Rose Tech Ventures

In the successful American TV show Whose Line is it Anyway?, professional improvisation comics are asked to act out a scene while members of the audience throw out changing characters and situations in real time. While most people hate to speak or present in public under the best of circumstances, what do you think would happen if instead of improv experts, the participants were venture capitalists, and if instead of characters and situations, the challenge was to passionately ‘sell’ a PowerPoint venture pitch presentation that they had never seen before? These results from Michael Eisenberg (Benchmark Capital) and Shai Tsur and Illi Edry (Giza Venture Capital and JVP respectively), brave (or foolhardy?) attendees at TWS08, the leading Israeli startup pitch competition, should give you a new appreciation both for venture capitalists, and for the difficulties in doing good pitches!

Since Bill Hewlett joined with Dave Packard in 1939 to create what is today the world’s largest personal computer company, there has arisen an evergreen debate as to who is more important in starting a tech company: the techie or the business guy? Steve Jobs or Steve Wozniak? Bill Gates or Steve Ballmer? Jim Clark or Marc Andreessen?

I propose that it is time to reject the notion of the “business guy” (or “business gal”) entirely. The underlying problem is that there are really three different components here, and like the classic three-legged school, they are all essential for success, albeit with differing relative economic values. What gets things confused is that the components can all reside in one person, or multiple people. And what gets people upset is that there are different quantities of those components available in the economic marketplace, and the law of supply and demand is pretty good about consequently assigning a value to them.

Perhaps surprisingly, the components are NOT the traditional coding/business pieces; nor are they even coding/UI/business/sales, or whatever. Rather, here is the way I see it, from the perspective of a serial entrepreneur turned serial investor, listed in order of decreasing availability:

1) THE CONCEPT

A given business starts with an idea, and while the idea may (and likely will) change over time, it has to be good on some basic level for it to be able to succeed in the long run. How excited am I likely to be when I see a plan for a 2008-model buggy whip? another me-too social network? The 87th investor-entrepreneur matching site with no investors? The base concept has to make some kind of sense given the technical, market and competitive environment, otherwise nothing else matters. BUT good ideas are NOT hard to find. Not at all. There are millions of them out there. The key to making one of them into a home-run success brings us to:

2) EXECUTION SKILLS

It is into this one bucket that ALL of the ‘traditional’ pieces fall. This is where you find the superb Ajax coder, AND the world-class information architect, AND the consummate sales guy, AND the persuasive biz dev gal, AND the brilliant CFO. Each of the functions is crucial, and is required to bring the Good Idea to fruition. In our fluid, capitalistic, free-market society, the marketplace is generally very efficient about assigning relative economic value to each of these functional roles, based upon both the direct result of their contribution to the enterprise and their scarcity (or lack thereof) in the job market.

That is why it is not uncommon to see big enterprise sales people making high six figure, or even seven figure, salaries or commissions, while a neophyte coder might be in the low five figure range. Similarly, a crackerjack CTO might be in the mid six figures, but a kid doing inside sales may start at the opposite end of the spectrum. Coding, design, production, sales, finance, operations, marketing, and the like are all execution skills, and without great execution, success will be very hard to come by.

BUT, as noted, each of these skills is available at a price, and given enough money it is clearly possible to assemble an All Star team in each of the above areas to execute any Good Idea. That, however, will not be enough. Why? Because it is missing the last, vital leg of the stool, and the one that ultimately–when success does come–will reap the lion’s share of the benefits:

3) THE ENTREPRENEUR

Entrepreneurship is at the core of starting a company, whether tech-based or otherwise. It is NOT any one of the functional skills above, but rather the combination of vision, passion, leadership, commitment, communication skills, hypomania, fundability, and, above all, willingness to take risks, that brings together all of the forgoing pieces and creates from them an enterprise that fills a value-producing role in our economy. And because it is THIS function which is the scarcest of all, it is THIS function that (adjusting for the cost of capital) ends up with the lion’s share of the money from a successful venture.

It is thus crucial to note that the entrepreneurial function can be combined into the same package as a techie (Bill Gates), a sales guy (Mark Cuban), a UI maven (arguably Steve Jobs), or a financial guy (Mike Bloomberg). And that it is the critical piece that ultimately (if things work out) gets the big bucks.

Who do you think got the biggest relative return from the development of Trump Tower? Architect Der Scutt (the IA)? Engineer Irwin Cantor (the coder)? Broker Louise Sunshine (the sales gal)? EVP George Ross (the biz dev guy)? Or whomever happened to be The Entrepreneur in that deal?

The moral of the story is that for a successful company, we need to bring together all of the above pieces, realize that whatever functional skill set the entrepreneur starts out with can be augmented with the others, and understand that the lion’s share of the rewards will (after adjusting for the cost of capital), go to the entrepreneurial role, as has happened for hundreds of years.

On July 7th, the New York Times ran a major obituary in the Science section, entitled William R. Bennet, 78, Pioneer in Gas Lasers, Dies. The lengthly article noted that he was the physicist and inventor who in the 1960s invented the HeNe gas laser “that revolutionized surgery and made possible compact-disc players and grocery-store scanners”. This was certainly true, and was what he was best known for. But as revolutionary and as important as the laser was, a little squib buried at the end of the article hints at a potentially even more important contribution to society:

“In the 1970s, Dr. Bennett introduced a popular undergraduate course for humanities and social-science students at Yale, intended to show the problem-solving promise of nascent computers. A colleague, Werner P. Wolf, a professor emeritus of engineering and applied science at Yale, said the course proved to be both prescient and persuasive, and “made the whole concept of computers exciting.”

It so happens that I was one of those social-science students who took Professor Bennett’s course, in 1976. Our textbook, which he had written himself, introduced us to the BASIC language, and painted a picture of all sorts of uses for this amazing new technology. Now, I had never been a science jock in high school, in fact I had never touched a computer before that class. But inspired by the obvious passion and vision of this world famous inventor, I began to see the extent of the change that these then-unwieldy devices might engender.

I never took another computer course in college and graduated with a degree in Urban Planning, but as soon as I got out, almost the first thing I did was to buy an Apple II computer (with a cassette tape drive, no less!) and start writing a program to balance my checkbook. And then one to catalog my book collection. And then others for both personal and professional use (one of which actually got a full page write-up in InfoWorld in 1983).

Now, some 30 years later, my coding skills are so rusty as to be completely useless in this day of Java and Objective C, but the vision, enthusiasm and inspiration of William Ralph Bennett live on, and at least in my case was the first step in a lifelong career that has led to startup investments in over five dozen entrepreneurial tech companies. Wherever he is, I hope Professor Bennett is looking down with some degree of satisfaction.

Perhaps the single biggest area of confusion in the world of early stage investing is the answer to the question “what should an ‘appropriate’ return be for a VC or angel investor in a startup company?” This is crucial, because the answer directly affects the valuations that investors are prepared to give early stage companies, and the assumptions that underlie the answer are the context for the long term relationship between the investor and the entrepreneur.

Before the question can be answered, however, there are several different numbers and theories involved, and it’s important to understand each of them in context:

IRR (Internal Rate of Return) is the return on an investment OVER TIME, usually expressed as an annual percentage rate (that is, if you invest $10 on January 1 and get back $11 on December 31, that would be a 10% IRR.)

ROI (Return on Investment) is the return on an investment REGARDLESS of time, and is usually expressed as how many times the original investment is returned (that is, if you invest $10 and get back $30 at some point in the future, that would be a 3x ROI.)

PORTFOLIO TARGET RETURN is the IRR that an investor hopes to receive in total, taking into account ALL of the investments, profits and losses made in a given time frame.

ASSET CLASS TARGET RETURN is the IRR that an investor hopes to receive from all investments of a certain type (such as CDs, stocks, bonds, venture capital, angel investments, etc.) TARGET ROI is the ROI that an investor hopes to receive on any one particular deal, taking into account the typical holding period for an investment of that type.

TIME VALUE OF MONEY is a fundamental economic concept that means $1 in your hand today is worth more than $1 a year from now (because you can put that dollar to work during the year, and make more money with it.) As such, ROI calculations are meaningless without an associated time frame. A 10x return that an investor would be ecstatic about if it came back in six months, would be a major disappointment if it took twenty years to come back.

RISK/RETURN TRADEOFF is the principle that the more risk there is in an investment, the higher return there needs to be to compensate for it. As such, an investor willing to take a 2.3% annual return on a US Treasury bill (essentially risk-free), might require a 12% annual return to be enticed to invest in a higher-risk corporate ‘junk bond’. (See tinyurl.com/6fby2v)

PORTFOLIO BALANCING means that most investors aim to diversify their risk/return profile by investing in several different types of asset classes, because in any given year one class will do better than another…but it’s difficult to predict which. It is therefore not unusual for the same investor to hold both US T-bills AND junk bonds, as well as several other asset classes. (See a fascinating historical chart of the relative returns from different asset classes over the past 20 years: tinyurl.com/5jygn2)

VENTURE/ANGEL INVESTMENTS in early stage companies are considered (for good reason) among the riskiest possible investments one can make. A majority of startups, no matter how promising, fail completely within a couple of years, losing 100% of the money that was invested in them. On the other hand, there is no way that an investment in T-bills (or General Motors) could ever have the potential return of an investment in a company like Google or Facebook.

Sooo…all of the above leads us into the following scenario: Mr. Typical Investor would like to get a somewhat higher total return from his investments than he would get by investing only in T-bills, and is therefore prepared to take some risk to get it. He decides to create a diversified portfolio with an overall annual target return of, say 5%. Since this is more than double the return of the average money market fund over the past five years, Mr. Investor’s safe (but low return) investments have to be balanced by some higher risk investments, such as small cap growth stocks, or international funds. But for investors who have an appetite for real risk, and the consequent ability to lose some of their investment if things go wrong, they can go even further up the risk/reward scale to…venture capital.

VC funds in general target a 20% or so annual return to their investors, which can certainly bring up the overall average return on Mr. Investor’s diversified portfolio. That sounds great, but with that high return comes equally high risk. Last year, a majority of US venture funds actually lost money and had negative returns, let alone not making their 20% IRR target!

Indeed, venture capital is only one part (the riskiest part) of an asset class called “alternative investments” that include things like private equity buyout funds, commodities, hedge funds, etc. And most institutional investors (the university endowments, pension funds and insurance companies who provide the majority of money to VC funds) nevertheless put only 2-3% of their capital into alternative investments as a whole…because they’re so risky.

Let’s look, therefore, at what it takes a VC fund to get that elusive 20% IRR. Well, it turns out (in case we didn’t already know) that investing in entrepreneurs is indeed a Risky Business. VC’s fund fewer than one in 400 deals they look at, but even with that discriminating judgment they are resigned to the fact that between 30% and 50% of their prized investments will crash and burn. Completely. And another 30% or so will end up being “walking dead”, that is, making just enough money to keep themselves alive, but not enough to provide any return on the investment. Indeed, statistics over many years have shown than virtually ALL of a VC fund’s returns will come from fewer than 10% of their investments. It’s the one home run with Google that makes up for all the WebVans, Pets.com and eToys.

Thus, continuing with our math lesson, and taking into account the facts that: one in ten companies in a VC portfolio need to come up with all the return for the portfolio; the average holding time for a VC investment is 5-7 years; and the return for the whole VC portfolio needs to be 20% or so, we can calculate at the end of the equation that ONE company needs to deliver an ROI after six years of something north of 20X! And therefore, since the VC doesn’t know WHICH of his investments is going to be The One (otherwise, of course, he wouldn’t invest in the other nine!), EVERY one of his investments must have the potential to hit a 20X return.

It’s because of all the forgoing realties, concepts and math that there is typically an enormous disconnect between entrepreneurs and investors. The former figure that ‘risk adjusted return’ means that an investor should be delighted if his/her/its investment brings back a 20 PERCENT profit (which is five to ten times the return from less risky asset clases), while the latter realize that if they don’t aim on each deal for a 20 TIMES profit (which is required on a deal basis to deliver the 20% return on a portfolio basis), they will be out of business.

The result? A two-order of magnitude misunderstanding.

As an active angel investor, I am faced with an embarrassment of riches when it comes to potential companies with which I can get involved. I receive new business plans every day from people who know what I do; I see all of the deal flow that comes through the professional angel groups to which I belong (such as New York Angels); and recently, with the advent of Open Deals, I find myself inexorably drawn to seeing the latest investment opportunities from around the country.

But because of the sheer number of companies involved, I, like most other active angels, tend to make very quick, first-pass decisions as to whether we should even bother to look at a plan, let alone invest. (For example, I personally have no interest in real estate investment deals, movie opportunities, or biotech; the first I’ve got enough of, the second is too risky even for me, and the third I’m not smart enough to understand. I also don’t generally look at deals that are too far away from me geographically…although this is beginning to change with the high quality of deals I’ve been seeing in Open Deals.) This first pass will typically cut by about half the number of companies in my mental in-box.

For most of the rest, however, I have only a limited amount of time to decide which deals warrant further attention. Now, I’d like to say that I carefully read every word of every business plan. But I don’t. I could say that instead, I not-so-carefully read most words of most executive summaries. But, umm, I really don’t do that either. These days, what happens in practice is that I pop over to Open Deals and skim the latest submissions. My eye is immediately drawn to deals that have videos (because the poster frame of the video is prominently displayed to left of the entry, like this:)

And then, because I’m essentially lazy, I click the video, sit back, and let the entrepreneur tell me why I should look further. It requires no additional action, and fewer brain cells, on my part. Not only that, watching videos is actually fun, whereas reading another business plan…not so. Most importantly, however, a video is an entrepreneur’s one chance to ‘look me in the eye’ and take a shot at conveying his or her essential self. Why is this important? Because as virtually every investor will tell you, in early stage deals our overwhelming preference is to bet the jockey, not the horse. That is, we’d much prefer to bet on someone we think has real entrepreneurial talent, even if the plan requires a bit of tweaking, than take a chance on even a superb plan in the hands of a mediocre entrepreneur. And letting us see you on video, looking right into the camera, is the first step in selling yourself…until we can see you in person.

“But…” I hear you object, “making a video and doing it right takes time and effort”. To which my response is, “Doh!” How much are you trying to raise from angels or VCs? $200,000? $500,000? A million bucks? And how many years of your life are you prepared to commit to this venture? Three years? Five? Ten? Whatever time it takes to do the video right, doesn’t it make sense to do so, if it will help your fundraising to even the teeniest, tiniest degree?

OK, now let’s get to some practical suggestions. In an ideal world, you’d find someone (either a friend, or a professional) who knows how to do videos, and you’d carefully gather B-roll footage, product shots, customer testimonials, and more, and then you’d go into a studio and record yourself talking passionately into the camera in front of a ‘green screen’, and then you or an experienced video editor would cut the whole thing into a gem-like, five minute elevator pitch (but not too, TOO slick, because then we’ll get a little suspicious).

The world, however, is rarely ideal, and if you’re like me (and every other entrepreneur I’ve ever known) you want to get started right away, be finished in half an hour, and do it at your desk. Well, let’s see what we can do to help.

First of all, built right into the Open Deals application, thanks to our friends at Viddler, is a nifty little widget that allows you to click one button, look into your computer’s webcam, and record a live video, which Open Deals will then upload and host for you at no charge:

No muss, no fuss, no cost…and absolutely no reason whatsoever that every single entrepreneur shouldn’t have a video included with his or her Open Deals submission.

But if you want to do a better, more professional job, there are quite a few tools available at very reasonable cost to give you a quick and painless way to create a polished pitch video. Putting aside all of the myriad high-end, production and editing packages, two companies in particular have really cool products that are just perfect for this purpose.

On the Mac side of the house, Vara Software has two great programs that you can try out for free, and download instantly. ScreenFlow lets you run your PowerPoint or Keynote presentation on your computer, while simultaneously recording an inset video of YOU, giving us the best of both worlds. Videocue 2 makes it really, really easy to write up your pitch, film it with your webcam while you read from a teleprompter, and seamlessly add in titles, overlays and images. Very cool…and they work.

Almost identical programs are available for Windows systems from Adobe, which last year acquired a really neat company named Serious Magic that had pioneered the whole ‘pro-sumer video upload’ field. Adobe Visual Communicator 3 does even more things than ScreenFlow, including letting you record and deliver your PowerPoint presentation, and Vlog It! is a virtual clone of Videocue. (To be fair, the Serious Magic/Adobe folks claim that it’s the other way around, and that they were first. I’m not choosing sides, just point out two sets of cool programs.)

(By the way, the third Adobe/Serious Magic product in the list is Ovation, which is a VERY powerful program that takes your PowerPoint presentation, adds in a full teleprompter, timer, and other goodies. Definitely cool for doing pitch presentations.)

So there you have it. Now that you know the secrets, please be nice and pander to your friendly local angel investors by recording a video along with your Open Deals submission. It makes it easier and more fun for us, and gives you a much better chance of rising above all those entrepreneurs who weren’t smart enough to read this blog entry!