The Art of VC: I was not wrong, just early

This is a common refrain from my venture colleagues.  It’s inherent in our job that we are always trying to justify our investments.  Making unsuccessful investments comes with the job description, so we want to glean some silver lining by pointing out our identification of a growth market.  Most of the time my colleagues use this phrase tongue in cheek, but sometimes they are serious and I find this to be disingenuous in the extreme.  Asking for credit, when your portfolio company was unable to ride the market growth wave, or rode it after being recapped so you earned  no reward from your investment, is tantamount to a VP Sales asking for credit for a customer telling him he has the best product in the market, but no budget to buy it! We often see company pitches that have dramatically growing (aka “up and to the right”) market size charts and revenue growth going from $1M in the first year of sales to $10M in the second year of sales, but the reality is that this is a 3 sigma outcome (ie less than 1 in 1000 startups will achieve this rate of growth).  This presents the VC with a dilemma.  While we are attracted to management teams that are advocating very dramatic growth, we know that 99.9% of them will fail.  So how do I increase my odds of finding the needle in the haystack? I have already discussed in my articles “The Art of VC: What do VC and Great Comedy Have in Common?” my investment thesis-led approach which serves as my first filter.  However there are also three additional filters or perspectives I bring to bear to assess whether the company is ready for dramatic revenue growth. Planning is Indispensable Any experienced early stage VC knows that revenue forecasts are highly unpredictable.  However, that is no excuse for not presenting a cogent financial plan that clearly shows how you plan to deploy capital.  The words of Winston Churchill are very a propos “have always found that plans are useless, but planning is indispensable” When reviewing a company’s financial model, I have four tests to ascertain whether the planning process has been sound or is just an exercise in the magic of excel (aka GIGO) • Complex models  False Precision Most startup businesses are not that complex in terms of how the business model translates into the financial statements.  If you come across a financial model that is several tabs deep, columns wide and rows down then you should be suspicious. • Assumptions are highlighted not buried Most business models are driven by a few key assumptions such as average sales price, sales cycle, sales productivity.  A good model will highlight these assumptions and not have them hardwired.  The CEO, not just the CFO, should be able to articulate which are the key assumptions and what is the risk and impact of them deviating from the plan. • Revenue and Expenses are Tied Too many models I review do not have an explicit connection between revenues and expenses.    This allows the management team to increase revenues without any explicit increase in revenues.  This does not reflect the reality of how revenues and expenses are interrelated.  The two main area they are tied are the cost to build and the cost to sell.  For the cost to build, there is a relationship between the engineering expenses both to ship and maintain the product and the gross margin you will be able to sustain.  For the cost to sell, there is a relationship between the cost of the sales model (direct sales reps, inside sales team, channel margins), its productivity and the bookings generated. • Shared and Internalized A good planning process will have included all the members of the senior team to the extent they are comfortable with the budgets and deliverables they each have control over.  So the plan is not just owned by the CFO but the whole team.  They should be familiar enough with the plan that they can answer high level questions without referring to the spreadsheet.  For example the VP Sales should be able to answer “how large does the sales team need to be to reach profitability?” Testing the Foundation (and Walls) Once I have satisfied myself that the team has not taken shortcuts in the planning process, I then move on to considering whether the foundations for a revenue generating business are in place • Technology ≠ Revenue Most technical founders have a technical background and their formative experiences are within large engineering teams where they have been partially isolated from the activities and functions that translate technology into revenue.  These experiences can lead them to believe (fallaciously) that great technology sells itself.  The best entrepreneurs soon learn that technology ≠ revenue, but many don’t and this can lead to dysfunctional teams where the founder bemoans the inability of the VP Sales to sell his great technology, or there are unrealistic expectations placed on the sales team without the infrastructure of marketing and support.  Founders’ attitudes have a disproportional impact on the team, so I always like to understand their formative experiences and whether they have been exposed to the cold commercial reality of having to sell a product. • MRD-PRD = Product Gap The discipline of product management is often given short change in startups where the focus is on engineering and sales.  In my experience this is mistake as the discipline is necessary in order to take the shortest path to first revenues.  You don’t have to have a dedicated product manager, but you do need the discipline which the senior team buys into.  Someone with the sales organization can own the Market Requirements Documents; someone within the engineering organization can own the Product Requirements Document.  Then the CEO can make the decision on the acceptable gap between MRD and PRD for version 1.0 of the product.  This should be the minimum set of requirements to solve enough pain for the customer that they will part with their cash.  There is obviously a tradeoff here where the small the product gap, the more the customer will pay, but the longer it will take to deliver.  I like to test to see whether this discipline is in place, regardless of whether there is a Product Manager.  In fact, the correlation between having a Product Manager and having the discipline of Product Management installed across the company is often very poor. • Tension is Good Just as you need both compressive and tensile forces to build a house, so you need all the key functions of engineering, sales, marketing and finance exerting their forces on the company direction.  In large corporations, the natural tension between these functions – for example engineering wants to reduce requirement to reduce engineering time and expense, while sales and marketing want to increase requirements to address more of the customers needs – is often masked to the individual contributor, but in startups everyone should be exposed to the creative tension.  This is where the magic of startups comes into play.   Closer communication between the functions is possible and in some cases the constraints imposed become more meaningful (“I need to get this product shipped so my sales guys can start selling”) because of the shared sense of destiny.  There are many tell tale signs that senior teams are not working harmoniously (and this does not mean always agreeing, but it does mean respecting the role the other has to play).  I have lost count of the number times I have seen a VP Sales roll their eyes while a VP Engineering is talking about the product.  This is a major red flag and has caused me to walk from deals in the past and, no doubt, will cause me to walk from deals in the future Phasing the Build Out So once you are convinced that the plans have been well thought through and the foundations have structural integrity, the final analysis is focused on whether the CEO has the skill to navigate the organization through the different phases of bringing a product to market and generating revenue momentum.  CEOs that do not have an appreciation for the qualitatively different phases a company will morph through and cannot identify these phase shifts, will often make bad judgment calls on the skill sets required, how hard they can push their customers and the compromises they need to make between time, expense and deliverables.  In general, I believe there are three qualitatively different stages • Nothing  Something of Value to a Few This first stage is when you have to place the first bet on the MRD-PRD = Product Gap equation.  You need to select a target set of customers who will i) extract value from as large a product gap as possible (ie minimum set of product requirements) ii) be able to extract greater value as the product gap shrinks (ie a larger set of requirements) and iii) act as a strong reference group for a larger universe of potential customers.   All the while you need to do this on limited capital so you can achieve referenceable customers before raising the next round of financing.  At this stage of development the key players is VP Engineering.  I have a strong preference for a VP Engineering who has a visceral understanding of the problem they are trying to solve for the customer.  In many cases, customers cannot articulate what they want in a version 1.0 product, they can only react once they see the product.  The VP Engineering needs to have enough confidence in their own ability and that of their team that they don’t get bogged down in process.  Process can be the death of creativity. • Something of Value to a Few  Something of Greater Value to a Few (More) This second stage is a test of how well the company can take feedback from its initial customers and incorporate the necessary changes into version 2.0 while developing a roadmap that gives the customers confidence that the product will be supported and improved to address all their requirements.  The company will be under pressure from its customers to address all of their requirements and make the product gap disappear.  However the company needs to balance the cost of doing this all at once versus incremental leaps.  Bear in mind the MRD is not a stagnant document, but a living breathing document which would be updated every quarter.  At this stage of development the key players are the VP Engineering (but they need to exhibit different skills from before) with the VP Finance/CFO and/or VP Marketing start to come more into play as well.   The VP Engineering needs to instill a greater sense of process and a greater sense of connection with their customers, compared to the more internal creative focus of the first stage.  The VP Finance/CFO shall ask the tough questions that helps optimize the next bite of the product gap, trading off development expense with revenues.  The VP Marketing shall be developing the marketing segmentation to identify and reach the customer segments most suited to the current product. • Something of Greater Value to a Few  Something of Greater Value to Many The third and final stage towards revenue momentum is about ability to predictably reproduce revenue given the product and the customer segment.  The buying process, the customer need and the competitive set is well defined and the issue is how to scale the sales effort.  At this stage of development the two key players are the VP Marketing and the VP Sales.  The VP Marketing needs to generate well qualified leads within the customer segments most suited to the product.  The VP Sales needs to build the sales infrastructure to convert these leads into revenue.  The VP Sales role in a startup is the one with the highest mortality rate and in many cases this is because the hired gun is hired too soon during either phase 1 or phase 2 and there is not enough opportunity for them to earn their commission and achieve the all important big W2 that is a badge of honor for VP Sales. The common thread through all of these filters or tests, is the philosophy and culture espoused and implemented by the CEO.  More on this subject in a future post.  For now I promise never to use the lame excuse “I was not wrong, just early”.  In the same way we ask our CEOs to take responsibility for their decisions and learn from our failures, I will strive to do the same.