I have lately observed a strange dynamic in the start-up/private equity community that a buyout friend of mine coined:  “the circle of envy”.  It harkens to the old saying, “the grass is always greener on the other side” (a very capitalistic and classically “American” saying, which actually has its origins in Erasmus’ 16^th century Latin writings, admiring the fertile look of a neighbor’s corn!).  It goes something like this:

Entrepreneurs are recently famous for sulkily observing that the VCs have the cushiest of lives.  Unlike entrepreneurs who live and die by quarterly and annual milestones, VCs get paid generous management fees whether they seem to actually perform or not.  In the mind of many entrepreneurs, VCs don’t work all that hard, parachute into board meetings without having done their homework, make a few trite, unhelpful comments and then leave.  In short, entrepreneurs are envious of the VC way of life, which seems to have lots of financial upside and none of the quality of life downside.

VCs are recently famous for grousing about how much money their private equity cousins are making.  A VC struggles to invest $5-10 million at a time while their private equity cousins pour hundreds of millions of dollars, and recently even billions, into a single deal.  Since the fee income portion of compensation is a function of assets under management, the more you manage, the more you make.  The other compensation component is the carried interest, and VCs are green with envy when they see buyout guys use cheap leverage to make money while retaining large stakes in their firms.  In short, VCs see the outrageous financial lifestyles of the private equity hitters, flying around in their private jets and think:  “if only I could be like them – they’ve really got the model figured out”.

Private equity executives are recently famous for expressing their envy for hedge funds.  Unlike private equity and VC firms, who only get paid on the gains when a portfolio company is liquidated, hedge funds take their carried interest off the table every year.  And when a private equity or VC firm gets hot, it has to wait three or four years in between fund cycles to raise new, larger funds.  Those lucky hedge fund executives can sweep big money in at a moment’s notice, raising their fee income with a snap.  Further, complain private equity folks, the hedge fund executives rarely travel to chase around high-stakes auctions and have none of the responsibility or liability that “owning” companies and controlling boards represents.  They just seem to coast along, accumulate more and more capital, and live it up.

And hedge fund executives?  The top of the heap?  Hardly.  I often hear them discuss with envy the life of the entrepreneur – cycling through exciting new start-ups every 5-6 years and then taking long sabbaticals in-between gigs.  Meanwhile, the hedge fund executive is chained to every international market every minute of the day for fear they miss spotting the latest currency or interest rate fluctuation.  Entrepreneurs actually create things of value and leave a mark on society, rather than simply financial engineering.  And that nonsense about money flowing in so fast being such a great thing?  Remember, it can flow out just as fast.  And, besides, the hedge fund business as a whole has little barriers to entry and struggle to find true proprietary elements of the busines, resulting in too much money chasing too few good investment opportunities.  Those entrepreneurs who can come up with original ideas, build proprietary technology and products, and then sell them out get all the glory, reap all the rewards and then unplug.  Now that’s the life.

The result of all this hand-wringing?  Perhaps the Chinese proverb is the truest:  “think about the misfortune of others to be satisfied with your own lot”.  Of course, relative to others in this world, each of these executives is as lucky as lucky can be!

I had the privilege of spending the day today back at Harvard Business School at a venture capital conference organized by the burgeoning entrepreneurship department.  Professor Bill Sahlman (who has easily trained more VCs than any other professor) organized a spectacular affair with 60-70 VCs from around the world, although with a heavy Boston weighting.  In addition to the riff raff such as myself, there were numerous luminaries there, including Arthur Rock (who wrote the business plan for Intel), Peter Brooke (Advent founder), Henry McCance (longtime head of Greylock), Jim Breyer (Accel), Rick Burnes (founder of Charles River Ventures) and others.  And the speakers outshone the audience!

A few interesting perspectives shared today:

• Larry Summers, Harvard’s President, emphasized the transformational impact that technological innovations in life sciences will have on our economy and lives, and the important role of the VC industry in taking projects out of the lab and enabling widespread distribution.  Summers has embarked on a massively ambitious Allston construction project which, when completed, will serve as a haven for inter-disciplinary scientific discovery.  Boston today, like Florence in medievel times, has the opportunity to be the most advanced community for the discovery and incubation of scientific breakthroughs and Harvard seems determined to truly lead that effort.
• Bob Langer, George Whitesides and Doug Melton added to this perspective with case studies of their own labs at MIT and Harvard and the incredible "innovation productivity" that they have achieved.  Some common patterns they highlighted:  pursuing high risk, big ideas; encouraging external and internal collaboration; stressing interdisciplinary approaches to problem-solving; and strong relationships with VCs and industry to reduce friction and improve throughput in the "from lab to market" process.  They cautioned, though, that typical VC time horizons (4-6 years) may be too short for early stage research commercialization time horizons (6-10 years).
• Clay Christiansen talked about the power of disruptive approaches (both low-end disruption and new market disruption) and the benefit to VCs of finding and investing behind disruptive opportunities rather than incremental ones.  A good lesson for those in the industry that jump on the "me too" funding bandwagon.
• Michael Porter highlighted the important role of strategy for the VC funds and their portfolio companies – the need to be unique at something, not "the best", and to make hard strategic trade-offs when building the value chain that delivers the unique product/service.  Good boards and CEOs, he noted wisely, need to be willing to say "no" frequently and with conviction.
• Jay Light, Andre Perold, Mohamed El-Erian and Jeremy Grantham discussed asset allocation and the capital markets.  They observed that pundits who believe a New Era is upon us are always wrong (as Jeremy quipped after analyzing 27 asset price different bubbles over the last 100 years:  "If it were a football match, it would be Reversal to the Mean: 27, New Era:  0".  They were quite bearish on US equities (predicting only 3-5% real return across a broad range of asset classes) and, like many others, lamented the dearth of untapped investment opportunities and the "stable disequilibrium" that the scary US current account deficit represents.  Makes you want to sit on cash!
• Felda Hardymon and Josh Lerner talked about the internationalization of private equity, warning against "tourist VCs" in China and India as well as reminding everyone that historical fund performance is best for small, focused firms with lots of experience — not newcomers parachuting in with large funds and overly general strategies.

Overall, a very thought-provoking event.  Bill Sahlman wraps it up tomorrow, where he will undoubtedly tell us the VC business is a crappy one (newsflash) and that we should all be pursuing new jobs as timber executives at hedge funds.

As 2005 comes to a close, a few 2006 predictions are on my mind…

1) The year of creative exits.

With the advent of Sarbanes-Oxley, the IPO bar is still too high for most VC-backed start-ups. If the company doesn’t have more than $100m revenue, four quarters of profitability and 8-10 years of operational maturity and history, it’s an unlikely candidate.  Besides, value-maximizing CEOs and VCs are not keen to pursue a financing event that’s not really an exit, given strict lock-up and public disclosure issues.  Thus, M&A has been the VC-backed exit path of choice.  Yet many companies are not necessarily appealing for M&A targets.  Therefore, 2006 will see more creative exit scenarios.  Will VCs take a page from their private equity cousins and begin to use leverage to recapitalize companies and achieve their return?  Will we see more aggressive redemption terms and board skirmishes to return excess cash?  Will we see private equity firms and hedge funds come into VC-backed companies that have gained some revenue traction to buy out the early-stage VCs?  Already, signs are emerging that these creative exits will be attempted by the impatient VCs sitting on 6-8 year old portfolio companies from the bubble days.  More will follow.

2) Traditional media, newspapers and magazines aren’t dead…yet.

Many have been predicting the demise of traditional publishing since the start of the Internet. The rise of Google has caused these calls to rise in volume. And yet, many of these companies just keep on ticking – and some are innovating into the online world through aggressive acquisitions (e.g., NY Times and About.com) and business transformations (e.g., IDG’s transformation from a mainly traditional print businesses only to a media conglomerate of online, research and investments). But despite rumors of their demise, many of these traditional media properties will retain great value – as subscribers, brands and advertisers all prove to be stickier than most think. After all, scientists believe it took decades, not years, for the dinosaurs to disappear from Earth.

3) Capital gap continues.

VCs continue to raise big funds, private equity firms continue to raise even bigger funds, and start-ups continue to fret about minimizing dilution.  Thus, there remains a "capital gap" for the early, early-stage entrepreneur that only wants $1-4 million, but can’t find a strong market for that small a "nibble" in the private equity world.  As a result, many entrepreneurs will push harder to hold their breath and self-fund in the earliest stages.  And smaller VCs (some old, some new) will continue to flourish in focusing on this higher risk, higher upside class of opportunities.

4) Blogging continues.  Even from VCs.

‘Nuff said.

I confess that I am a devout Red Sox fan.  The habit started in 1975 when I sat on my father’s lap and watched one of the greatest World Series of all time against the Big Red Machine (my second favorite team at the time).  The great tragedies of 1975, 1978, 1986 and 2003 are forever burned in my memory – as well as the great triumph of 2004.  Even my chosen blog photo is a bow to the Red Sox – a picture of me sitting in manager Terry Francona’s office at my beloved Fenway Park.

Therefore, I am a sucker for baseball-VC comparisons.  I have refrained from writing too much about my beloved Red Sox, but the departure of Theo and the recent blockbuster trade to acquire Josh Beckett, a pitcher recently heralded as the second coming of Roger Clemens, have awoken me from my self-imposed restraint.

The first comparison of note is applying the Moneyball theory to venture capital.  Written by Michael Lewis in 2003, Moneyball provides an inside look into how Oakland A’s General Manager Billy Beane constructs winning baseball teams with a constrained budget.  One of Beane’s secrets is to stay away from over-priced, super-stars.  Having put a number of strong years under their belt, a player on the “back nine” of their career may have the ability to earn a high price in the market, but may not be able to recreate the performance numbers going forward that would justify their inflated value.

One veteran VC friend of mine commented to me when Moneyball came out that he felt the same way about entrepreneurs.  VC firms like to brag about their habit of backing superstar, repeat entrepreneurs.  But my friend observed that the problem with superstar, repeat entrepreneurs is that they know they’re superstars.  Therefore, they command a high premium in cash, equity and deal price.  A typical series A of $4-6 million on a $4-6 million pre-money valuation might suddenly become $8-10 million on $10-15 million pre-money valuation if a superstar, repeat entrepreneur is at the helm.  Will the performance justify the inflated price?  Manny Ramirez has had a terrific five seasons in Boston, but the team keeps trying to unload his contract because they’ve concluded his great numbers simply aren’t worth the astronomically high price they pay for him.

Like top baseball scouts, VCs are better off looking for the lesser-known players who have superstar potential.  It’s easy to get into the hot deals with proven entrepreneurs if you “pay up”.  But who among us can spot the next David Ortiz, a player that languished for six years with the Twins, was signed for a relative pittance by the Red Sox, and has emerged as the game’s premier superstar, receiving the most votes for any player for the 2005 All-Star team?  At age 25, recently acquired Sox pitcher Josh Beckett could be the next Roger Clemens in terms of prospective performance – but he certainly won’t be paid anywhere near Roger’s $18 million 2005 salary.

If you subscribe to the Moneyball theory of VCs, you would be better off backing the young, hungry entrepreneurs who have something to prove – and are willing to make the financial and personal sacrifices to achieve a “win”, than the proven superstar entrepreneurs who command premiums.

Another interesting VC insight from baseball struck me a few weeks ago with the news of General Manager Theo Epstein’s departure.  The wunderkind general manager decided it was time to spread his wings and break out on his own.  Despite the great mentorship he received from CEO Larry Lucchino, Theo decided his own interests were no longer aligned with the rest of his “partnership”.  Sound familiar?  How many stories have we been reading about the young guys in VC firms breaking out on their own (with my own firm reflecting this general characterization), never mind other private equity shops and hedge funds?  No longer satisfied with the status quo of marching to someone else’s beat, young talented executives are often compelled to make their own way in the world and build their own legacies.  Although I am saddened by Theo’s departure, I acknowledge that this is simply the way of the world, and know that my own industry sees this behavior quite frequently as well.

There are many other amusing analogies – VCs combing the landscape like a good scout looking for undervalued opportunities/players, VCs behaving much like the most callous GMs when they treat entrepreneurs like pawns in a chess game – that are worth further exploration.  But I will now return to more business-like analogies rather than allow my blog posts to further reflect my Red Sox obsession!

When an entrepreneur has taken VC money in a first round of financing, there is almost always a second round.  Rare is the company that is able to develop a strong, sustainable cash flow positive business with a single round of financing.  When that bridge is crossed, the age-old debate begins within the boardroom:  do we do an inside round and save everyone (especially management) time and hassle or do we go outside and get someone else to price and lead the round?

Frankly, this “inside-out outside-in” dance was always a mystery to me as an entrepreneur.  And now that I’ve been a VC for nearly 3 years, I find myself still confused by it all.

If the VCs around the table love the company, why would they want anyone else to invest in it?  Why not keep investing and continue to (one of my favorite phrases) “put more money to work” (whenever I hear this oft-spoken phrase, I imagine a bunch of George Washington dollar bills slaving away in the salt mines and a VC foreman barking:  “Get me more dollar bills!  I need to put more money to work!”)?

So VCs only push entrepreneurs to go raise money from outsiders because they don’t love the company and don’t want to invest?  But if all VCs do this, then all VCs know this.  Therefore, when a VC receives “the call” from a VC buddy (sotto voice:  “I’m only exposing this to a few folks, it’s moving fast, but I wanted to get you exposed to it because you have such unique value-add and we have such a unique relationship”), the savvy VC buddy gets very suspicious.   A VC friend of mine refers to this as the “VC buddy pass”, and warned me when I got into the business to run for the hills when it comes your way.

And then there’s the famous bait and switch technique – the VC board member loves the company, but their partners are more skeptical and insist on outside validation.  So, the VC pushes management to spend an inordinate amount of time trying to attract interest from new investors, and then once the outside term sheet is put on the table, the insiders decide that they actually do want to invest and keep the round to themselves and shut out (and annoy) the outsider, particularly now that the price has been set.  This is known as the “rock fetch” (VC to entrepreneur:  “go find me a rock.”  Entrepreneur comes back panting hard with a rock in hand.  VC responds:  “No…I don’t like that rock, go fetch me another one.”)

As I said, I find it all pretty confusing.  That said, I have learned that there are mitigating circumstances.  Specifically:

• Capacity.  There are times when the company’s capital needs are beyond the capacity of the existing syndicate.  Raising $10-15 million of fresh capital can be hard for the two original VCs, particularly if their fund sizes and average capital per firm constrain their ability to split the check while reserving adequate dry powder for another round.
• True Value-Add.  All cynicism aside (or most of it, at least), there are times when a new, outside investor adds unique value.  This so-called strategic money can come in the form of an institutional VC, a corporate VC or a business partner with an interest in putting a few George Washingtons to work.
• Market Validation.  As I mentioned in my VC accountability blog, an individual VC partner is accountable to their LPs and fellow partners.  If they continue to support a company on the inside without seeking outside market validation, there is a risk of eroding the natural checks and balances behind cutting off bad businesses and not allowing good money to be poured in after bad.  In my experience, this can lead to a very frustrating outcome for entrepreneurs.

My suggestion:  entrepreneurs should be proactive and have a frank discussion about the next round right after closing the first round.  Something like: “If I hit these milestones, will you continue to support the company?  If so, what is the stepped up price that we will deserve?  20%?  30%?  What if we exceed the milestones?”

Ultimately, the inside-outside dance can be an area of great and unnecessary tension and time-wasting between the VC and the entrepreneur.  As with most things, direct, open communication can mitigate the potential negativity that can result in the dance ending poorly when the music stops.

The Jewish holidays are an interesting time of reflection and soul-searching.  One of the concepts I found myself mulling over this holiday season was the notion of accountability.  One of the most critical elements of Yom Kippur is to stand before G-d and be accountable for your actions of the past year.  Webster has a pretty simple definition for this word:  “having to answer for what was done”.  With the holidays behind us, I was thinking about the nature of VC accountability, a concept that can be subtle to understand, but critical for entrepreneurs to get their arms around.

For entrepreneurs, it’s really simple.  Every month, quarter and year, an operating executive is held accountable for results.  The VP of sales is accountable for revenue.  The VP of engineering is accountable for shipping products on time.  The VP of marketing is accountable for prioritizing sales and engineering resources, generating leads and providing superior positioning to the competition.   And the CEO is accountable for everything – revenue, expense and cash position – all as compared to the board-approved plan of record.  The consequences:  a nice bonus on the one extreme and preparing your resume on the other.

What about the VC?  What is the VC accountable for?  If posed that question, many entrepreneurs would smirk, roll their eyes and crack that VCs seem to be highly unaccountable creatures.  But that is a misguided view.  VCs are, in fact, highly accountable in two ways, and I would suggest a third as well.

First, VCs have to answer for their actions over a multi-year period to achieve what they are paid to achieve – make money.  Over some (typically long) period, how much money did they invest as compared to how much they returned?  The Limited Partner (“LP”, the VC’s investor) cares primarily about results.  After all, they, in turn, are accountable to their investment committees to make money, and so that accountability flows right to the VC.  Although the operating executive has a shorter time fuse, the VC is no less answerable for their performance and that performance is extremely measurable.

Second, VCs have to answer to their partners.  In a VC partnership, each VC is investing the money of their peers as well as theirs, and affecting the overall results of the fund.  And so while an LP may not hold a VC accountable for periods shorter than 6-10 years (the period after which fund performance is well-known), VCs are accountable to their partner every week at the partners meeting.  For 4-6 hours, the partners pour over their strategies for deploying the capital, high-priority projects and individual portfolios.  Every week, each individual VC must stand and deliver and demonstrate in front of their partners that they are on track to fulfill their obligation to their LPs to make money.

The third source of accountability is the one that is most often neglected – accountability to the portfolio company.  Some VCs take this very seriously.  When I was an entrepreneur, one of my VC investors shocked me when he said: “I’m simply a service provider – I work for you”.  It was a refreshing attitude that I’ve always taken to heart – good VCs are those that answer to the entrepreneurs.  What did they deliver in terms of value-add that month, quarter, year to their portfolio company?  I would recommend entrepreneurs not be shy about holding their VCs accountable.  Just as the board of directors evaluates the CEO/entrepreneur every year for their performance against results, the CEO/entrepreneur should have the license to evaluate their VCs for their performance.  Who did they help recruit?  What business development introductions did they make?  Were they proactive in giving critical strategic advice?  Were they available and responsive when needed for emergency issues?

No harm in a little extra accountability for VCs, don’t you think?

Today’s post is brought to you by a guest blogger:  Chip Hazard, my partner at IDG Ventures.  By way of background, Chip’s been a VC specializing in enterprise IT for twelve years and has a great perspective as someone who has seen the good times, bad times and everything in between.

[Chip Hazard]

Many pundits, from Larry Ellison to…uh…Jeff Bussgang, have pontificated on the maturation, consolidation and eventual death of the enterprise software business – at least for companies whose names are not IBM, Microsoft, Oracle, SAP or Symantec.  The general thesis goes something like the following: 1) corporate IT departments are looking to reduce, not increase their number of vendors and are therefore not inclined to work with start-ups; 2) customers no longer are pursuing best of breed strategies but instead want integrated suites; 3) the sales and marketing costs of large enterprise software solutions are extremely high and drive a need for significant investments that are beyond the capabilities of many early stage companies; 4) the overall rate of growth of the software industry as a whole has slowed and there are few areas for innovation.  Common analogies used by these pundits include the maturation and consolidation of the automobile and railroad industries in the early to mid 1900s.  Pretty depressing stuff.

So where does that leave a talented entrepreneur (or VC for that matter) with deep experience in this now passé field?  While challenging, if you look at some recent successes (deliberately selected from outside our portfolio), themes and strategies emerge that entrepreneurs can adopt to drive the creation of successful companies.

These are discussed below:

• Innovate to drive efficiency.  For many times over the last decade, enterprise software companies positioned themselves as automating certain functional departments of corporations.  First it was manufacturing, then financials, supply chain, sales, marketing etc.  If this is your view of the enterprise software environment, then by and large Larry Ellison is right – there is little room for new categories and innovation.  That said, if you spend time with you average CIO, you will hear a different story.  In today’s “post-bubble” environment the average CIO has seen their staff and capital budgets cut back, but the demands on their organizations from business executives have continued to increase as companies seek to have a more flexible and cost-effective IT organization to support their business plans.  Compounding this challenge of doing more with less is the sheer magnitude of the accumulated applications and technologies that have been deployed by enterprises over the last 20 years.  As a result, there remains a robust opportunity for focused vendors to drive innovative technology into enterprises to drive efficiency in IT operations.  The bar, however, is quite high.  If you can’t drive a 5 to 10 times reduction in key metrics, the status quo will prevail.  A recent success story is VMWare, which EMC acquired in early 2004 for $635 million, primarily due to the company’s success in enabling server consolidation, a primary method of driving efficiency in IT operations.  Other examples indicate there is a relatively healthy M&A market, as these innovative companies fill key product gaps for large acquirers, such as IBM, Microsoft, Oracle, HP and EMC, as well as mid-sized public companies such as BMC, Mercury, CA and Symantec.
• Dominate a niche.  Start-ups are often caught in a quandary.  To raise money and hire the best people, they need to convince VCs, employees and other supporters of the company they are going after a billion dollar market.  To do so, however, they run the risk of going too broad, too quickly and losing the laser focused approach to solving problems that allows start-ups to win versus large, incumbent vendors.  A better strategy is to instead think about climbing a staircase.  You know you want to reach the next floor, but you don’t do that by trying to jump up 13 stairs all at once.  Ask yourself, “What can I uniquely do today for a customer that solves a real problem and also provides a link to doing more things for those customers in the future?”  Unica, a recently public $80 million in revenue marketing automation company in Boston is a good example of this.  When they first got going, they had the best data mining tools for marketing analysts on the planet.  Not a huge market, but one that valued innovation and provided a logical steppingstone to campaign management, lead generation, planning and the other marketing tools that the company sells today. 
• Explore SaaS (software-as-a-service).  If the key barrier to success for early stage enterprise software companies is excessive sales and marketing costs, adopting a software as a service model may be the right approach.  This is more that just selling your software on a term or subscription, versus perpetual license, basis.  Instead SaaS is all about making it easy for customers to understand, try and ultimately gain value from your software.  In 5 minutes and for no money down, I can become a user of Salesforce.com and within the 30 day trial period I can qualify myself and decide if it is the right solution for me that I am willing to pay for.  Most importantly, I can potentially do this without consuming a single dollar of their sales and marketing spend.  None of the airplane trips, four-legged sales calls, custom demos, proofs of concept or lengthy contract negotiations that lead to the 6 to 12 month sales cycle that costs a traditional software firm 75% of their new license revenue in a given quarter.
• Consider Open Source.  To us, Open-Source is not about free software, but rather products that have seen, or have the potential to see, widespread grassroots customer adoption.  A passionate end-user community has the benefit of driving a development cycle that quickly surfaces key product requirements and needed bug fixes. Further, the grassroots adoption of the product provides a ready installed base of early adopters who will promote the product across their enterprise, purchase professional services and acquire more feature rich versions of the product.  Like SaaS, this is a way to mitigate high sales and marketing costs.  RedHat’s version of Linux, Jboss’s version of the application server and SugarCRM are three of the best known examples, but other opportunities abound.
• Go Vertical.  In today’s age of rapid development, componentized software and offshore resources, software code is relatively easy and cheap to write and is no longer the “barrier to entry” and source of competitive advantage it was ten or twenty years ago.  Instead what matters to customers, and potential acquirers, is the deep domain specific knowledge instantiated in that software.  For an early stage company to build this knowledge, they need to be incredibly focused in a given domain and make sure they have people on their team who understand a customer’s business better than the customer does themselves.  Profitlogic, another Boston area company that recently sold to Oracle, is a good example.  Profitlogic’s products were all about the retail industry, and in fact a particular part of the retail industry related to pricing optimization.  Their team knew more about the margins, operating metrics and best practices of this industry than their customers often did, and it showed up in how their software was architected, deployed and operated.  No wonder Oracle made the group a key part of their Retail industry vertical as an add-on to their Retek acquisition.

Enterprise Software entrepreneurship and investing is certainly not for the faint of heart, but when pursued with some combination of the strategies above, we believe interesting opportunities remain for innovative companies to make their mark in the world and have a positive impact. It is also worth noting, again contrary to the claims of many, that it is still possible to build these companies in a relatively capital efficient manner.  Sticking to the examples cited above, according to VentureSource, VMWare raised $26 million of venture capital, Unica $11 million, Red Hat $16 million, Jboss $10 million, and ProfitLogic $38 million.  Only Salesforce.com raised a lot of capital – $64 million – although almost 75% of that came in their last round when one would assume there was evidence the model was beginning to work. 

In the end, we believe the analogy to the automotive industry is flawed.  The manufacture and distribution of cars is fundamentally different from the software industry.  In auto industry, there are tremendous benefits of scale, the underlying platform (tires, chasis, internal combustion engine, frame and skin) has remained the same for decades and there is little room for small players to access end-users.  Software, on the other hand, is a digital good and an information business.  Innovation is limited only by the creativity of the author.  Small teams can be extraordinarily productive – often times more so than larger teams and organizations. The underlying platform and architecture has changed several times in the last 30 years and there is no physical product to distribute, thus end-users can be accessed much more directly.  Is there a benefit to the incumbency and distribution might of IBM, Oracle or EMC? Absolutely.  Does that mean there is no place for creativity, innovation and entrepreneurship in this industry?  Absolutely not.

While attending this week’s CMO Perspectives conference, I was reminded of Tracy Kidder’s famous 1981 book, The Soul Of A New Machine. Why did a conference of Chief Marketing Officers, showcasing brand reinvigoration efforts at McDonalds and Dove (whose "Real Beauty" campaign I absolutely love, by the way), remind me of a geeky cult hit about the development of Data General’s latest big iron machine?

Simply put, all the talk about brand attributes and personality reminded me of the importance of "soul" in a start-up.

Keynote speaker Charlotte Beers (who had great stories about her experience in Washington when she was tapped by Colin Powell in October 2001 to run the US PR campaign in Arab countries after a long Madison Avenue career running Oglivy & Mather and J. Walter Thompson) talked about the importance of company executives, particularly CMOs, personifying the brands of their companies. Although the CMOs of Pepsi and WalMart, who were in the room, took her advice as very relevant to their global branding efforts, it struck me as even more critical to the little start-ups we VCs deal with every day in a very different way.

VCs tend to approach start-ups with cool, analytical rigor to get to the bottom line answer: "Will this make me and my limited partners money?". Entrepreneurs tend to approach start-ups with extreme emotional attachment beyond any rational borders, seeking the answer to the question: "Will anyone love and appreciate my [professional] baby (which, by the way, I hope makes me money so I can retire and get back to spending time with my family)?" Anyone who’s been involved in starting a company knows what an incredibly emotional adventure it can be.  The ups and downs are incredibly exhilirating yet terrifying.  One moment you’re king of the world, the next you’re afraid you’re going to run out of money, and then it flips again.  The tension between that emotional roller-coaster that the founders/insiders are feelings as compared to the cool, analytical perspective of the rational VC/outsiders is an extremely healthy one – over-weighting one side or the other will result in a sub-optimal company-creation process.

And it is that tension that gets to heart of the concept of the soul of a company. You don’t have to be a religious person to appreciate that every start-up has a soul. Webster defines the word as "the immaterial part of a person". The soul of a start-up is thus the immaterial part of the company that personifies its unique character and culture. The soul of a company typically comes from the founding team, although I have also seen it come from mid-level hires, often young, who so completely embrace the company’s mission that they begin to deeply eminate it in all of their activities.

The importance of nuturing the soul of a new company can’t be under-estimated, but can be very difficult as the start-up grows and evolves. Too often, that soul can erode when VCs come in to start-ups and begin to engineer the process of bringing in the "grown ups" (by the way, how old do you think you have to be to be considered a grown up at a start-up?). If the board and management team aren’t careful about preserving the soul of the company during growth, "grown-ups" and founder transitions, the company can easily lose its way. Perhaps not on a rational level (strategy, finance, products), but on an emotional one (culture, passion, commitment).

Think of a start-up. Now picture who represents the "soul" of that start-up. It’s probably a pretty easy exercise. Now imagine that person missing from the start-up. Ouch.

Nurturing and evolving the sould of the start-up is as critical a part of the stewardship of the company as nurturing the product strategy.  Boards and founders shouldn’t be afraid to use this emotional language when describing what they are creating.  After all, it is how they are feeling.

It’s the end of summer, so I’m trying to get some last-minute summer reading done.  Like many people, I try to pick a few books that take me away from my day-to-day job.  Unfortunately, I just read a book that had the opposite effect:  Blink by Malcolm Gladwell (author of The Tipping Point).  This book kept bringing my mind back to the VC business.

First, a quick summary of the book.  Blink’s thesis is that human beings make intuitive decisions very quickly, often without consciously thinking or knowing why analytically.  Many times, these decisions are dead on as the brain subconsciously, rapidly absorbs and processes vast amount of observed data.  One amusing example the book provides is a psychologist who can observe a married couple for 15 minutes and with a 90% success rate, predict whether they will still be married in 15 years (begging the question of who would be crazy enough to run a 15-year longitudinal study!  You can imagine the phone call:  “Hello?  Is this Susan?  Hi Susan, Dr. Gottman here.  Yes, yes, we spent time together at my lab 15 years ago?  I just wanted to know if you’re still married to Bob.  Oh you’re divorced?  Wonderful!  Just as I predicted…uh…I mean, I’m so sorry for both of you.  Thank you very much.  Goodbye”).

To be fair, Gladwell also points out that at times these unconscious decisions can be very wrong.  As another psychologist notes:  “When we make split-second decisions, we are really vulnerable to being guided by our stereotypes and prejudices.”

Now why did this make me think of the world of VC?

Simply put, VCs blink all the time.  Ask your VC friends how long it takes them to decide whether a deal will be a good one in a first meeting or call.  Typical answer:  15 minutes.  How long does it take them to decide whether an interview candidate is an “A” player worthy of an executive position in their portfolio companies?  15 minutes.  Everything else is just to fill the time.

You see, although many VCs are typically fairly analytical, particularly those with private equity backgrounds, by and large the VC investment business is an intuitive one.  When analyzing companies without a historical track record pursuing nascent, emerging markets, VCs must heavily rely on their intuition.  When assessing executives without long track records as successful CEOs or department VPs (i.e., young, up and coming and therefore, typically unproven executives), VCs again must heavily rely on intuition.

Test it out.  If you’re pitching a VC or interviewing with them, challenge yourself to get through your opening pitch in 15 minutes and then pause.  Sit back, look them in the eye, and say:  “Let’s hit the pause button.  Based on what you’ve heard so far, what do you think?  I don’t want to waste anyone’s time if you think this would not be interesting.”  I bet you very few VCs will say, “tell me more – I haven’t formed an opinion yet.”  The honest ones will say:  “This is really interesting” or “I’m sorry, this isn’t a good fit – I can tell already”.

And what about the bias issue?  What to make of the insightful comment that intuitive, unconscious opinions and decisions play to stereotypes and biases?  Unfortunately, that’s another factor in the VC business that entrepreneurs need to take into account.  If they wish to break out of the bias, entrepreneurs need a break out approach to their pitch.  Imagine a prospective CEO with a spotty track record starting off an interview by saying:  “Look, I know I’ve worked for three failed start-ups in a row, but let me tell you what I’ve learned from that experience and why I would make an outstanding CEO.”  That would be a refreshing way to start an interview!

Finally, entrepreneurs should know that there are no hard feelings if their 60 minute pitch slot ends after only 15 minutes.  The VC will respect them all the more for being efficient and straightforward rather than dragging out the inevitable.

When friends ask me what the biggest change has been in transitioning from sitting in the entrepreneur’s seat to the VC’s seat, I often think of the profound difference in the way entrepreneurs and VCs look at that all important dimension of time.

When you’re an entrepreneur, time is your enemy.  You need to solve the problem of “simultaneity” – hire the team, build the product, raise money and close deals – all in parallel.  If you have only 80% of the data surrounding a decision, you simply make the call and move on.  When I was an executive at a public company (Open Market), we used to think about every quarter like an hourglass, with the sand running out every 90 days and a mad scramble to close as many deals as possible before time ran out.  At an earlier stage company, that hourglass metaphor is similar, but the sand running out is the cash on your balance sheet!  In short, entrepreneurs learn to fight hard against the passage of time.

When you’re a VC, you have a very different relationship with time.  VCs seem to love the passage of time.  When you’re evaluating a deal, more time means more information.  When making investment decisions, VCs prefer to watch movies rather than look at snapshot pictures – in other words, they like to see a project evolve over time, not evaluate it at a discrete point in time.  They like to see teams gel together.  They like to see entrepreneurs actually achieve the milestones they claim they’ll achieve with time.  The more a VC can delay a decision, watch something progress over time, “turn another card” (a new expression for me when I joined the VC business!), the happier they are.  In short, VCs are trained to embrace the passage of time.

And so there’s the conundrum:  what’s an entrepreneur to do in the context of a fundraising process when time is their enemy, but the VC’s friend?  One piece of advice is to simply recognize this difference in this attitude towards time and try not to fight against it. One wizened general partner at a top firm once remarked to me about a particular deal:  “They told me I had to make a decision in the next few days, so I told them I’d save them a few days and simply pass.  It’s VC 101 – anytime an entrepreneur puts a gun to my head, I pass.  There’s always another deal.”  If you can create a sense of urgency in the fundraising process, you’re running an unusually charmed process.  More typically, you can expect to run a fundraising process where you simply have to give VCs the time they need to “soak in” the deal, live with it for a few months and then, at the right moment, try to call their interest to question.  Rushing the process only gets the VC alarm bells ringing.  For the entrepreneur, this start-up is their life’s work and on their mind every moment of every day.  For the VC, there’s always another deal.