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The Heat Is On Us
A bi-weekly column with timely, relevant and possibly irreverent insight into the BC technology industry.

Something Ventured:
July 16th, 2004

By Brent Holliday
Greenstone Venture Partners

“You can make a break
You can win or lose
That's a chance you take
When the heat's on you” – Glenn Frey, The Heat Is On

There was a provocative letter sent to me a month ago (an anti-VC rant) that I chose to respond to at length in my mid-summer issue.  That happens below.  To start, I thought I’d make a few comments on the state of things as we gear up for the second half of 2004:

IPOs down, M&A up – The public markets are not being kind to technology of late.  Certainly the dramatic change in earnings from 2002 to 2003 is not appearing in the 2003 to 2004 numbers.  The warnings of Veritas, Intel and Nokia have shaken the industry into thinking that IT spending has slowed.  Perhaps expectations merely got ahead of themselves.  I think we are back to the old days where technology buying cycles slow in Q2 and ramp in Q4.  Look for better numbers at the end of the year.  The IPO market in Canada and the US perked up for 6 months and is now lukewarm due to this effect.  But M&A continues at a solid pace.  Companies that have righted their ship since 2002 are looking for acquisitions that can get them into new markets.  They are buying for growth. Cisco, Broadcom and IBM are buying again and are not shy about paying for non-revenue or low revenue companies (i.e. not accretive to earnings) because they are expanding into new markets and need the innovations of the start-ups.

There must be IT jobs out there – Entry level jobs must be increasing locally as EA, Business Objects, MDA, Nokia and Sierra Wireless are hiring.  More evidence of the lower cost of business here comes in the form of JP Morgan opening a call center, although only a few IT jobs will come from that.  The biggest piece of anecdotal evidence I have is that no one has sent me a letter in the last 6 months complaining about the job market and the number of resumes coming to Greenstone has slowed perceptibly.  The fact that some of our companies are having management and employees getting recruiting calls is another sure sign.

Governments and Technology – The minority government of Paul Martin will likely do nothing much for the technology industry that wasn’t already contemplated when they had a majority government.  I don’t think new initiatives will get much support, especially if the Liberals need to appease the NDP party to get things done.  This will be a government of major issues and minor ones will simply not get support.  As for our provincial government, have we kept score on Mr. Campbell’s commitments to the technology industry made back in 2001?  Where are we on the 3x more engineers and 4x more investment?  While some progress has been made, an upcoming election in 2005 is not going to ride on the technology industry’s votes.

Without further ado, let me get to the letter


Letters From Last Time:

This letter dates back to the column in June, Behind the VC Curtain (http://www.bctechnology.com/statics/bh-jun0404.html).


I have worked for companies that have been partially financed by a particular local VC, that prides itself in its expertise and ability to step in and help manage the company that they are investing in.  This sounds very appealing to the investors of the VC.  These guys are in control!  In two cases I watched as the CEOs that they had appointed to run these companies, rape and pillage the company.  They were 100% focused on their personal gain, and frankly did not give a damn about anybody else.  These CEOs were paid handsome salaries and had lots of perks. As this charade was going on, the VCs were rarely visible, and took forever to fire these CEOs that they had touted so highly and not before a lot of damage was done to the company, its reputation and its clients. The companies both failed and were eventually sold merged or whatever. 

Unfortunately VCs for the most part are using OPM (other people's money).  Yes they may have their own skin in the game, but it is being offset to a certain degree by the fact that they are drawing a pretty decent salary, bonus etc. and also have the upside potential should their investment prosper and actually increase in value.  This is not the case for the people that invest along side of these VC principals.

I do not want to paint all VCs with the same brush, but I am very careful in who I approach when I am looking for investment partners for my clients.  One of my observations is that a lot of people in the investment industry, brokers, VC's, fund managers and other participants often have not had any exposure or first-hand experience to the operations side of a business.  Whenever I sit through a presentation by a company seeking financing, it very clear to me that the investment industry folks are very focused on the financial side and less so on the operations side. Pro forma financials are presented with all of their blue sky which will impress the potential investor.  A common question is what is the home-run with this company which translates into how am I going to make money quick.  A more important question is how realistic and achievable are the pro-forma numbers.  It seems to me if you have never worked in the operations side of a company or never worked outside of the investment industry you would have difficulty in understanding the complexity and challenges faced in running a successful company. Therefore, how good at analyzing financials can you be.  You really can only take the word of the people giving the presentation. 

Another area of concern to me is the sales, marketing and distribution.  I often hear the argument that the total market size is say $2 billion.  We should be able to get at least 2% of that market or $40 million if my math is correct.  This seems such a simplistic view of the world and the challenges ahead.  It is never quite as simple as that. This is often the Achilles heel of the company.  Many companies have a proven product or service, but the task of taking it to a viable, profitable commercial level is completely another story.  Here again, I am sure that many of the investment folks do not comprehend the difficulty, time and work involved in successfully launching a product or service.  Do you go direct indirect, North America, Europe, Asia and on and on.

I have read recently that the returns generated by VCs for their investors is pretty abysmal. Again I am not saying this is the case for all VCs. But from an outsider's view looking in, it looks like a very scary proposition for me as an investor or a company that is considering using a VC to know who to use and who to trust.  I can say one thing for sure, I know who I would not use.  From most of the companies that I have talked to in the last couple of years, they feel that a VC is not a good alternative source of capital as the VC wants the lion's share of the spoils and provides questionable value.

Best regards

Paul Brown

Thank you for taking the time to prepare a long and emotional letter.  You are putting in writing a sensitive topic and I will respond without any bias whatsoever {grin}.  I’ll try to address your main points, which I see to be:

-         VCs you have worked with lack operational expertise leading to bad decisions at the Board level

-         Co-investing with VCs is problematic because, even if they have skin in the game, it is not enough to offset the fact that they can afford a few losses in their portfolio and thus, pay less attention than they should when things go bad, but get more upside than they deserve when things go well.

-         VCs that you have worked with don’t appear to do enough diligence and take the word of the entrepreneur too literally on upside of the opportunity without realizing the underlying complexity in growing a business

If I’ve got that all correct, then here are my comments back to you:

The venture business has no “school” to learn at other than some cursory basics in business schools.  Good VCs are made by years of experience.  A wise 23 yr veteran of the Silicon Valley told me that the most expensive MBA in the world is learning to be a VC because it costs millions of dollars and at least 10 years to see and do it all.  I can count on one hand the number of VCs in this town with that length of experience (one of Greenstone’s partners has 10 years, the others have 7 each if you are keeping score at home).

VC is broken down into three functional areas: Picking good deals, managing/helping deals through the lifecycle (good or bad) and raising money from investors.  Since the third task is irrelevant to your comments, we will ignore it.  Let’s start with the first task.  Picking good deals is art, not science.  If you were operational prior to being a VC you have no advantage in this part of the game.  In fact, most new VCs from industry are far too optimistic and unrealistic in expectations of opportunities that they see.  I fell into that trap in 1997 when I left the software business.  I thought each deal was the best one I’d seen.  It seems to me that many deals get done, and will continue to get done, that are, in the beginning, very poorly thought out and woefully short of management talent.  The other end of the stick is old, grizzled VCs that don’t like any deals and it is like pulling teeth to get them to take some risk.

Why do crappy deals?  Some VCs have quotas to invest.  Others have time pressures put on them to get money out.  Some are very inept at performing diligence and asking the right questions.  And inexperienced VCs can do bad terms in deals that either hurt the company or hurt themselves.  But crappy is always in the eye of the beholder.  In the egocentric world of VCs and entrepreneurs, every deal that isn’t theirs is crappy.  You have made the same subjective analysis in your comments.

In the managing/helping company’s part of the VC business, every VC mentions “value add”.  The most value add is experienced decision making at the Board level and great networks of high level contacts that help the company.  In a perfect world, the entrepreneur would hold sway and pick the investors that they want.  Very, very few entrepreneurs have the track record to be able to do that, either here or in the heart of venture investing, the Silicon Valley.  But a good question to ask yourself as you are getting money for your venture is this:  Would the investor about to sit on my Board as part of their ownership of a large portion of my company be someone I would think of for my Board even if they would not invest?  Would they bring the operational experience that you talked about? The answer is likely no.  But there are VCs that do meet that high standard and there are those that bring directors to their companies that meet this standard.  If you want leadership from a VC and good decisions that benefit the company, you should press for that kind of investor. 

Your observation about “VCs not paying attention” is accurate in some cases.  The unfortunate truth is that VCs play a portfolio theory, meaning multiple bets placed in different stages and sectors.  If things go awry (and my experience is that VCs are not to blame for most stumbles in businesses), that is usually when too much attention is given by VCs.  If they aren’t paying attention, it’s a good thing if it means the entrepreneur is free to build a business.  If they add no value at all, even when prodded for action, then there is a problem.

When things go well, everyone is happy until they get greedy.  A huge win gives you remorse at how much of the company went to others.  It is completely natural to be an entrepreneur and sweat and toil and make it all happen and look at others making money as “freeloaders”.  But that thinking is dangerously narrow-minded.  The fact that VC exists as an industry is because you can’t make a business as fast as you would like without early injections of capital.  When you are mortgage free, do you think of your bank as pirates for all the interest they took?  Or do you thank God that all of the years of living in that house were made possible by the bank giving you that money in the first place?

Finally, co-investing with VCs (that is going in on the same round of investment as them) should not be an issue, if you, like them, make bets elsewhere to diversify your risk.  If you have all of your capital (or capital you raised from others) bet on one or two companies, you are taking a huge risk.  That happened to a poor group of investors on one of my deals that failed.  While it hurt to lose millions of my investor’s and my money, I can make it up on the other investments.  These guys had bet it all on black and had nothing, thus ruining their and their investor’s experience in technology 

There are early stage, non-VC investors in VC backed companies like Angiotech, Pivotal, Creo and Sierra Wireless that are certainly not complaining about VCs.  There are plenty of investors that lost money that look to cast blame, rather than share it.  A particular group of angels locally fit into that category… but alas, the emperor is missing some clothing in their case.  And there are certainly instances of inept management and Boards that led to losses.  But the industry is what it is.  The investors keep raising money and turning to entrepreneurs to help them make returns.  We are not unique in Vancouver and much of the bad sentiment is cyclical due to the huge downturn we just went through.  At the end of the day, everyone needs to improve and learn from mistakes and admit responsibility.  The industry improves if we all get smarter.

So, Paul, you can view VC as a necessary evil or you can view it as a positive strategic partnership.  Or you can fund the next one on your own.  As for the VCs, they either pick up their socks or lose the really good deals to firms that are deemed to have the value worthy of gaining the spoils.  That’s how the marketplace should function.


What Do You Think? Talk Back To Brent Holliday


Something Ventured
is a bi-weekly column designed to supplement the T-Net British Columbia web site with some timely, relevant and possibly irreverent insight into the industry. I hope to share some of the perspective and trends that I see in my role as a VC. The column is always followed by feedback (if its positive or constructive. I'll keep the flames to myself, thanks).

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