreneur is not just about the money – although, sure, they are motivated by the money — but what really drives great entrepreneurs is the ego, pride and feeling of recognition and respect.  When an entrepreneur sells their company or goes public, it’s that feeling of being a winner and having everyone notice that is most powerful.  Ask any entrepreneur if they’d rather own 1% of a $1 billion company that changed the world and makes the front cover of Business Week or 100% of a $10 million company that no one ever hears about and you’ll learn a lot about that entrepreneur. 

The NBA Finals “There Can Be Only One” advertisements with split screen images of Kobe Bryant and Kevin Garnett and other multi-jillionare stars said it all:  “We all want respect and there is only one way to earn the kind of respect we all want.  The kind of respect they can’t take away from you.  Win.”