Five Years Too Late

January 30, 2009

Smaller is Better

Filed under: Startups — Tags: , , , , , — fiveyearstoolate @ 2:43 pm

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

will

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.

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October 21, 2008

Setting the Record Straight

Stuart Ellman

Stuart Ellman

I admit it. We at RRE Ventures are terrible at public relations. We tend to want our investments to speak for themselves. So, this is what I hear all of the time, “Yes, RRE… you guys do later stage enterprise and financial services deals, right?”

Wrong. Here is the real answer. The quote above was true in 1997. Not now. We have evolved, much like the rest of the venture industry. We have figured out what we do well, and where there is opportunity. Here is a snapshot of what RRE does in 2008:

Roughly half of our deals are in the New York Metro area. When we started RRE, this wasn’t true, but as NYC has grown as an ecosystem for technology startups, we have allocated an increasing amount of our time, energy and capital to companies here. We love doing NY deals for a bunch of reasons. The environment is getting better and better, we know the entrepreneurs, we get an early look at great companies, and awesome entrepreneurs are starting businesses here. The downturn on Wall Street will only bring more smart people to startups in NYC.

Roughly half of the deals in our latest fund are early stage investments. Why? Mostly because we can. We have a reputation with entrepreneurs for being good startup investors and a firm that’s genuinely interested in the type of company building early stage investments require.  Also, because there are only a handful of VC firms in NYC that will make early-stage investments, we get a look at the very good deals. We have incubated two companies per year in our downstairs conference room during each of the past few years. Sure, there will be higher failure rates with seed investments, but we are often backing CEOs that we have backed before, getting in at lower prices, and having a significant influence on how the companies are built.

Here are the industries that we focus on:
• Consumer and Digital Media
• Mobility
• Green Technology
• Software and Services
• Financial Technology
• Infrastructure

The proof is in the pudding. Here are the early stage and NY deals we have done in the past two years.
• Drop.io
• Storm Exchange
• RecycleBank
• GoMobo
• M-Via
• Peek
• Payfone
• Skygrid
• Stealth Company #1
• Stealth Company #2
• On-Deck Capital
• Betaworks
• Tendril
• Certeon

So yes, we agree that the venture market has gotten tough all of a sudden. But we are still doing deals. The bar is set very high and our valuation expectations have been lowered but we are closing two deals this week. And we like them a lot. And moving forward, we’ll continue to invest in the same mix of early and growth stage deals we’ve been doing for the past few years. We’ll spend a lot of time looking at deals here at home, but will continue to be active in Silicon Valley, Seattle, Boulder and other geographies as well.

In sum, sure – if you’ve got a great B2B company, we’d love to see it. But if you’ve got a great early-stage B2C or B2B2C company, we do those as well. A big reason why we started Five Years Too Late was to take the opportunity to let people know what we do here at RRE. We’re interested in a variety of sectors across a range of stages, and across the information technology spectrum. Late-stage enterprise and financial services deals have been very good to us, but there are a lot of opportunities in a lot of other areas today, and we’re looking at all of it.

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