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Taking Control: Due Diligence on Your Terms

November 21, 2011

Brad Svrluga

This post has been rattling around my brain for awhile now, but was finally jarred loose when reading Roger Ehrenberg’s terrific post last week, Fund Raising: Manage the process, don’t let the process manage you. If he and I were collaborating on a series on fundraising (whaddya say, Rog?), what follows would be part two. Or maybe part three. Eric Paley’s post on Convictionshould be required contextual reading for anyone starting a fundraise.

Roger’s post did a great job describing how to manage the timing and flow of interest from a range of investors. It’s very important stuff, and you’ve got to pay attention to it if you want to optimize your outcome while also keeping your eye on the ball in running your business. But there’s another level you can take it to in working and planning to maximize success, and that’s how you plan and work to make due diligence happen on your terms, not on the random terms that investors will dictate if you let them.

Having observed hundreds of financing processes from both sides of the table, there are some clear patterns as to how they play out. One of the more troubling and time consuming patterns is that of the investor who is bumbling through his processes (and I’ll tell you, process is a generous term for what we VCs frequently put companies through!), feeling pretty interested in a company but groping aimlessly in search of that thing that’s going to get him and his partnership over the hump. You can burn a lot of cycles at this stage of the process. And I think it’s frequently completely unnecessary.

So how can you, as entrepreneur, speed things along? My shortanswer to this is to spend some time up front with people who’ve seen these processes dozens of times before (ideally a VC friend or a multi-time entrepreneur) and do the work to anticipate what all those derivative analyses and data requests are likely to be. Poke all the holes you can in your business. Think about your business like an investor will. Go so far as to do your prospective investors’ work for them. Assemble a collection of diligence materials in a Dropbox folder that you can give them access to.  Then, when you’re getting into diligence with a prospect, don’t let them get distracted. Drive them through that material.

A critical point to realize here is that there are two competing threads in the entrepreneur-investor dynamic. One is the thread of your story – what is the most compelling way to engage an investor’s interest and describe the problem you are solving and what your brilliant solution is. That narrative is generally best told with a real storyteller’s arc to it.

The second thread is that of the investment recommendation that the VC is ultimately going to write for her partners. That follows a much more plodding and analytic approach. You’d never want to construct your pitch deck around the outline of a VC investment recommendation – you’d bore those investors to tears. But you do need to recognize that it is this framework they will ultimately need to wedge your business into. So you may as well help them do it. Here’s a few key sections of that investment recommendation that you should address:

  • High level description of market need and how the product addresses that need (an evangelist’s pitch that is hopefully in your story already)
  • Market size – this has to be bottoms up. Not “American companies spend $6 gadzillion per year on software. We address 15% of that market.” Instead, “There are 2.5 million logical potential customers in our market. Our product will cost $2,000/year/customer. That makes for a $5 billion Total Addressable Market.” Beyond that, do anything you can to offer insight on how that market is segmented and which segments are most attractive.
  • Business model / unit economics – how does your business actually make money at the level of an individual sale/customer? Price – COGS = gross profit. Then what’s the sales/customer acquisition model? You need to really understand this in a detailed way so that the investor can see how the business builds up into something which, with lots of customers, will clearly cover it’s variable and selling costs, and then corporate overhead, and ultimately drive profits.
  • Competition – be honest and expansive. In addition to the obvious direct competitors, give some thought to the other questions investors will ask. “Why couldn’t Google build this and crush you?” “Is this really a big enough pain point that the status quo won’t prevail?” “Can’t big customers just build this themselves?”
  • Go to Market Strategy – we alluded to it in the Unit Economics, but this has got to be a believable story about how you acquire customers and, hopefully, do it at ever decreasing costs/customer.

The above may be painfully obvious to some, but there’s nuance within each for any particular situation. Again, I encourage you to get an “expert” on these processes to walk through each of these sections and think comprehensively about how they apply to your business.

Some of this work will result in you tweaking the arc of your story a bit. But much of it will not. This work will become your “back pocket” analysis – things you’ll do the work on and then keep handy, knowing you’re likely to be asked. I can tell you that there are few things that impress a VC more than asking what they think is a brilliant, insightful question and then having the team come back immediately with an answer of “Great question. We’ve thought a lot about that. Let me share some analysis.” If it’s well-packaged and pretty analysis, so much the better. It’s the kind of thing that leads the VC to go back to her partners and say, “Man, these guys are good. We asked a couple of deep dive questions on tough issues andthey were way out ahead of us – they’d already done the work. They’ve really thought through and deeply understand their business.”

You might worry that this could lead to a lot of wasted work, to which I have three responses. First, I wouldn’t advise leaving much of anything in your back pocket, regardless of whether or not you’re asked. If you’re smart about it, you can cleverly find opportunities to proactively slip this work into the dialogue. Done effectively, you can shift the balance of the conversation from the VC saying, “I’m asking you this question because I think it’s critical to your business and you better have a great answer,” to you saying “I’m sharing this analysis, background research, and insight with you because I know it’s what’s important about my business.”

Second, whether or not you spend time talking about it, much of your work is likely to find its way into an investment memo for my partners. When sponsoring a deal, we allwant our recommendations to be as thorough, thoughtful, and data-driven as possible. If you give us more smart stuff, we’ll use it, and be that much better at advocating on your behalf. Make sure that any investor who gets serious about the business gets an invite to that Dropbox.

Lastly, and perhaps most importantly, you should be thinking about this stuff anyway! One real benefit of a well managed financing process is that it forces you to step back and think about the forest for a bit, rather than that tiny piece of bark you’ve been staring at on that one little tree. If you’re thoughtful about which analysis you choose to do, you’re going to learn some valuable new stuff from doing the work, whether or not any prospective investor ever asks specifically for it.

A financing process is a high stakes game upon which the future of your business ultimately depends. You can’t afford to leave anything on the field. So go into the game with a plan of how to control the discussion. Do so and prospective investors will walk away understanding your business better, and with more convictionthat you are an entrepreneur they want to be behind. And that will lead to a competitive process where you end up holding the cards.

Good luck.

Introducing PublicStuff

November 15, 2011

Brad Svrluga

We are thrilled this week to introduce our newest portfolio company, PublicStuff. We partnered with our friends at Lerer Ventures and First Round Capital on this $1.5MM seed round, which closed a couple of weeks ago.

PublicStuff was founded by Lily Liu, a talented first time entrepreneur with Carnegie Mellon and Harvard Kennedy School degrees and several years working in municipal government in California and, most recently, in the Bloomberg administration. Lily, through PublicStuff, is taking a practical and elegant approach to helping governments better connect, communicate, and interact with their citizens – “crowdsourcing customer service,” as Lily calls it. And it’s selling like crazy.

PublicStuff helps governments extend customer service through web, phone, and mobile platforms that let citizens of PublicStuff communities report incidents (potholes, downed power lines, litter, etc.), check service status, and monitor resolution.

Using the PublicStuff administrative platform, municipalities can better track and manage resolution of service tickets, and eliminate the inefficient, usually paper-based systems that dominate these environments today in all but our largest cities. For both sides, it’s a simple, elegant, lightweight solution that is improving municipal service delivery in 50 communities across the country. Have a look at Plano, TX’s website to see PublicStuff in action.

Remember the movie Startup.com? It’s one of my favorite memories from Internet Bubble v1.0, when I got my start in the venture business. If you’re an entrepreneur who hasn’t seen it, watch it tonight. It’s a terrific historical perspective on the madness of the Bubble and the tragedy of its bursting, told through the experience of two entrepreneurs and their startup, GovWorks.com. The lessons about the challenges – interpersonal and otherwise – of building something from scratch are timeless.  The trailer is here:

Startup.com chronicles friends-turned-entrepreneurs Kaleil Tuzman and Tom Herman as they work to build GovWorks.com, a collection of websites that aimed to completely change every element of the way that governments and citizens interact. It was a totally logical, yet wildly ambitious goal. They raised $60 million of venture capital, grew from 8 to 250 employees in 2 years, and then imploded.

GovWorks was a business that, if more intelligently managed, deserved to succeed. So with PublicStuff, it’s been fun to think about successfully reinvigorating the failed GovWorks vision.  Fortunately for us, as investors, Lily is taking a far more rational and measured approach to capital raising and company building. I firmly believe that she will ultimately dominate the government services marketplace, but I think she’ll be a whole heck of a lot more thoughtful about how she gets there.

Consistent with Lily’s measured approach to building her business, we took a relatively measured approach to our decision to invest. It’s not that easy to take your time in developing a deep understanding of investment opportunities in today’s overheated NYC startup environment – things are moving far too fast in most cases. Fortunately, with PublicStuff, I met Lily just as she started this past summer’s ER Accelerator program. Biased by a pervasive belief in the venture community that any business that sells to governments is all but DOA, there wasn’t an overwhelming amount of interest from the investor community right out of the gates. But I was intrigued by what I saw, and signed up to be a mentor to Lily through the program.

It became quickly apparent that, unlike so many of today’s startups, Lily had identified a very real marketplace itch that needed scratching. Even as a tiny company with only a couple of employees, she was steadily signing up new customers, pushing out new product releases, and proving over and over that the market wanted what she was selling. Most impressive to me – she sold her first 35 municipal clients without ever meeting one of them in person.

We talked to several of those customers and heard rave reviews. In September I asked my colleague Rahul to join Lily at the annual convention of the International City Management Association to see her selling in action and to talk to as many potential customers as possible. By the end of the day, Rahul had become the company’s #2 salesman (no one will ever eclipse Lily), and had secured over 30 warm leads. He called me excitedly with a “fish in a barrel” report of his sales efforts. The PublicStuff offering is so strongly desired by these customers, and so simple to explain that someone who only tangentially knew the company was able to quickly become an effective pitchman.

With Rahul’s Milwaukee experience in hand, and a growing sense that Lily was a superstar of an entrepreneur, we had everything we needed and signed up to invest. We’re excited to have the deal closed, a terrific group of investors around the table, and a world of opportunity in front of Lily and her team. If you’re reading this, live in a town or small city, and want to help your municipality crowdsource its customer service, tell your mayor or city administrator about PublicStuff. You won’t regret it.

Thoughts from Fall 2011 Village Ventures Summit

November 14, 2011

Brad Svrluga

I spent a terrific couple of days in Boston last week at one of our semi-annual gatherings of partners from the 16 early stage venture funds across the country that are affiliated with Village Ventures. These meetings – and I’ve been to 20 of them in the last 10 years – are consistently high quality events, and provide valuable impetus to step away from the office and the regular patterns of weekly life to actually think about things for a bit. Last week was no different.

There were a number of sessions that really got me thinking, so I figured I’d jot down and share thoughts from a few of them.

After a brief welcome from VV Managing Partner Matt Harris on the morning of day 1 we were “treated” to a session on board governance, fiduciary duty, and how to keep yourself from getting into trouble as an investor director on an early stage company board. Not exactly the most fun topic in the world, but the folks at Pierce Atwood did a terrific job of keeping it real, relevant, and engaging.

The short summary is that being a director is, as we know, a serious responsibility. And being an investor director creates particular challenges and potential conflicts as we work to balance our dual roles as investors – with obligations to maximize the value of our share holdings, and as board members – with a responsiblity to all shareholders. Tricky stuff, and very important to be thoughtful about. Not surprisingly, the trickiest territory here is generally around bad news situations, where the preferred stock that venture investors generally purchase is in a position to be exercising its liquidation preference at the expense of other shareholders.

I walked away from this pondering one question in particular, about which we had had some fruitful discussion: Do VCs really need board seats? There’s certainly a lot of downside to being a director – exposure to all manner of litigation being the primary issue. What if we were to forgo board seats in favor of documented rights to serve as observers in board meetings? After all, it’s being privy to the information and having a voice in the discussions that really matters. Surely the combination of the moral suasion that comes from being a check-writer and the control provisions that are present in most every venture deal are where the bulk of our influence formally originates. Maybe we’d all be better off if we left the board exposure to others and spent our time more freely operating as non-fiduciarily bound advisors? It’s worth thinking about.

This governance discussion was followed by a real treat of a special guest. Gina Raimondo is the Treasurer of the State of Rhode Island, and used to be a peer of ours in the VV Network, having been an early VV employee and then working as a partner at Point Judith Capital. She ran for state office last year and won convincingly. If you’re not already aware of the amazing work she’s doing to overhaul Rhode Island’s busted state pension system, read this WSJ profile from the summer. We should find out this week if Gina is successful. If she is, little Rhode Island will offer a model for how to reform the dozens of other broken pension systems across the nation. These challenges are not widely enough discussed, but could have crippling impact on our state economies. It is so inspiring to see an old friend leading the charge.

Gina was followed by the Main Event, a 90 minute fireside chat with Fred Wilson of Union Square Ventures, interviewed/facilitated by Fortune’s Dan Primack. This was technically an off the record conversation, so I’ll respect Fred’s wishes by not sharing too many details. But one key takeaway: Fred reminded us all that he didn’t become the Tom Brady of venture capital overnight. He’s been at this game for over 25 years now, and had been at it for nearly 20 before founding Union Square Ventures in 2003. He took an awful lot of lumps along the way, and could probably be described better by Malcolm Gladwell’s Outliers framework than by assuming he is some Tiger Woods-esque prodigal savant. Or at least that’s what I’ll choose to focus on – gives me some hope that with another dozen years in the business I might get good at it! Regardless, a real pleasure to have the time with Fred, the man who built the firm that, with its innagural fund, was the first investor in both Twitter and Zynga, amongst others, and now has a very good chance to become the single best performing venture fund in history.

The downer of the conference was without question the discussion of the fundraising landscape for venture firms. As if we needed it, we had a collection of institutional venture capital Limited Partners to give us the confirmation. In short, it’s abysmal out there, with no reason to believe its going to get better anytime soon. State pensions like Gina’s are rapidly shifting asset allocation models away from venture, as are large university endowments, as they increase focus on liquidity and decrease risk tolerance. VC funds-of-funds are struggling to raise their own capital. Banks and other large financial institutions are almost entirely out of the game post-financial crisis. Go to a gathering of Limited Partners and you’ll struggle to find anyone who’s not making a risk-adjusted-returns oriented shift away from venture.

Ian Sigalow offered some good perspective on this last week. Bottom line, all but a very fortunate handful of VCs have some reason to fear for their (our!) job security in the medium term. Is that a bad thing? Not necessarily. The industry has gotten a bit crowded again, and I’ve always been a fan of creative destruction.  However, I worry about the speed and efficiency by which market forces will adjust in this case. Like many, I suspect we are headed for a medium term that involves a substantial continued shrinking of the venture industry and a resulting decrease in support for entrepreneurial activity. We’ll get through it, no doubt. Such a change will surely create opportunity, which will result in outsized returns and then a flood of funds back into the asset class. But it’s going to be bumpy for awhile. And in a macro climate where innovation and job creation are certainly in everyone’s interest, we as an industry are not going to be able to do quite as much as I wish we could.

The final session of note was a conversation with Dave Balter, founder/CEO of BuzzAgent, one of the early leaders in the Word of Mouth (WOM) marketing space. Dave is a terrific entrepreneur, and the BuzzAgent story is important for its lows as much as for its highs. Dave’s candor about the company’s meteoric rise, rapid fall, and his struggles to stabilize the company and reposition it were reflective and thought provoking. The conversation served as a compelling reminder that we have as much or more to learn from our struggles as from our successes.

All in all, a terrific couple of days. And always a real pleasure to be around my friends and colleagues from across the VV Network.  As with most such gatherings of peers, it was the dinner and cocktail conversations that offered the most valuable content. This is a hard business, and at times a very lonely one. Having a network of likeminded soldiers fighting similar fights has always been invaluable to me. I’m looking forward to our spring 2012 gathering already.

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