At Johns Hopkins University, I teach students of entrepreneurship. These students vary across disciplines. They include biotechnology students who are studying how to manage innovation, engineers and computer scientists who learn to write business plans, and MBA students who are learning about venture capital. The model used for this process is to begin with an innovation that can be packaged into a product or service, write a business plan, and then go seek venture capital.
This is a common approach, but the facts show that venture capitalists do not fund many ventures before they have completed product development and have proven revenue streams. Even then, only a small percentage of ventures get venture capital. How can a venture succeed, then, in transitioning from the initial product innovation to a successful growing company that has penetrated a sustainable market share? This zone of early development, between science and business, is often called the ‘Valley of Death’ because funding sources are minimal.
The ‘Valley of Death’ is really a testing ground to see what teams and what products survive and which do not. It is in the Valley of Death where small amounts of funding must be secured to prove products, where initial sales have to be made, and where the tenacity of the founding team is tested. To many, it may seem there is nowhere to turn. I believe it is a good test of the worth of a venture, to see if they survive the valley of death. Otherwise, we may return to the inefficient use of capital that was seen during the dot com era before the bubble burst.
So where does funding come from during the transition across the Valley of Death? The answer is everywhere, and many places. Failure to secure adequate resources is a sign that the venture doesn’t have what it takes to reach an efficient and powerful launching point. The following list names just a few of the sources, and the validation proven by each. A venture that crosses the Valley of Death must be good at bootstrapping using a multitude of these resources. Not all are needed, but many are. My top 10:
10. Founders use their own money and credit sources, showing they believe in what they are doing
9. Founders and early employees work without pay or for low pay for a while, demonstrating a commitment for the long term
8. Early money from friends and family, which serves to greater incentivize the founders not fail
7. Government grants and contracts and economic development support, demonstrating that others believe in the future of the venture is doing
6. Consulting and services revenue prior to product completion, providing cash flow to keep the team around, done artfully so as not to distract from the mission
5. Private placement equity from angels, angel groups or accredited investors, acquiring working capital for critical tasks and proving that others will back the venture
4. Leases for necessary equipment, office space or vehicles, therefore minimizing the amount of upfront capital needed to meet early milestones
3. A corporate strategic partner who provides development capital and possible a distribution channel, securing the first major piece of business
2. Custom sales to early adopters and visionaries, providing early customer usage and testing of the product or service
1. Acquiring some mainstream customers, proving that “the dogs are eating the dog food” (the customers are buying the product, the team can sell the product, and there is revenue that counts).
The truth is, if the venture cannot do these things first, there is a problem. The problem may be that the product is ill-conceived or there is no market pull for it. The problem may be a lack of conviction or talent among the team. The problem is often lack of critical mass — high potential ventures cannot be developed by one or two people as it usually takes a team of a half dozen or more to build up the necessary energy. The problem may be a team that cannot sell or who will not leave the cave and network — if so, this team is not ready or deserving of funding. Sometimes the problem is immaturity of the technology — the world is not ready for this yet.
Whatever the case, the passage across the Valley of Death is a better test than a venture capitalist reading an executive summary.
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I used to work for Westinghouse back in the day when it was a Fortune 500 company. I left to become a serial entrepreneur when I became convinced that there was no true technical career path and that most managers there, particularly my early ones, were Dilbertized. I wanted to make a difference through innovation, not politics.
In Obama’s SOTU speech tonight, he emphasized a need for America to become more innovative. Other countries are turing out more engineers and scientists than we are. Somewhere, the American culture lost its respect for engineers and scientists.
Companies, like my former employer, advertize a “dual career path” so that engineers and scientists may advance in their fields like their management counterparts. However, the dual career path is, for the most part, fiction. A senior engineer could follow the technical path and eventually become a fellow engineer or an advisory engineer, and the latter was allowed a bonus. But a person choosing the management route could parallel this, becoming a department manager with a bonus. However, the department manager could go on to become a general manager, vice president, senior vice president, president or CEO. There was no such path for the “techies” and these senior managers made “N” times more money through high salaries, bonuses, and stock options. So I chose management, at least until I discovered the Dilbert culture that prevailed by first hand exposure.
Companies like the former Westinghouse paid lip service to technical professionals, but do not truly give them the chance for senior positions with the serious equity that management professionals are given. That was a conspiracy of silence. Further, our society refers to engineers and scientists as “dorks”. Lastly, the American business culture pays doctors, lawyers, investment bankers, and top tier MBAs 5 to 10 times more than it pays its scientists and engineers. I speak without bias because I have both in my background.
Do you still wonder why Americans do not pursue PhDs in engineering and science and most such degrees granted by American institutions are going to Asians and other foreigners?
Obama is right about innovation. And while business professionals are squarely involved in innovation, we need more science and engineering education of our citizens to be competitive. We can start by changing our cultural attitudes and values. Until then, we are the laughing stock of China.
At a recent overview for entrepreneurs on angel investors, it was emphasized that there are “smart angels” and “dumb angels”. After listening to the angel groups talk about it, they seemed to classify angel groups as “smart angels” and individuals such as friends or colleagues as “dumb angels”. They claimed that the smart angels brought more than money and could really help your business.
If you are an entrepreneur, watch your back! I have raised angel money for 5 or 6 ventures over the past 20 years, and the money has come from both the “smart angels” and the “dumb angels”. Hindsight being 20/20, the smart angels really are not so smart, and the dumb angels are not so dumb. Sweeping generalizations such as this are unfounded. What the angel group leaders are really trying to tell you is that they deserve a better valuation than the dumb angels. They won’t say those words, but that is the reason they think they are smart.
The truth is, these groups most often do not add real value and they certainly don’t deserve a better valuation than your friends, family, colleagues, and local business people. They claim to be old and wise and have big roladexes. There are plenty of unemployed consultants out there with business smarts and big roladexes - you can get business advice easily and inexpensively and it is not worth diluting your company for it. The reality of old wise might be crusty old men who are retired and give you the willies.
Angel groups do not move fast and they do not do many deals. They are social dinner clubs and committees with the herd mentality. I’d rather raise money from “dumb angels” any day of the week? Why? It goes faster, valuations are more fair, it is based on personal relationships, generally more pleasant, and you avoid the group effect. Less time raising money is more time selling. Less dilution and more revenue. When you here someone claim they represent “smart money”, watch your back!!!
A recently overused phrase connoting inability to raise money is the “valley of death”. It refers to the funding gap between research and revenue, that is product development funding.
There is plenty of funding for research from government agencies and nonprofit organizations. This money usually goes to universities. There is also some applied research money called SBIR (or “Small Business Innovation Research”). While this is supposed to be money for prototyping and early product development, it rarely really is. SBIR money goes to small businesses that have scientists and engineers on their staffs and a senior person with a zippy wowwy resume and some talent for proposal writing. The money usually serves the special interests of the funding agency.
For example, the DOD often issues engineering funding to solve hard problems. The NIH uses the SBIR program as an extension of their research program because for the most part, they have no clue what the word “business” means (or more likely, they are left wingers who hate the word capitalism). Lately, a number of universities have been trying to form programs where their professors, who are good at writing proposals, can set up companies and grab the money and just spend it from their university office. This, of course, is an abuse of government funding. Most of these professors don’t have a clue how to start a venture and probably shouldn’t be doing so.
Later stage companies that have completed products and customers have little problem raising capital. Many of them qualify for loans based on assets. Others will find strategic partners or sell receivables. Venture capitalists like to fund here. They have shied away from true venture investing because their record has been dismal at it since the dot com crash. Who cares? I would not take money from one of these “vulture capitalists” to fund an organization that already makes money. That is akin to allowing someone on the street to pick your pocket.
The “valley of death” is that space between grant funding and a going concern. Government agencies do not fund this. Venture capitalists and bankers are afraid of it. The source of funding for the valley of death today in 2010 is known as “angel investors”. Angel investors refer to individuals who have a net worth over $1M and/or an annual income greater than $200K. Hopefully, they also have some business experience and know what they are doing. Some do. Many don’t (consider, for example, asking your dentist for money to fund your nanotechnology venture - the sale may be made on buzz words).
Lately, it has become popular for groups of these investors to form a dinner club and call it an “angel fund”. Typically they meet once per month and have a few companies present to them. Once in a while, they do a deal. But mostly they eat dinner and drink wine. They are often organized by crusty old men who like to hob nob but who know nothing about technology. If you are an entrepreneur, it is popular to clamor for their attention to get a speaking slot. Sometimes worth while, but often just a ticket to free drinks. Angel groups add unnecessary bureaucracy to the angel investing process, in my opinion.
So then, how do you fund your product company to transition across the valley of death? Two sources: the first is known as FF&F, and the second is the angels themselves. FF&F stands for “friends, family & fools” (as well as your own money). When an entrepreneur takes this kind of money, the probability of success goes up a bit, because the entrepreneur does not want to lose face with these people and he or she will do what it takes to succeed.
The angels themselves may lead to larger investments. Here, you forget the angel groups, eliminate that bureaucracy, and sell the deal directly to the payer. By far the quickest, most effective, and lowest overhead of all the methods. Angel groups are slow and sometimes take management fees. VCs take 20% of the deal, substantially more than they are worth, and they take 9 months to close a deal.
You do need to make sure that you comply with securities law. That almost always means having a good lawyer who knows the securities business (not your family lawyer, this is a very specialized area of the law).
There is money out there for the valley of death and it is with people who have liquid net worth and are willing to risk some of it. But you have to be a convincing salesman to get it. That rules out most professors and inventors who can’t sell. If that is you, then get a business partner. Ventures succeed in teams.
I have been reviewing a lot of business plans this Spring. It seems to be a combination of student projects, student competitions, early stage ventures looking for money and case studies up on a pedestal. No matter how much is written about or how much preaching is done, entrepreneurs (and students of entrepreneurship) all seem to forecast the ever elusive J curve for financial projections.
The message they send: we are not going to make much this year, but in 5 years, we’ll hit $50 million, through an exponentially rising revenue curve! Oddly, that’s what most investors seem to want too. It’s just that is doesn’t really happen that way. I call attention to the fact that neither Oracle, nor Microsoft, had come close to $50M by year 5. They did by the 5th year after a stable product with market acceptance was created….but getting to that point was unpredictable and several years of hard work and experimentation.
New business ventures are almost always a series of experiments. Some things work, some don’t. But the more things you try, the more you learn what works and what the market will buy (some technocrats don’t care what the market wants to buy). So the real path to revenue is a few false starts, some intermittent down time, and eventually a solid product emerges that gets some real revenue traction. But it is difficult to predict WHEN that break point occurs and how FAST revenue will grow thereafter. This is due to the experimental nature of new ventures. We simply cannot know everything about the market in advance when a never before introduced product arrives on the scene.
So then why don’t we have an honest conversation with the investor about that process? A savvy investor knows this, and the rest are just being snowed. Why not forget the J curve and speak reality? I can suggest several reasons why we don’t (even though we should):
1. It’s about valuation. Gee, if we admitted ventures are experiments, the cost of money might be a lot higher….
2. It’s about pride. Hmmm.., if we admit the venture is an experiment, we might be seen as a neophyte who doesn’t know what he’s doing….
3. It’s about fear. If we call the venture an experiment, we’ll never raise money…
And probably a handful of others.
Honesty from the entrepreneur indeed could lead to more confidence. And from the investor….. well that 10 year VC fund business model just might be in trouble. Or it already is….how many venture funds made money in the last 10 years?
During the Internet bubble, it was common to think an upstart could go public within 2-3 years after launch. Prior to that, it was common to think 5-7 years was the window. I suggest by “getting real”, innovation will lead to a better recovery. Growing companies takes time…more than 5-7 years….and it takes time to get from the idea to a product that produces revenue….more than the commonly believed 6-18 months…it takes several years if done right. I believe there are no short cuts unless you plan to sell a house of cards. Let’s get real.
In my conversations with entrepreneurs, stories abound about university technology transfer offices who just couldn’t get a deal done. Some universities are even dubbed as “closed for business”. It seems that their technology transfer offices are more interested in crafting the perfect license with large financial payoffs (in their minds) to the university and the investigator. They can’t see the forest for the trees. Or maybe they are steeped in policy decisions and committees yada yada yada….so they still don’t get anything done. Maybe somebody forgot to teach them in math that 15% of nothing is still nothing.
But wait a minute! Looking more objectively at technology transfer, it is easy to see that this should be a sales and marketing (and business development) function, not a legal exercise in writing terms and conditions. The university has the goods (the intellectual property) and there is a market out there (start ups, venture capitalists, and corporate America). Why then do universities put lawyers in the role of Director of Technology Transfer? It seems to me that what is needed is someone who understands business development — and let the lawyer work for them. Besides lawyers are famous for screwing things up by taking too much of the decision making authority!
The few universities that “get it” focus on how to create a start up, how to analyze a market and determine demand, and most importantly - just going out there and selling something. A good consultative business development professional who understands start up company finance and corporate culture would fill the bill. Not a PhD researcher (they are introverts and perfectionists) and not a lawyer (they think the Ts & Cs are the deal).
Universities that get it — like Stanford and MIT — also understand ventures. They don’t ask for onerous terms and large cash upfront. They do a lot of deals at attractive rates and play the numbers. Some universities are now claiming that they are changing. Johns Hopkins, for example, now has experienced executives helping out. The University of Virginia is seeking a new tech transfer director with business skills. And recently in the news was UNC who announced that all deals will look alike and the royalties are low single digit figures with no equity. This takes the friction out of the process, and of course, will expose what I stated above. It’s a sales and marketing function, not a legal exercise!
And by the way, kudos to Harvard Business Review for boldly proclaiming that university researchers should be free agents who choose their own licensing agent! Maybe that will help get university politics out of the way and let innovation accelerate!
Along these lines, Infinity Venture Group is announcing this later month that we are starting a technology transfer practice to outsource university tech transfer. We will do this as a retained agent of numerous state and private universities, including smaller universities that don’t have a well established tech transfer function, as well as being an agent for individual investigators whose home institutions allow them to act on their own. And yes, we are treating this as an aggressive sales and marketing function aligned with new venture development. Legal is a mere supporting management function.
For more information, email ed@addison.us.com. And do feel free to respond with a post.
In my venture management consulting work, I am often asked about the management team — what is needed to attract funding and what is needed to be successful. A founding CEO and management team is usually quite different than the management team that takes a company through its high growth phase after it goes public. This is because the required skill sets are different.
A founding team needs strong leadership and vision. The founding CEO must know the technology and the market and is usually very “hands on”. The team needs creative technical talent and shrewd marketing smarts and the ability to sell. Less needed at this stage is a CFO, business analytics, or a hierachy. More important is a strong vision, ability to motivate creative people, the confidence to surround yourself with smart advisors and listen to them, and a willingness to step aside for more process oriented professional management when that time comes. A very clear vision and compelling value proposition is an essential leadership tool.
It is often said that venture capitalists look for a strong team and that is more important than the best product. The philosophy is that a strong team can adapt to the market and build a great product in due time, but a company with a great product and a poor team will not adapt when needed.
So what is needed on a founding team — that is, the team that goes from nothing to something? How does this differ from the team as the venture matures — that is, the team that grows the company from $10M to $100M in sales?
1. A CEO who knows the business, ideally who has run a start up before, who has strong credentials, strong leadership skills, and is hands on. It is equally important that the CEO is “coachable” and not a control freak. (Investors will shy away from CEOs who think they know it all, or who expect unrealistic valuations and an an excessively large piece of the pie.) The CEO should be seen as someone who is capable of raising capital.
2. A founding technologist who either invented the underlying IP or who knows it in great depth and who has the ability to lead a technical team in product development. Additional team members who are engineers or technologists thatb report to this founding leader are important as well.
3. Someone who really knows the market well and who is influential on the team.
4. A chief operating officer (COO or similar title) who can manage the team and the milestones. This person is usually not the CEO, but sometimes a single person can do both. The skill sets are somewhat different so it is more usual that it is not the same person.
5. A good advisory board. These are people from industry who can help and who are willing to do so without taking significant cash out of the company.
The entire founding team is expected to be motivated with generous equity, but equity that vests over a four year period. The management team usually owns about 30-45% of the venture after Series A. Additioinal equity is set aside for employee option pools. Equity among the individuals varies based on whether they were hired guns or true founders. Salaries are typically modest, often a bit below market due to equity compensation, with the CEO earning nom more than $200,000 after Series A. Salaries can be expected to adjust to normal market rates after the company achieves profitability, usually several years after start up.
Generally a CFO can be hired later. Similarly, a professional sales force is not needed much before the product is released, with the exception perhaps of the sales VP.
Once a company has penetrated the market and emphasis shifts from start up to growth, it is not unusual for new management to step in. Often the founding CEO must step aside for someone who has experience with rapid growth. This is a different skill set than a founding CEO or a Fortune 500 CEO. The founding CEO is a strong and visionary leader who is creative. The Fortune 500 CEO is a good politician and primarily a manager and listener. But the high growth phasse CEO is one who may not have the creative talents to start a company, but one who is very good at running an efficient set of systems in a procedural way, a “business pump” so to speak.
It is well known that many new innovations occur by borrowing a concept from a different field and applying it to a current problem. Some authors call this “technology brokering”.
As an active pilot, I have always been impressed with the tremendous safety record of aviation. Commercial airlines are as much as 100 times safer than driving automobiles on a “fatalities per passenger mile basis”. General aviation is 10 times safer provided the pilot has greater than 1000 hours experience.
This safety record is largely due to the vigilant practices required by the FAA. Aircraft must have in depth annual inspections. Pilots must meet currency requirements. Regulations are defined around safety. Every accident is investigated and the causes are incorporated in one way or another into improving aviation safety.
In stark contrast, I am extremely unimpressed with the safety record in hospitals. Patients are often given improper medication doses. Unnecessary infections occur frequently. Changing of shifts causes discontinuities in the treatment of patients, sometimes leading to errors, even fatal errors.
I have often thought that if the medical field, particularly the management of hospital care, were able to borrow the best practices of the FAA (at least at an abstract level), the safety in hospitals could be improved dramatically.
Yes, potential liabilities causes errors to be buried rather than reported. But isn’t there a way to change the system to require or incentivize the reporting of mistakes so that we can learn from them. How can the best practices of the FAA be transformed into the field of health care to improve safety? Feel free to post.
Interesting article on how technology transfer can prosper during hard times.
I posted this in response to an Innovation Daily article entitled “Is the Venture Capital model dying?”
Venture Capital is clearly not just in a cyclical downturn. But its problems are not about invention value and title. Venture Capital is using an old business model not fit for the current period. The 10 Year Fund that invests $5M per company and expects IPOs when investments reach $10M in revenue doesn’t work. SOX has forced the IPO threshold to $50M. VC investees cannot normally achieve $50M inside a 10 year fund and they need much more than $5M to get that far.
The model is broke. Fund life may need to 20 years and investments of $25M each. The longer life will force ROIs way down and make VC funds difficult to raise. Further, the partners in the VC funds are not worth the 20% fee (management fee, carried interest) that they charge. They just have not been adding that kind of value. Lastly, the VCs that contributed to or caused the Internet bubble were rewarded, not punished. No wonder the model is broke.
