Smaller is Better

Today we’re happy to have a guest post from our partner Will Porteous on the benefits of small, entrepreneurial teams. – EDW

Will D. Porteous

Over the years we’ve come to believe that small teams can be stunningly effective at the early stages of a company, often much more effective than larger teams. We have also found that, when they are good, such teams typically only need a modest amount of capital. This may sound overly simplistic. After all, some endeavors are just more complex and require a wider array of skills. But in our experience good entrepreneurs understand that resource constraints can make it easier to focus on what’s really important in a new company. What follows are some observations on this idea:

Product development is a fundamentally creative endeavor that requires incredibly tight coordination among the participants. Three great developers are usually better than thirty average developers, particularly if they have worked together before and if there are one or two strong leaders among them. Over and over we see core innovations that become great products coming from small teams (often just three to five people). In our current portfolio this has been particularly true at companies like Drop.io, Payfone, and Kashless. And this phenomenon isn’t just limited to software companies. At hardware companies like Data Robotics and Peek (both current RRE portfolio companies) we’ve seen the innovations of two or three founders get to market as products with fewer than fifteen people in either company. This is not to say that there aren’t some tasks that large teams, or even large communities do well (e.g. look at the strength of many open source products that were refined by hundreds of thousands of person hours from their communities). But in pursuing a new opportunity, at the early stages smaller highly focused teams tend to do better.

And it’s not just creating great products that small teams do well. Small founding teams should also be able to prove real customer demand. Good founders tend to know the problem they are solving intimately well. And they tend to know more than a few prospective customers. If they don’t, they know how to reach them without the formality and expense of a big marketing effort.

When I first joined the venture business in 2000, at the start of the last downturn (was there an upturn in between?), we were receiving a lot of inquiries from systems companies making gear for the telecom equipment market. Their target customers were both the established carriers and the emerging CLECs (Competitive Local Exchange Carriers). Most of these new systems companies had already raised heaps of money. There was a lot of capital available for these new equipment companies after the multi-billion dollar exits of companies like Chromatis and Cerent. It was as if the race was on to build the next “God Box” and get bought for a ten figure number. I remember walking into one such systems company that had raised a lot of money. They were raising a Series D. There were thirty hardware engineers, thirty software engineers, ten people in QA and documentation, ten in marketing, plus a whole complement of senior management including VPs for every area. And they were all good people working very hard. And they had never shipped a product.

Not only had this company never shipped a product or booked a dollar of revenue, it couldn’t definitively tell you when it would. The glut of resources early in the company’s life had contributed to an undisciplined culture. Product plans were not clear and too many people had their “hands in the code.”

What was worse, the established carriers weren’t buying and the CLECs were going out of business. The management team had never anticipated that there might not be demand for their products and they couldn’t conceive of a way to build the company that didn’t entail burning $2.5 Million per month. While they were growing the organization they had lost sight of what was changing in the markets they hoped to serve. They had raised too much money and made too many promises to their existing investors to stand up and say “this isn’t working; we need to make something else that somebody actually wants to buy.” Instead, they kept running the company like nothing had changed hoping to persuade a new group of investors to underwrite their outdated view of the world. You can imagine what ultimately happened.

Companies that have raised too much money in pursuit of the wrong idea are scary places. They are like a parallel universe where everything appears normal, but it really isn’t (movie buffs, think of “The Truman Show” or “Stepford Wives“). Getting back to reality is always painful and usually includes a major reorganization and often a recapitalization. The motivational challenges that come with downsizing or restarting on a new idea with a smaller team can be withering. And the odds of long term success in a restart are never as good as in a new company. More on that another time.

The point of this story is that it is better to stay small and wait until you know you’ve got something great before you raise a lot of money. Good entrepreneurial teams can achieve a remarkable amount on just a few million dollars. They can usually build at least a Beta version of their product. They can put that product in front of some potential customers and learn a LOT. They can iterate until they have something that prospective customers REALLY like. Along the way, they can learn a lot about how to sell the product and what customers are willing to pay. And, by keeping their team small and their burn rate low, they can preserve their option to change direction if they need to.

So, why is it that small teams are often so effective? There must be many reasons for this. Certainly, good entrepreneurs tend to hire strong and surround themselves with broad gauged, talented people who can lead, manage, and also be major individual contributors. Such agile teams know how to both live in the details of making the product and to focus on the larger questions of building a business. They bring together many different skill sets in a small number of people. There’s often a high degree of trust in such teams, especially if team members have worked together before. In addition, the sense of having been chosen to be a part of something new and special is often very inspiring and motivating. The work at the early stages of a company is massive in its apparent importance – and there is a lot of both work and responsibility to go around. Good teams must have a tremendous work ethic and reject any team member who doesn’t measure up. And perhaps most simply, communication is easier in a small team with a shared sense of mission.

Small teams are also hard emotionally. They often feel very anonymous to people coming from large, well known organizations. They demand tremendous amounts of vision and faith. They tend to be fairly democratic, which can be good in the early days, but doesn’t work for too long. They are stark, demanding environments. They can also be a lot of fun. They are the true crucible of company formation and long term value creation. So, if you want to get big for the right reasons, it helps to start small.

Pitching 101: Be Prepared

Eric Wiesen

Today’s installment of Pitching 101 was motivated by a great recent presentation I saw. The message this time is – be prepared for each pitch. Two young entrepreneurs had been referred to RRE by one of our portfolio companies and we set up a time for them to come and tell me about the business and what they think it can be. These are guys a couple years out of college who have bootstrapped the business for the first year and who have achieved significant proof points while working on the company part-time and holding down “day jobs”.

Separate from the business itself (which I liked), it was immediately clear that these entrepreneurs were well-prepared for this meeting. They were prepared not only to present the business in a systematic, thoughtful way, but they had clearly looked at RRE’s current and previous investments and were prepared to talk about investment themes that we had already explored and where they might be an intersection with their business and its model. They had gone through the bios of the different investors at our firm to see ways in which we might be a good fit for their company, and had even read this blog and worked some of the ways we’ve indicated we like to be pitched into their presentation.

Is it work to do what these guys did, especially if you are pitching a lot of firms? Absolutely. But think about it the other way – you’d prep for a major sales meeting, partnership meeting or other significant line-of-business presentation. When a company pitches a potential investor, you are typically asking to be one of the two to five (depending on fund size) investments that firm is going to make that quarter, and are asking the VC to get involved with you and your company for a period of several years (and potentially as many as eight or nine years, although few want to admit that hold times can be that long). If you come in with a presentation that shows you were thoughtful and prepared, it’s a huge positive indicator of other things we can expect from you.

If you’re wondering what happened, the company doing the pitching isn’t going to be an RRE investment, for a few reasons. On the one hand, it’s not in a sector that’s of particular interest to us. On the other hand, the company doesn’t need very much money, and have quite a bit of their round already spoken for by angels. It would be a very small investment for RRE even if we took the whole thing.

And in most cases that’s where the story would end, but in this case I’ll be actively referring this company to either firms who specialize in seed rounds or to angel investors I think might be interested, because I want to see these guys succeed and because the level of professionalism and preparation for our meeting lends me confidence that I can recommend them to others.

In sum, take an hour to know the person or people you’re pitching. It will improve your odds of getting to next steps with them, and will generally help you form a relationship with that investor that may be helpful down the road.

Bootstrap ‘n Flip?

Eric Wiesen

It’s not the same argument as “VC is dead”, which we’ve addressed a couple of times in this space, but another common theme emerging out of the discussion around startups and how to fund them successfully is the notion of a dramatically new model for funding companies. In a nutshell, this new perspective is that the decrease in fixed costs (servers, enterprise software required to develop and deploy web applications, etc…) and the increase in developer productivity has essentially made it so easy to build a compelling web application that raising institutional venture capital is simply no longer necessary. Further, those advocating this position argue that viral channels like Facebook and Twitter make building an audience so easy that sales and marketing (expensive human capital) are no longer necessary. Lastly, they assert that big companies don’t want startups to grow into standalone businesses who compete with them, so they will snap up these companies early, before they ever have to raise a lot of money (or, presumably, make any).

In the world hereby envisioned, a new class of angel investors emerge who routinely fund companies with under a million dollars and enjoy quick exits in the $5-25M range, which provides them with a terrific internal rate of return (IRR) that would never be available to institutional VCs, because firms can’t deploy such small chunks of a capital. Some will point to a few firms like First Round Capital as paragons of this new world, but are quick to conclude that the rest of us have no place in the land of quick flips to Google and Yahoo.

Now as “traditional” venture capitalists, you’d expect us to reject this thesis out of hand, but we’re not immune to the appeal of such easy exits, even on small base dollar amounts. The question I ask is – is this really happening? Is there an entire generation of ultra-agile startups, built on open-source software on a shoestring that are being acquired for the same price as the valuation of a Series A company?

Well, as far as I can tell, the answer is no. Not really. I’ve had this conversation (online and in person) quite a few times. And it’s usually fewer than five minutes in that someone brings up del.icio.us, the social bookmarking startup Joshua Schachter built and sold to Yahoo in 2005. Sometimes Dodgeball (acquired by Google in 2005 and recently shut down) is raised as well. Or Mybloglog (acquired by Yahoo in 2006). These are the companies whose history is typically put forward as evidence for this tectonic shift that will upend the entire startup ecosystem. But let’s look at these companies a bit and note a few things:

1. These are all B2C web companies.
2. The exits were all in 2005 and 2006.
3. They were all to Google and Yahoo.
4. None of them have really worked for their acquirers.

So there’s an open question in my mind of whether there was simply a mini-bubble where Google and Yahoo were buying startups as features in 2005 and 2006. But generally speaking, none of this has made money for the acquirers (who themselves are hurting now). So I look at companies being built now.

One of my favorite early-stage web companies is tumblr, founded by my friend David Karp (note, RRE is not an investor in tumblr). Tumblr is, in a lot of ways, the perfect archetype for this 21st-century web startup. It was founded by two smart guys (David and Marco Arment), was originally built as a side project, and was run for the first year or so with just the two founders. They raised a small seed round to get the product off the ground and get traction with users. Which they did.

So what happened next? What happened next is they decided to make a go at turning tumblr into a real, standalone business. They went back to their investors (two institutional VCs) and raised a $4.5M “traditional” round. This round will, as such rounds have often been in the past, be used to staff up, light up revenue and prove that there’s a business behind tumblr’s user engagement. Were there quick flip acquisition offers on the table? I don’t know (like I said, we’re not investors). So I’m going off of what I see – further fundraising, from institutions, and in an amount much greater than one million dollars.

When we meet interesting companies creating B2C products on the web, one of the first things we try to figure out is – are they really building something sustainable, or are they trying to build something viral and flip it to Google? Because while that looked like a pretty good strategy in 2005 and 2006, I think we’re seeing a whole lot less of that now and for the foreseeable future. We look for companies who can build something real, and to do that you need products, sales, marketing, management and the rest of the pieces that constitute a business.

Is it true that the cost of building software on the web has come down dramatically since the 1990s? Of course. And angel investors and firms specializing in seed rounds play a very important role in nurturing companies through this very early stage. And sure, there will be a few easy, small exits. But in our view this is still a business of building companies, and the evidence we’re seeing is that the ones that really work usually wind up looking to the venture capital community for funding to do all the things companies built for the long term have to do. The ones that flip to an acquirer after 18 months will have our congratulations, but those aren’t the ones we’re looking for.

Pitching 101: Say What You Do

Eric Wiesen

I’ve been thinking about putting together a series of posts about pitching, not just to RRE, but in general. Some other bloggers, particularly my friend Mark Davis at DFJ Gotham Ventures, have done an admirable job of putting together well thought-out and structured guides that go through a lot of best practices around pitching, and I’m frankly not looking to recreate those efforts. Rather I occasionally see a poor practice repeated so frequently that I think it might be helpful to point out a few “hot spots” in pitching methodology that I think are important.

Today’s topic is one of the absolute most important: SAY. WHAT. YOUR. COMPANY. DOES. I am continually amazed by the number of PowerPoint decks, executive summaries and in-person pitches that don’t tell the investors being pitched what the company’s product or service does until halfway through. This is not the right approach. If you’re sending around a deck, the second slide should be a succinct description of what you want to do. In an executive summary it’s the first paragraph. If you’re pitching in person you should plan to tell investors what you’re doing shortly after introductions have been made and you have all sat down to “get down to business”. If you need a script, it’s something like this:

“Thanks for meeting with us. We’re [ScoobyDooCorp] and we’re [the first ad network for pet-related websites].”

Instead, the first half of the pitch is often one of three things:

1. Long-form description/discussion of the management team’s accomplishments.
2. Lengthy discourse on the problem or pain point being addressed.
3. Treatise on the technology, how it works and why it’s superior.

Don’t misunderstand me – every one of these is important and I want to hear them all. But if you tell me these things before you tell me what your company does, it makes it much harder for me to contextualize the value of these other parts of your presentation. This isn’t a “VC ADD.” issue. It’s not that we’re so impatient we can’t listen to a well-structured pitch. But it’s much more valuable to you as an entrepreneur if I’m hearing your accomplishments, the problem you’re solving or the virtues of your technology in the context of what you’re going to do after I fund you.

“Mad Men Day” at RRE

Our esteemed Managing Partners declared today “Mad Men Day”, the anti-casual Friday!

The Death of Venture Capital (again)

Stuart Ellman

Eric Wiesen

In these last months, the drumbeat proclaiming the death of venture capital has grown louder, even becoming mainstream. Some of what’s appeared in the press sparked an interesting conversation amongst us about what all this means for venture capital as an asset class and for the entrepreneurs whose businesses are funded by venture capital. A number of perspectives were shared within RRE, and we collectively agreed that our industry faces some real challenges ahead, and that we want to be as thoughtful as we can about how we as investors face them, so that we can advise our portfolio companies and friends.

One analytical method that has been applied by some is to simply note that Venture Capital as an asset class has not had great returns in the eight-year period since the dot-com crash, then connect the dots toward a conclusion that an asset class with limited liquidity and sub-par returns is doomed. With this model we should expect capital outflows until the industry is essentially gone. This strikes us as a lazy way to think about a complex problem. Had you applied this same method to publicly-traded stocks in 1940 or 1980 you could easily conclude that equities was an asset class whose best days were behind it, and would have then missed two of the greatest bull markets in history. In a more contemporary context, we’re likely to see a moribund real estate market, but that doesn’t mean real estate as an asset class is dead either. Assuming that because something has performed poorly in the past it will continue to perform poorly in the future has rarely proven an effective method of prediction.

One way to more accurately explain the last eight years is with basic economics: what goes up must come down. Returns for venture capital from 1995-2000 were so phenomenally good that the asset class attracted massive amounts of new capital, new players and lots of me-too activity. As in all such episodes throughout history, this influx caused previously good returns to become concomitantly bad. Since the party ended, the VC industry has been slowly unwinding its way out of this overpopulation, but as our colleague Jim Robinson IV noted in a recent interview, the long cycle time of a VC firm (often 10 years) makes this unwinding a slow process. But it has been happening consistently and inexorably since 2001. When the case against Venture Capital is made, it is often mentioned that there are “several thousand” venture capital firms, and that it’s simply too many firms for what was a relatively small industry during its most profitable periods. And that is ultimately true. But there aren’t anywhere near that many venture firms who are genuinely active. If you define active as those firms that have made an investment in the past 12 months, that number is more like 500 than 2500 (Thompson claimed 1700 in 2007 while the National Venture Capital Association is more judicious, calling it 800 in 2006). And let’s be realistic – it’s still trending down and will likely continue to do so for the next couple of years. By the time the full 10 years have passed since the last of the bubble-era funds were raised, the industry will once again be relatively small.

But ultimately all of this is simply Monday-morning quarterbacking. Yes, too many firms were formed during the late 1990’s and too much money was raised. Too many companies were funded without real business models or that couldn’t justify the valuations investors accepted. And the price is still being paid for that excess. But the argument that venture capital is dead in 2009 seems, in our view, to oversimplify and confuse the two major economic collapses of the nascent 21st century: 2001 and 2008.

2001 was all about technology. Our ecosystem ballooned and then popped. Duly noted. But 2008 has nothing to do with technology or venture capital directly. 2008 was a collapse of historic proportions, largely driven by misguided government policy, leverage and a real estate bubble that dwarfed anything we saw in 2000. These factors have little to do with venture capital (which typically is 100% equity and has no leverage) or the companies in which we invest (which also typically use little to no leverage). We aren’t real estate investors and we as an investor group didn’t buy toxic assets. So then the question becomes – will venture capital and the world of technology startups be collateral damage in this collapse? And of course the answer is: yes and no. There’s no question that the broader economy affects startups and VCs alike. These effects have been widely discussed — here and elsewhere — from the slowdown in consumer spending to cutbacks in big company budgets to the challenges of raising VC money and that VCs face with their limited partners.

Some will single out sectors as unusually troublesome (usually advertising-driven web startups or cleantech companies that have high CapEx). In these sectors there are going to be winners and losers just like everywhere else. And sure, some VCs will have a hard time raising their next fund as LPs shy away from all “alternative” assets, resulting from a “Denominator Effect” or other rationales. But while it’s fun to put “the death of Silicon Valley” on the cover or to write a story about how the lack of a robust IPO market will be the end of Venture Capital, in the final analysis the basic rationale for venture capital is as sound now as it has ever been.

There are only a few ways to grow the economy: more inputs (natural resources, labor) or higher productivity (which introduces a multiplier to the foregoing). And higher productivity typically comes from innovation. Venture capital is in the business of funding companies who will go after opportunities that established players can’t or won’t pursue. And in this day and age this rationale is more important than ever. Will capital be harder to come by to fund these companies, on both the startup and VC sides? Probably. A bad economy with damaged financial markets will do that. Will some startups manage to fund themselves to a quick exit without raising any money? Sure. It’s definitely cheaper to build a company now than it was ten years ago. Is there an argument to be made that we’re in the middle of a slow-rise period of incremental, rather than disruptive innovation? I think there is. But based on what we’re seeing, there are a lot of interesting companies being started, and most of them can use both capital and guidance. Ultimately those are the two commodities venture capital provides.

We know this is a challenging time, and it’s going to continue to be. But as things get better, innovation, new technology and new ideas will be a big part of it. We believe venture capital continues to be an important ingredient, and there’s no obvious substitute.