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Here’s the program.
Andrew Warner: Hi, everyone. My name is Andrew Warner. I’m the founder of Mixergy.com, home of the ambitious upstart. And the question for today is how does the venture capital process work? Joining me is Jeffrey Bussgang. He is the author of “Mastering the VC Game,” a book which shows how to get from startup to IPO on your terms.
Jeff is a venture capitalist with Flybridge Capital Partners, and before that he was an entrepreneur who co-founded Upromise which was acquired by Sallie Mae. This interview, like his book, will go through the funding process in very simple terms.
Many of you funded entrepreneurs who are listening to me will already know much of this stuff. So, I’ll ask Jeff to add some color to his explanations by including some of the stories from the experiences he’s had in the venture capital and entrepreneurial world. So, Jeff, welcome to Mixergy.
Jeff Bussgang: Thanks so much, Andrew. Since you told me I should do this, I’m going to show you the book.
Andrew: Hold it up a little bit higher. I really want people to see this book. If they want an explanation of the VC process, I don’t know of a better book than that. Now, let me show you what I do.
I read all my books on my iPhone. I know I need a bigger screen or the actual book, but I prefer this except for the cover. Do you see this cover? Look at what they did to your cover.
Jeff: That’s terrible.
Andrew: That’s like the kind of cover that I might create using Microsoft Word. All right. There might be some kind of restriction on who wrote it or who designed the cover for the paper version. They didn’t get the rights for the Kindle. I’m just glad that you made the book available in the Kindle because that’s the way many of us are reading it today.
Jeff: It’s actually funny. There was a fight between Amazon and Penguin, my publisher, when the book came out, and the Kindle version was not available upon release. It took another 30 days to have those two guys settle on the royalty scheme.
Andrew: Well, I’m glad the fight was won by the good guys. I’m glad that whoever won it that I get to read it this way.
Jeff: You get the benefit.
Andrew: So, let’s start off this way. I want to understand what the process is like when it works well, the VC entrepreneurial birthing of a business. Can you give me an example of a situation where that’s worked well?
Jeff: Yeah. First, I’ll tell you, in general, it works best when there’s a lot of open communication, trust, and honesty. I know that sounds very simple, but because entrepreneurs are selling VCs and, in turn, VCs are selling entrepreneurs, at least, the good ones in every interaction sometimes you gloss over the hard truths and the hard challenges that you face in building these businesses. I think the best way this can work is when people are very direct and honest about the challenges and articulate about their plans to overcome those challenges. That helps build trust between all parties going in.
Andrew: Okay. All right. Here’s the thing. We know the rags to riches, non-funded entrepreneur story. Even funded entrepreneurs fantasize about having one of these what they call “lifestyle” businesses because it’s simple and it’s clear. And you build a business and you work like mad and you earn a few pennies.
You work like mad and you parlay those pennies into dollars and those dollars into big bank accounts with lots of money and, more importantly, a big company that you could be proud of. Maybe, you sell it. Maybe, you live off of it, but it’s a clear, simple business process. My dad built his business that way. His dad built his business back in the old country that way.
The venture capital process, we know it. We also hear about the issues along the way. I want to hear when it works well. What are we aspiring to? Tell us a story that will help us say, “Okay, this is why we need to listen to what this interview is going to be about. This is why we need to take notes. This is why this process is worth our while because it’s what?”
Jeff: Well, first I should say, my dad built his business the same way. My father was a Holocaust survivor. He came to the U.S. after the war and started a business with no outside funding and built it hand-to-mouth, customer by customer. So, I grew up with that model.
This model’s a new model. It’s a new model that’s only been invented for over the last 30 years. One great success story that I talk about in my book is not a sexy business to consumer company, but rather a business software company called ConstantContact. ConstantContact is run by a woman named Gail Goodman who in the wake of the crash teamed up with an entrepreneur in 2002/2003 and had a vision for small business communication using email marketing techniques.
At the time, email was not a very popular medium. At the time people didn’t want to hear about small business marketing, and at the time, as Gail says, being a first time entrepreneur, being a woman in the wake of the crash, it was a very difficult to sell. Gail was able to raise money, despite pitching a hundred VCs, from only one or two. But those one or two VCs helped team with Gail to create a fabulous company.
Today, ConstantContact is used by tens of thousands of companies. They went public in 2007. It’s now got a six or seven hundred million dollar market cap, three quarters of a billion dollar market cap, and Gail is driving that company forward to being an even bigger business.
I think the thing that is so impressive about the story when you read it in the book or when you learn more about Gail Goodman and ConstantContact is the tenacity and the vision that she had for the big business. You said, Andrew, small businesses sometimes have small visions. Gail had a very big vision, which is that every small business on the planet should be using email marketing through this service and pursue that vision with great effort and tenacity.
Andrew: It looks like we have a little bit of an audio problem here. Your audio is going in and out. Since we can’t fix it during the interview, I’ll have to see if we clean it up afterwards. Sorry to the audience if it’s a little up and down, but we’ll work on it.
Why did she need venture capital? I want to understand why venture capital money helps a business grow, because you listen to guys like 37Signals who are really anti-venture capital and they make good points. They say a company like that could build up a small user base of small businesses, add more features, add more businesses, add more revenue and grow organically.
How did it help her to have that infusion of cash?
Jeff: Well, I think any business has that option, almost any business. But the businesses that are technology centric where you have a big vision that you want to build against and sell against and the businesses where you need advice and help around the table, I mean, the best venture capitalists really make the business successful through their advice. They’ve seen the movie tens of times, hundreds of times across the partnership. They know how to bring both capital and resources but people, business development assistance and a broad range of value ads. So, it’s not just a . . .
Andrew: Can you be more specific in this case or maybe in another case? How has having the advice of a venture capitalist or the money of a venture capitalist or the connections of the venture capitalist helped an entrepreneur? I want to really get a good example of how this works and then dig into the process.
Jeff: I’ll give you another example. Another woman entrepreneur I profile in my book is Dr. Marsha Moses. Dr. Moses is a researcher at Children’s Hospital in Boston and an expert in cancer diagnostics. She discovered a biomarker in urine that allows you to pee in a cup, and she will tell you what kind of cancer you have, if you indeed have cancer, an extraordinary breakthrough in cancer diagnostics.
The thing that’s so powerful about what she discovered is the breadth of the applicability. It could be for ranges of cancer — bladder, breast, prostate, what have you. But Marsha was not a businessperson. And Marsha knew that she needed a lot of capital to build a big company that could solve this diagnostics problem globally.
And so, we teamed with her and another venture capital firm. We helped her negotiate the license with Harvard. We helped her build a team of entrepreneurs who could take the company forward and commercialize the technology. And we helped her fund the company so that the team could be attractive and business partnerships could be developed. That company is now live today with a urine-based biomarker to detect bladder cancer.
So, it’s got to be a mix of a company with an entrepreneur who thinks they need help because no entrepreneur is complete and where capital can really make a difference to bring something to commercialize technology, bring it out of a lab, or accelerate development.
Andrew: All right. Let’s go on to the details. Actually, before we get to that, here’s what I’m going to ask just so the audience knows where we’re going. I’m going to ask about the structure of a VC firm. What’s a general partner, or who are the principals? What does an associate do?
I want to find out about how a VC makes money, if you don’t mind me asking about how much money you’re making or how you’re making your money. The pitch that an entrepreneur needs to make to you. Those are the kinds of questions we’ll get into, but you say that you helped open doors to Harvard. You and I now know each other. We’re about to spend about an hour on the phone together.
If I reach out to you and say, “Hey, I’ve got an idea. It needs an introduction to Harvard,” and you respect the idea and think it’s a good fit for Harvard, wouldn’t you make that introduction? Why do I need your money in order to get that, and why do I need to give you a piece of the business in order to get that?
Jeff: You know, Facebook and LinkedIn and relationships in formal networks absolutely can get you email addresses and phone numbers. The real question is when you’re face to face with, in this case, a technology license officer and you’re negotiating a deal or when you’re face to face with a corporation with whom you’re trying to strike a partnership with, and this may be the first time, the second time, the third time that you’ve ever done this. You know, the venture capital firm and the collective partnership will have done this hundreds of times, and just knowing that capability, that breadth of experience is going to be that much more valuable.
By the way, Andrew, as every entrepreneur knows, these early things, the early decisions you make, the deals you strike, the team members that you hire, those early founder decisions make or break the company.
Andrew: Okay. What I was getting at was that you probably are working harder at making that introduction, spending more time on that introduction, and bringing more people to help make the connection if you have a vested interest in my business than if we’re just friends here who chatted for an hour on Skype.
Jeff: I think that’s absolutely right. And I’m not only going to make the introduction, I’m going to follow through. I’m going to be shoulder to shoulder in the negotiations. I’m going to help you recruit team members. That’s what VCs do. They don’t just forward a LinkedIn message and move on. They’re in the business, and they’re paid to be hands on, helpful company builders.
The way I look at it is it’s just like a service provider. You hire the best lawyer to give you legal advice. You hire the best accountant to give you accounting advice. You want to hire in exchanging equity for cash, you want to hire the best VC you can find to give you great company building advice.
Andrew: General partner, what is a general partner?
Jeff: Let me back up and talk about firm structures, just to help frame that. So, a venture capital firm is usually structured as a partnership, and there’s a management company that owns the economics and the decision rights for that organization and that partnership.
And then, there are individual funds with Roman numerals typically attached to then — Fund I, Fund II, Fund III, and so on. There are general partners that manage those funds that make investment decisions and that deliberate on major portfolio company activities. And then, there are some of those general partners that are owners in the firm.
So, I call them owner-general partners who own the management company and really control the economics and the decisions and employee-general partners who are employees of the firm and may sit on boards and have the partner title but may not be truly an owner in the enterprise.
Andrew: Okay. And . . .
Jeff: What do they do?
Andrew: Yes. I was going to move on to the next person and then ask, what do they do? You’re right. What do they do?
Jeff: The general partner is responsible for making investment decisions. They make the thumbs up/thumbs down decisions on the investment. It is often the case that before you can get a term sheet from a firm you have to meet all the general partners, and all the general partners need to vote positively to make that investment. And so, many times, you’ll have interactions with one general partner who will be very enthusiastic about what you’re doing, but in truth you need to get the full partnership support in order to affect the deal in the relationship.
Andrew: Okay. Principals?
Jeff: Principals can mean different things, but they’re often junior partners in training. They’re often resources that the partners use to leverage their time. They do a lot of the detail diligence They may not sit on the board but be a board observer for the company. They’re responsible for sourcing opportunities.
And so, when you get called by a principal, you take it seriously but know that the principal can’t make the investment decision. It has to be a full partnership investment decision. People have to be very careful, though. They can’t blow off the principal.
You know, a lot of people will get called up by an associate, who is just a younger version of a principal or a principal and brush them off. That only sours the relationship with the firm as a whole. So, you’ve got to treat these younger up and coming professionals with respect, but also know that they’re not the decision maker.
Andrew: How does an associate rise up and become a principal?
Jeff: They do it by finding deals that the partnership decides they want to do. So, they have good deal flow, good sourcing skills, good relationships in the entrepreneurial community. And then, also, they have good business judgment, and the partners begin to respect their business judgment.
And so, it’s a very small industry. I mean, in the United States, there may be 500 active firms at best, 400 or 500, no more than a thousand or so senior professionals who sit on the boards of these companies. And so, to make your way into that small circle is a very difficult path.
Many of the associates and principals entrepreneurs meet will never become partners in firms. They will be there for a few years and then move on to another job. And so, you’ve really got to dig in and figure out what their motivation is, what they’re trying to achieve, and where they are in their careers.
Andrew: Why? How would it help me to know where principals go next? When I say me, I mean the audience and I as entrepreneurs.
Jeff: In any dealings that you have in business, not to get too philosophical on you, but in any dealings you have in business, you want to get to know the person and the motivations that drive them. And so, when you’re dealing with venture capitalists, they’re humans too. They have jobs. They have careers. They have concerns. They have things they’re trying to achieve in their life, and knowing that underlying set of motivations will help you in your business dealings with them.
As I said in the very beginning, entrepreneurs are trying to sell VCs. It’s authentic selling. You’re not trying to spin people. But in authentic selling, you need to build the relationship, and you need to understand the motivation behind the person you’re selling to.
Andrew: How long would somebody stay as an associate before, say, rising up as a principal or know this is not working out?
Jeff: You might see two or three years from associate to principal before they move on. And then, again, there may be another three years from principal to partner. Those are rough estimates. Everyone has stories, I’m sure, of faster or slower movement. But if you’re around for three, four years and you haven’t been promoted, you’re not likely to be there at the firm for a long time.
Andrew: Okay. What share of the business do you own as a partner?
Jeff: Well, employee-partners and owner-partners have different answers. Venture firms typically run in one of three models. One model is the CEO model. There’s one senior partner who runs the firm, has the majority of the decision authority, and has a disproportionate amount of the economics. And that’s the CEO model firm. And there’s some terrific firms where there’s one strong leader that drives the enterprise.
Other partnerships, like Flybridge Capital, my firm, are equal partnerships. Each general partner has an equal voice, an equal amount of decision authority, and equal economics.
Other firms are hybrids where the more senior people may share in the economics more than the junior people. It’s one of the most sensitive things that entrepreneurs don’t ask about. When you’re across the table from a partner, which is, how senior are you in your firm? And the real metric for that, which I say in the book, what you should ask is how do you split carry at your firm and how much carry do you have?
VCs are always asking entrepreneurs with their co-founders, “How do you two divide up responsibilities? How do you two or three split your equity?” It’s only fair, I think, for turnabout. This is an equal relationship. You’re vetting each other. You’re choosing each other, and entrepreneurs need to have the courage to really push on the VC to know their place at the firm.
Andrew: By split carry, you mean how you split the percentage of profits at the firm?
Jeff: Yeah. So, I didn’t explain carry.
Andrew: Actually, we’ll go into that in a little more depth later. But that’s a question that an entrepreneur can and should ask. How are you splitting up the profits with your partners?
Jeff: You have to do it diplomatically, but I would think at the right stage in the process as you’re getting to know the partner that you’re considering working with, it’s very fair to say, “What kind of partnership do you have? How do you make decisions? How do you split the economics, and where is your position in that?”
Andrew: Okay. Entrepreneurs in residence. Who are these guys?
Jeff: Or gals.
Andrew: Or gals. Are there any female entrepreneurs in residence? I don’t remember hearing of any.
Jeff: Oh, yeah, sure. There was one recently at SouthBank. I think she’s moved on, but I was with one of the SouthBank partners today talking about that. But, yes, entrepreneurs in residence. VC firms are talent magnets. The best VCs gather talent like trophies that you put up on your wall. And when you come across a great entrepreneur who you want to be in business with, either as a starter, somebody who can create a company from scratch, or as a senior manager that comes in later to team up with the founder or as an advisor or board member, you want to look for a way to get close to them, and that’s what the entrepreneurs in residence are. They’re typically senior executives, former entrepreneurs or former senior executives who the VC aligns with, brings into their tent, into the family in the hopes that they will start a business or help them find a new business or help manage a business.
And so, as an entrepreneur, when you meet those people, what many an entrepreneur will tell you is you need to be careful. You need to be careful. The paranoid side of you needs to be careful that they don’t take your idea and suck all the knowledge out from you and replicate it somewhere else.
You know, if you’re in the mobile payments market and you meet an entrepreneur in residence who is introduced to you as someone who is going deep in mobile payments, it may be that it’s their mission in life is to start a mobile payments company. That company may compete with your mobile payments company. That company may be a good partner for your mobile payments company, or that entrepreneur in residence may become your CEO if the venture capital firm falls in love with what you’re doing but tells you that you’ve got to hire an outside CEO. And here’s one right here that we have on the shelf that we’d love to put in front of you.
So, there are a set of situations where you want to be wary of that entrepreneur in residence, but there are a set of situations where that entrepreneur in residence can be a great help to you because they can go to the VC partners and say, “I’m an expert in this field. I’ve spent a lot of time with this entrepreneur. They’re worth investing in.”
Andrew: What’s the benefit to the entrepreneur of being an entrepreneur in residence?
Jeff: Well, it’s a cushy job frankly, Andrew.
Andrew: It’s not a long-term job.
Jeff: No, it’s a cushy way station.
Andrew: Okay.
Jeff: And what I mean by that is it’s a great way to see a broad market of opportunities. It’s a great way to build relationships with a firm, and as long as you’re smart in how you navigate things, you will build relationships broadly with not only the firm you choose to hang out with but other firms.
And it’s a great way to see and learn a lot as you’re beginning to retool and reinvent yourself from one company to another. It’s a very few that are in existence. Of the 400 or 500 active firms, there are probably a thousand, I would venture to guess, entrepreneurs in residence. So, it’s not tens of thousands of these folks running around.
Andrew: How long can somebody stay as an entrepreneur in residence typically?
Jeff: Typically, it’s 6 to 12 months, maybe 18 months. It’s very unusual to see it happen longer than that. Some firms will use the entrepreneur in residence program as a farm team process. It’s very sensitive to bring someone into a partnership, just like in a law partnership or a management consulting partnership. So, you want to live with someone for a period of time. So, sometimes you see an EIR entrepreneur in residence, come into a firm, hang out for a year, be a part of the team, and then evolve into becoming a general partner.
Andrew: Finally, limited partners. Who are they?
Jeff: Well, limited partners are the ones who make the world go round because they have the money and as Deep Throat said, “If you want to learn about a situation, follow the money.” So, the entrepreneurs get money from VCs, and VCs get money from LPs, limited partners.
And so, in the same way that the entrepreneurs are very sensitive to the relationship with their venture capitalists and their board members, we, the VCs, are very sensitive to the relationship with our limited partners. They are the ones that pay us to manage their money and expect to get a meaningful return from those investments that we make with their money.
Andrew: In your book, you talk in the chapter on the VC structure, you talk about David Hornig and how he became a venture capitalist. I’d like to hear your story. How did you go from being an entrepreneur to VC?
Jeff: Yeah. My story is kind of a funny one in that I really never intended to become a VC. In fact, I didn’t know what a VC was for many years. I’ve always aspired to be an entrepreneur. As I think I mentioned earlier, my dad was an entrepreneur as an immigrant in this country and built an interesting company that I had the benefit of watching it grow over many years in the technology field.
And so, I studied technology. I was a programmer at a young age. I learned how to program in Fortran so that I could do that as a summer job instead of flipping burgers. I majored in computer science in college at Harvard, and then went off to get some business experience at a management consulting firm called the Boston Consulting Group.
I went back to Harvard for business school with the focused intent of being an entrepreneur. I helped start a small software company while I was in business school, which was a great sandbox for me to learn the game. And then, I bumped into or actually was invited to a dinner by a venture capitalist at a venture capital firm.
That was my first experience and interaction with venture capital, and I thought it looked like a fascinating business, but it was not for me. It was a business that struck me was, and one of the partners described it, a mile wide and an inch deep. You didn’t really dig into a company and get a chance to build product, build teams and lead businesses, which was what I wanted to do.
And so, that venture capital firm very graciously introduced me to a couple of their portfolio companies. I ended up joining one of them, an Internet commerce software company in the late ’90s called OpenMarket, which was in its heyday a hot company that went public in 1996. And we had a billion dollar market cap with only $1.8 million of revenue under our belt. So, pre-bubble, a very bubble-like company.
That was a great learning experience for me, and I got to do a lot of things and help build what ended up being close to a $100 million software company. And then, got a phone call from another venture capitalist, and at this point in my career I was learning to listen to venture capitalists when they call me. I was invited to meet with a great entrepreneur named Michael Bronner who was starting a new company, which I joined as his co-founder and president of, called Upromise.
The vision behind Upromise that Michael had was to take all the marketing dollars that large consumer companies spend on points and miles and minutes and direct those to the major stay-awake issue that many American households face, which is saving for college. And that was sort of the central idea that Michael had behind Upromise that we then embarked on building and creating. We started the company out of Michael’s house. We raised over $100 million in venture capital money and built an interesting business.
As I was in the middle of that, I got another call from another venture capital friend. And again, when venture capitalists call me, I listen. He had a terrific opportunity which was out of left field and very unique. These were two friends of mine who had started a new venture capital firm and had invited me to join them in getting the firm off the ground. And that’s when I joined my partners at Flybridge Capital back about eight years ago now.
Andrew: What was it about the offer that drew you in?
Jeff: Well, the thing that inspired me was the opportunity to start a VC firm from scratch and to do it in the context of the current environment. Today, very similar to what we saw after the bubble, which was that you needed to build a new age VC which had capital efficiency as the central theme. You know, building companies with small amounts of capital, investing one to two to three to five million dollars at a time, early stage focused and a small cohesive team in one office, trying to practice the business as we felt it had been successfully practiced in the 1980s and 1990s before the bubble made everyone a bit crazy.
And the other dimension, and this I think is true for every entrepreneur, it’s about who you partner with. I had great affection for my partners when I started this adventure with them and now have even more affection. So, that’s the good news. We actually continue to work well together and like each other, having fun together.
Andrew: I remember when we were doing really well in business. I used to look at these guys who were just starting out and kind of had a little envy for them, saying, “They have so much control over their companies now. They can do anything because no one is paying attention. They can take risks and fail, or take risks and be outrageous and still, and it will grow their business and no one is going to stop them. Then you get back to that stage and then you realize that just is not as much fun as I remember.
Jeff: [laughs]
Andrew: You’re making a complete shift. You’re going into the venture capital world, maybe with a little idealism. Once you’re in there, what did you find that was different? What were you starting to miss about the old world?
Jeff: Well, I will tell you that it is hard to get feedback on this business, in terms of whether you’re good at it or not. As an entrepreneur, it’s really clear in a very short time frame. You put up numbers every month, every quarter, every year. You close deals. You make progress and you build value in the enterprise. That’s typically, for an early stage entrepreneur, a three or four or five year cycle. You have a lot of feedback over the course of those five years.
Venture capitalists have very long cycle times. One of my partners likes to refer to the business as a “get rich slow” business. It takes a lot of time for these companies that you invest in to mature and exit and you need a lot of data points and a lot of economic cycles to figure out whether you’re smart or lucky, or not so smart. So that’s the thing that I found very difficult, frankly, to adjust to, which is how long it takes to see these things through and how long the feedback loop is with those early decisions that you make to invest in companies and hire teams and move forward with strategy and all those things.
Andrew: What indicators along the way do you use to let you know that you’re on the right track?
Jeff: Well, ultimately, our job is to make money for our investors, and so certainly, when you can return capital and . . .
Andrew: I mean before you get to that stage. How do you know, a year in, that you are on the right track? Oh, did you just say listen? Did I interrupt you?
Jeff: Oh, no, no. I said, “No, you’re right. That’s the easy answer that I was going to give you.” but I was going to say that takes time to develop, and so the more nuanced way you know is when you see progress in your portfolio companies. When you see these little fledgling companies, and this is the thing that I find so exciting, when you see them make progress, when you see them ship products that the market likes, when you see them win customer deals, and when you see the entrepreneurs mature in their jobs, many of the entrepreneurs we work with are first time, younger CEOs, and when you see them really thrive and step up, that’s really fulfilling and you really feel like you’re making great progress in what you’re doing.
Andrew: Let’s talk then about how a VC makes money. Fees and carry, what are they?
Jeff: Sure. Those are the two main economic drivers of a VC’s business. And again, as I said before, when you think about working with a venture capitalist, you want to think about what they do as a business and you want to think about the individual that you’re working with as a business partner and as a human being with their own incentives and their own motivations. That’s something that I really emphasize a lot in the book, really understanding who you’re dealing with, both firm level and individual level.
At the firm level, VC firms have a revenue model, like many money management businesses, where they make money on fee income from the assets they manage. So you may pay 70 basis points or 7 hundredths of a percent or maybe one percent in the mutual funds that you buy. VC investors often pay two percent or even two and a quarter or two and a half percent of the fee income as compared to the assets under management. So a $100 million fund that an investor may provide to a venture capital firm, that venture capital firm will make something like $2 million a year in fee income to manage and invest that fund.
Then, the other element of the economics for the VC is what’s called the carried interest or known as the carry. The carry is the percent of the profits above and beyond the capital that the VC returns. And so in that $100 million fund, if the venture capital firm can generate two times their investment over an eight or ten year period, or $200 million, then that incremental $100 million of profit is considered the carry, and they share in that $100 million of incremental profit. Often the carry for a venture capital firm is something like 20 or 25 percent. So if a venture firm can double their fund and it’s a $100 million fund, they may get $20 million or $25 million of profit sharing across the partnership.
Andrew: I see, $100 million profit. They take 20 to 25 percent for themselves. The rest goes back to the limited partners.
Jeff: Right. Now the way the limited partners measure VC funds, like you probably measure your mutual funds, is performance after fees. The more you charge, the higher performance you expect. So, VCs have to be careful not to charge too much, and many have sliding scales and complex formulas with inflation adjustors and fee revenue dropping after five, six, seven, eight years because you really want to be careful not to charge too much because that’s coming right out of the pocket of the limited partner, and those limited partners won’t come back if you’re not returning good capital returns on the investment and you’re just lining your own pockets.
Andrew: You talked earlier about those funds that have the Roman numerals after them. What are those? How do they work?
Jeff: So each fund is typically an eight or ten year cycle, where an investor, a venture capital firm will invest in a number of companies — 10, 15, 20 companies out of that fund. When that fund is fully invested, including capital that is reserved for follow-on investments, which typically happens every three or four years, the VC firm will [interference] another fund. For example, Flybridge Capital, we raised our first fund and that was the founding inception of the firm. Then we raised another fund in 2005, our second fund. Then we raised another fund in 2008, our third fund, which is the current fund that we’re managing and investing out of.
Andrew: And each fund has its own agreement on fees and carry and everything else.
Jeff: That’s right. Each fund is a separate deal with the limited partners who invest in that fund. Typically there’s consistency across funds, but there are times when venture capitalists have historically gotten greedy during the good times and were a little aggressive on terms. And then in the more recent years, when times have been more difficult and the venture firms are struggling to raise their capital, they’ve been more lenient on terms, and the LPs in turn have been a little tougher on terms.
Andrew: All right.
Jeff: For the entrepreneurs, I would say, all that is interesting. But what’s really relevant for the entrepreneur is to know the VC firm they’re talking to and where they sit in their fund cycle. Should I talk a little bit about that?
Andrew: Yeah, please.
Jeff: So what’s really important for entrepreneurs to understand is where that VC fund is in their own fund cycle and with their business. If they are still making new investments out of that fund, or are they really closed to new investments, focused on managing their portfolio and supporting the portfolio and waiting to make new investments when they raise a new fund. The real horror stories you hear are entrepreneurs who waste a lot of time with VCs, educating them, pitching them, answering their questions, only to realize that, that VC firm is out of money and doesn’t have the capital to invest. And VCs can say, oh I’m managing a $300 million fund or a $600 million fund, or I have a billion dollars of capital under management. And all of that is interesting, but not totally relevant to the individual entrepreneur. The individual entrepreneur cares about right now what is the situation at hand. Can you make new investments? What percent of the fund is already committed, and do we match your investment criteria? Because if not, why am I wasting time with you?
Andrew: How do you find that out?
Jeff: Well, I think again, entrepreneurs need to have a lot of courage in asking questions. The due diligence process is a mutual process. Some people use marriage as a metaphor for when entrepreneurs and VCs decide on each other. And one of the things that I really try to do in the book is, if I can hold it up again, is I really try to help empower entrepreneurs to help give them the tools to have that conversation with the VC and to have a level playing field of knowledge when they’re dealing with the VC.
Andrew: By the way, you held up the book . . .
Jeff: So the short . . .
Andrew: Sorry, go ahead.
Jeff: Well, I was going to say the short answer to how you find out is you ask, and you ask directly. When a venture capitalist is asked good, direct, thoughtful, penetrating questions by the entrepreneur, they react quite positively. When the entrepreneur shows naiveté, and doesn’t ask questions, and is neither intellectually curious, nor demonstrates depth and understanding of the situation that they’re in, the venture capital firm views it less positively.
Andrew: So where are you guys in your fund? And what is your percent of carry?
Jeff: Yeah, so we are midway. We raised our fund in mid-2008. We are about two years into it, so kind of halfway into the fund’s cycle, and we are an equal partnership. We have each of the partners have an equal amount of carry in the fund and an equal amount of decision authority.
Andrew: So Jeff, an entrepreneur has to figure out how to make things work with his employees, with his partner, and how to find the right employees and how to stay on top of them as a manager. He has to figure out what the market wants yesterday and what it’s going to want tomorrow and how what he thought it wanted is different. He is going to have to figure out the technology and how to get the software and the hardware to do what it needs to do. In addition to knowing its business, the entrepreneur needs to figure out this whole process that you live in. This is your world. It’s like going into a car salesman and expecting to know as much as the car salesman about what the prices are and how the process works. It’s such a big disadvantage that you’re walking into. Is it possible to level that disadvantage at all, considering all of the other obligations that an entrepreneur has?
Jeff: Well, first I think you’re totally right. It is a disadvantage. I’m not going to say it’s fair or not fair, but at the end of the day, venture capitalists do tens of deals a year, as compared to, when I was an entrepreneur I was involved in two or three fundraising efforts over five years. So it’s a really huge information asymmetry problem. And the only way I know to solve an asymmetry problem is to do your homework, and entrepreneurs who do their homework can really level the playing field. What’s extraordinary today, as compared to ten years ago when I was raising the Series A for Upromise, is that there are a hundred times more information available on blogs and books and shows like yours, video blogs. I mean, the amount of information available to entrepreneurs is extraordinary today as compared to previously. And that’s a good thing. I would tell you that entrepreneurs who do their homework can very quickly get up to speed. The other thing I would tell you is that you have got to get good advisers. Entrepreneurs need to hire a fantastic deal lawyer and potentially a senior executive, serial entrepreneur who’s been through the cycle before who can help guide them through the process.
Andrew: You need to hire somebody who’s been through the process to basically manage the process for you.
Jeff: No, don’t let them manage it. That’s the last thing you want. You want them behind the scenes whispering in your ear like a conciliare, but you have to be the one in charge. When a VC sees an entrepreneur delegating the fundraising process to an investment banker or to a senior executive or friend or advisor, it’s a yellow or red flag.
Andrew: Why, isn’t it a good thing to delegate the parts of the business that you’re not good at and focus on the ones that you need to be great at?
Jeff: You know, capital raising is so fundamental to the entrepreneur, and the relationship with their board is so fundamental that you can’t delegate that. The CEO of Hewlett-Packard, if I may use this analogy, can’t delegate board relationships with the HP board. They need to have direct relationships with their shareholders. They can’t delegate relationships with the hedge fund that owns ten percent of the public stock. You have to really focus on building those relationships directly. Yes, get advice. Yes, get a lot of input, but absolutely manage that relationship directly, just like you would with your own management team.
Andrew: Okay. I think you said that you funded not a single business that came to you through a cold call.
Jeff: Yeah.
Andrew: Explain to me, why do entrepreneurs love cold calls so much?
Jeff: You know, that is a mystery to me. Anyone who does the slightest bit of homework can get to almost anyone else that they need to get to. You know, a salesperson trying to sell to a chief information officer at Staples would never pick up the phone and cold call. They would look for an edge, an angle, a way to network in, meet them at a conference, or find a peer that was a customer that can refer you in. It’s the same with the venture capitalist. The best references for VCs are entrepreneurs who have made them money. If an entrepreneur who has made us money calls us and says this is a business you should learn more about, this is an entrepreneur you should meet, we always take that meeting.
Andrew: Okay.
Jeff: If we get a random email from our website and a random business plan, I’ll tell you, it’s very hard, the odds are very long. We’ve never done it. We’re open to it. You never say never, but we rarely, rarely see that anywhere in the industry.
Andrew: Okay. So an entrepreneur’s listening to this, maybe he’s a young guy. He says, “I don’t know very many people in this industry yet. I’m just entering it. How do I find out, how do I connect with someone who’s made Jeff money?” What’s a good way for them to connect with an entrepreneur?
Jeff: Well, I used to make money as the highest bar. They’re obviously other terrific ways to get networked in. You know, people we respect in our network, people who sit on boards with us, people who we just think are terrific people. Venture capitalists are in the business of finding you. Entrepreneurs don’t, perhaps, realize how much energy and time venture capitalists spend on being open and accessible and finding great entrepreneurs. So, if you don’t know anyone, find a path, show up at an event or at a conference, use university connections, use your friends. You know, it’s a clear sign of a great entrepreneur if they can be scrappy and resourceful and find a way to get to the right investor, because that’s a clear signal that they can be scrappy and resourceful to find a way to get to the right prospective hire and scrappy and resourceful and find a way to get to the right prospective customer.
Andrew: Give me an inspiring story. Do you have an example of an entrepreneur who found you in a way that shows you that he’s scrappy?
Jeff: So I was at Harvard Business School, where there was a case written about Upromise that I was involved with and sitting in on the class. At the end of the class, a student came up to me, and this is a room of a hundred students, and I probably did three classes that day, so I saw about 300 students. And a student came up to me, introduced himself, and said, “I’m an aspiring entrepreneur. I’m working on an idea with an MIT professor and I want to meet you, not to pitch you on the idea, but just to get your advice. Will you take a meeting?” And I said sure.
So I took that meeting with that entrepreneur, and I listened to what he was working on with this MIT professor and I gave him some advice. A few months later, he called me again and said, “Jeff, I’ve listened to your advice, as well as others, and I’ve done a few things. Let me update you on what’s happened with the idea.” And I took another meeting, and I saw his progress. And then a few months later, he came back and said, “I’ve made more progress. Let’s get together and talk more.” What impressed me about this entrepreneur, who we eventually invested in, and his name is Eric Paley, and Eric was the co-founder with his partner, Michael Rosenbloom, of a company called Brontes Technology, that we invested in and very successfully. Eric sold it to 3M for just under $100 million.
What we learned in that process was we get to see the movie. We got to see the Brontes movie. It wasn’t just a snapshot, and investors like to invest in movies. You like to see how things evolve over time. You like to see the entrepreneur make progress. When you tell an investor, I’m going to do A, B, C and I’m going to accomplish those three things in the next six months, the natural thing for an investor to say is, “Before I write a check, show me. Let’s stay in touch and over the next six months, let me watch you and see you do it.” Now, entrepreneurs will say, “But I need to raise money now, so I don’t have six months.” That is a chicken and egg problem. You need the money to build the company, but you need the company’s progress to raise the money. In truth, the only way to get around that is to either self-fund or convince someone to build a relationship over a long period of time before you have created the company, so that when it comes time to create the company, you have a history and relationship with that investor.
Andrew: Or, find an angel?
Jeff: Or find an angel. Or, you know, self-fund or customer-fund or get a government grant, an SPIR Grant and bootstrap your way into a point where you can then answer some of the questions and address some of the issues that the venture capitalist will have for you.
Andrew: Eric, I think, in one of the quotes in your book, said that he pitched 30 to 50 VCs. That means 30 to 50 companies that he had to make sure were at the right stage fit, that didn’t need him to have more progress than he had, that invested in his kind of company, that invested in companies in his part of the country. That’s a lot of research. How does an entrepreneur do that on 30 to 50 companies?
Jeff: You know, there’s an incredible amount of information available on venture capital firms publicly on the Web, both at their own websites as well as some of the various news sites that cover the venture capital industry. peHub is one. “Fortune” magazine has a new newsletter called the “Term Sheet.” So, you know, it’s really straightforward to go online, and it’s really straightforward to talk to people in the industry. Venture capitalists, they’re very few of them, and they tend to be very well networked and well connected. And so it’s pretty straightforward to reach out to people and reference check them.
In fact, it’s very easy to cold reference check venture capitalists. People don’t appreciate this. When you cold call a CEO and say, “I’m thinking of working with Jeff Bussgang at Flybridge Capital, and I know you’ve worked with him in the past, can you tell me about him,” that CEO will almost always take that call, because they will feel obliged, in this sort of brotherhood and sisterhood of entrepreneurship, as well as feel obliged in the context of being helpful to the investor that they have worked with in the past, they’ll feel really obliged to be helpful and work with the entrepreneur. And I say in the book, this is very important, when you are thinking about and considering working with a venture capitalist and a venture capital firm, check their references.
Again it sounds very simple, you would never hire someone without checking their references. A VC is a partner that you can’t fire. You have to check their references thoroughly — the ones that went well and the ones that didn’t go well — to really understand that firm and how they are motivated.
Andrew: Okay. We’ve done our research. We found somebody to introduce us to you. What do we do next?
Jeff: Well, I think the next thing is you have a tight summary of what you are doing and how it’s unique, and you put that together and use that as a teaser for the individual who is brokering the introduction. You try to get a meeting, phone call, less preferable than face to face, but either will do, and you try to get pass the first meeting. The first meeting is obviously the most important thing, like in an interview, is to get to the next meeting and to establish creditability and interest. The venture firm may give you feedback that they are interested but need to see more, and you want to be very precise with getting their feedback. To ask them, “What more do you need to see from me? If I come back to you with A, B, and C accomplished, would you be interested in meeting and talking about this more?” That’s the kind of dialogue you want to have in that first meeting.
Andrew: Okay. You get somebody in the door who you are interested in. What do you do internally with that person after you have that first good meeting? And I know that we’re coming up to the top of the interview, so we don’t have that much time for it. But take a as much time as you need. I want to be respectful of your time is what I mean.
Jeff: So, in just the last few minutes, we, venture capital firms do a lot of due diligence on the company, on the technology, on the market, and on the team. And so a prospective entrepreneur needs to be prepared for all of that. And one of the things I coach entrepreneurs to consider is, how do you get ahead of the venture capitalists. How do you anticipate the questions they will ask, the information they will need, the people they will want to talk to, and how do you help package and prepare that for them? Venture capitalists are busy people. They have a lot of competing priorities, and you want to make it as easy for them as possible to conduct their diligence and be convinced of your market opportunity.
Andrew: All right. I want to ask how you do that, but I also want to be respectful of your time. How about we do this? I cannot recommend this book enough. I always wished that a venture capitalist would do this, that somebody would do this. But it comes with so much more authority when it comes from you, somebody who is in the business, who’s been on both sides of it. So the book is “Mastering the VC Game.” I think I just scratched the surface. There it is.
You talk about term sheets in there. You talk about when the relationship goes bad, you talk about why it goes bad, and you do it in a way that’s engaging, because you tell stories, and you do it in a way that’s simple so that we could absorb it without devoting, I don’t know, without having to go to Harvard and spend a whole semester trying to understand it. The book is really well written. I put my personal reputation on the recommendation that I give to this book. I’m really glad you did it.
Jeff: Thank you, Andrew. It took a lot of time and it also took some courage. I’ll tell you honestly, because . . .
Andrew: Why?
Jeff: Well, revealing the inside story, putting myself out there, as one does in a blog, as I do in my blog and other VCs who blog, it takes courage to put yourself out there and try to embark on something like this. There was a lot of effort, but it’s really, I think, paid off emotionally. I don’t mean paid off financially, that’s certainly not the focus. And by the way, I’m donating the majority of my proceeds to Endeavor, which is a global entrepreneurship focused nonprofit, which I think is a wonderful organization. So for me, it was just about trying to create a product that would really be helpful to entrepreneurs.
Andrew: Well, I know you have. Thank you for doing it. Thanks for the interview too. It’s great meeting you, Jeff.
Jeff: Thank you. I really appreciate you doing it.
Andrew: Thank you all for watching. Bye.
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