Slow Capital and Capitally-Disciplined Start-ups

I was recently reading through Seth Godin’s new free ebook (you should get it … it’s 90% great stuff) and saw Fred Wilson’s page on Slow Capital.  I remember reading his original blog post on slow capital and thinking it was a bit motherhood-and-apple-pie at the time… but seeing him dedicate his one page in Seth’s big-ideas book to this concept made me consider it a bit more.

I like the notion of slow capital.  I think it’s the other side of the coin of agile / lean, capitally-disciplined start-ups.

updated 1-04-10 a quick side note:  Increasingly, I’m not a fan of the term of “capitally efficient” applied to start-ups because I think the notion of efficiency is closely coupled to the concept of “minimal” and I think there are plenty of situations that start-ups need to raise / spend / invest more capital if they are doing it in a purposeful, disciplined way. For example, a sudden, threatening appearance of direct competition necessitating an increased investment in development.  And, remember that in almost every case, people (head count) will be your largest expense within a start-up; adding employees too early is very inefficient.

In particular, I think there is a direct relationship between the stage and the need for capital efficiency. To be clear, the younger the start-up the more benefit there is to spending as little as possible; so, in this case, the term “efficiency” makes sense.  As a start-up matures and begins to put good execution and product/model experience successfully behind it, “capital discipline” is a more appropriate notion.

A start-up has capital discipline when:

  1. it raises just enough capital (plus or minus some margin of error) to move the business to the next (financeable) milestone
  2. it practices a lean-orientedcustomer-development / minimum-viable-product strategy in order to make informed, measured progress
  3. it invests to maximize the business opportunity independent of timeframe

I think the notion of a start-up having capital discipline goes hand-in-hand with the notion of Slow Capital.  According to Fred Wilson, Slow Capital

  1. doesn’t rush to conclusions and doesn’t expect entrepreneurs to do so either
  2. flows into a company based on the company’s needs, not the investor’s needs
  3. starts small and grows with the company as it grows
  4. has no set timetable for getting liquid: slow capital is patient capital
  5. takes the time to understand the company and the people who make it up

This style of investment is considerably more time-and-place appropriate today than the big first rounds and if-we-build-it-they-will-come operating plans of the late 90’s and early 2000’s.  Furthermore, I like that there’s a rich subtext to each of Fred’s statements that describe Slow Capital.

Take #2…what does this even mean? What sort of needs do investors have to PUT money into a start-up?

Here’s a swag at a bit of context to this statement: Typically, when VC firms raise a fund, management fees are typically 2% annually.  For example, if you have a $900m fund, that’s $18m per year in management fees (over a 10-year fund) that must be PAID BACK to the limited partners according to a disbursement plan.  To avoid a discussion of internal rate of return (IRR), imagine that the firm wants to return AT LEAST 30% on the fund.  That means, for $900m invested, at least $1.35 billion should go back to the limiteds over ten years.

So what?  Well, if you’re shooting for returns of that size, putting $3m into a company and getting $30m out (a truly great 10x return) doesn’t constitute a drop in the bucket relative to what you need to return to your limited partners.  Therefore, folks running very large funds really “need” to put at least $10m-$20m into that same company and hope for at least a $100m-$200m exit in order to have a chance at returning the $1.35b over the life of the fund in our example.

THAT is an example of “investor’s needs” – and it may or may not have ANYthing to do with the needs of the start-up…and in most cases, results in something that adds a significant amount of risk:  over-funding the company.  And while it takes two to do the funding tango (both start-up and VC saying ‘yes’), it’s generally understood that an over-funded company is more capable of funding / accommodating sloppy execution instead of being required to choose a single path of focus and execution.

I also think there are a couple of concepts missing from the notion of Slow Capital.

More on this soon…


Product versus Services Orientation in Start-ups

When early-stage companies operate with new products or in nascent markets, there can commonly be strong pull from customers to behave like a services-oriented business to gain favor within customers, educate the target market, or rally support from the business’s ecosystem partners.   And providing more instruction / hand-holding / customization can feel like the right thing to do when customers don’t understand your business’s value proposition, how you may drive their future success, or how you might enable them to cause (or avoid) disruption and disintermediation.

I believe that carefully thinking through this very typical situation can help start-ups avoid a common trap and better focus on executing towards long-term vision.

My bias favors product-oriented businesses even though there are plenty of examples of successful services-oriented businesses. I tend to agree with the common saying that service businesses “add” where as product businesses “multiply” comes from the (difficult & expensive) human-capital requirement to scale within service-oriented companies.

First,  three quick definitions:

Product-orientation: a business that generates the predominance of its revenue from products it has created.  The selling motion may be varied (direct, indirect/channel, or SaaS) but the “thing” that is sold is something that is made once and sold over and over again. This includes subscriptions to web-based data/analysis products that change in content but are, in essence, the same thing delivered repeatedly over time.

Service-orientation (NOTE:  no “s” at the end of service):  To me, this is just the concept of being customer-centric or having a “the customer comes first” attitude in your business.  In general, this is a healthy attitude and you can be service oriented no matter what type of company you are…I bring it up here for the sake of distinction with the next term.

Services-orientation:  a business that generates the predominance of its revenue from selling human-delivered work, expertise, and process directly to customers.  The selling motion is typically direct and relationship-based and the “thing” that is sold is typically customized and unique to each customer’s requirements (which tend to be jointly developed and agreed to as part of the selling process).

Product-based businesses include software companies like SolarWinds,, Google and Microsoft.  Some of these product-based companies have a services team that ensures the products are “consumed” and/or implemented correctly for their customers.   Services-based businesses include ad agencies, PR firms, graphic designers, video production businesses, IT consulting firms, and even tax-preparation companies.  Most services-based companies leverage or depend on a variety of products (their own or created by other companies) to do their job.

Below are a few A-B examples of how I believe the two different orientations can cause a company to behave. Hopefully, they can be instructive in pattern matching how your business is behaving or being asked to behave by customers in your target market.

What your customers are paying you for:

  • A product-oriented company is (duh) being paid for a product; while the product may include a bundle of “components,” it is created or defined once and sold over and over again.
  • A services-oriented company bundles time, materials, expertise & technology into an offering that is customized for a particular customer.

How you price what your customers are paying you for:

  • Product-oriented companies strive to have a single price or pricing tier (free, silver/gold/platinum) that appeals to the broadest range of customers possible.
  • Services-oriented companies delineate the time, materials, expertise & technology that make up each unique offering in order to ensure that each engagement can be piece-wise profitable and that the price can change as the project scope inevitably changes.

How the sales function engages with customers:

  • Product-oriented sales tend to own the customer over long periods of time, re-engaging those customers to “up-sell” as new products are delivered. Education and expertise may be provided as part of the sales process.  Other support roles (Sales Engineers, Professional Services) may exist, but the sales manager is the quarterback.
  • Services-oriented sales tends to focus on initially winning a customer / engagement only to hand off that customer, post-win, to an account management roll that owns the customer as the project is delivered as well as for future extensions to the original deal.

How the business invests in “what you’re selling:”

  • Product-based businesses invest in building the product ahead of revenue
  • Services-based businesses have invested in people but generally do not proactively invest in solutions for their target market; instead such businesses define the solution in real-time as part of the sales cycle and think in terms of “work for hire.”

When you say “yes” and “no” to customers:

  • Product-based businesses should say yes when customer’s requirements align with the product’s capabilities; when customer’s requirements fall outside of the business or product focus, there must be sufficient discipline to say “no” to the potential revenue associated with that opportunity.
  • Services-based businesses must find a way to increasingly say yes to potential customers. This is true because in relationship-based sales of expertise and capabilities, trusted vendors will be asked to do more and more.  Figuring out how to say yes, profitably, is core to growing a services-oriented business.

How your business scales:

  • A product-based business scales by creating an ever growing/evolving product set and selling it multiple times, broadly to many different customers
  • A services-based business scales largely on the backs of people and relationships; winning and servicing an increasing number of customers requires an increasing number of people with very little exception.

let me know if you agree or not…

In demand: early-stage start-up legal library

Early-stage, cash-efficient start-ups increasingly require an equally efficient supply chain in order to make it work.  Take for example Capital Factory, Y-combinator or even micro-style investments from more traditional VCs.  A start-up raising $20k – $250k simply cant afford traditional legal costs associated with:

  • incorporating,
  • equity and option plans,
  • option grants,
  • convertible debt agreements,
  • all docs associated with being INITIALLY funded (term sheets, standardized series-A docs),
  • NDAs,
  • separation agreements and release paperwork,
  • contractor agreements, and so on.

I propose the following:   forward-thinking law firms should create a FREE legal library that includes AT LEAST the items listed above.  The should GIVE this library to start-ups that agree to become clients after a funding event of a particular size…maybe $250k or more.  I’m suggesting that law firms loss-lead with this free legal library and win clients that may become the next Google (or, realistically, may also go out of business).  It’s time for the supply chain to evolve.

The barbell problem for start-ups

One quick note related to the discussion of life-style versus high-growth businesses. Today’s venture capital environment plus the infrastructure available to start-up companies will start to create a “barbell” problem/situation for start-ups.

The current environment will sort start-ups into 2 categories

The current environment will sort start-ups into 2 categories

Historically (before October of 2008), companies with solid business plans and good teams were funded largely based on amorphous subjective capital requirements for operations and scaling the business over a well-defined period of time with well-defined goals within that period (break-even, financeable milestones). Start-ups, not wanting to re-enter the funding cycle again too soon, would gun for as large a round as possible while balancing valuation / dilution concerns. VCs, having raised large funds with a limited number of partners + hours in the day to put those funds to work (among other supply chain issues), would generally prefer larger deals that enabled the firm to capture a larger percentage of ownership. I believe this “traditional” model is already changing.

Right now in early stage venture firms and start-ups, I believe there is a huge amount of “sorting” going on. The sorting categorizes all start-ups into two big buckets – or ends of a barbell – one that has light capital requirements (software, web applications, SaaS apps) and one that has larger capital requirements (hardware, semiconductors). There is no opportunity for start-ups in the middle right now because the barbell defines the acceptable outcome and ANY outcome is rare right now.  Non-capital intensive companies need to be run lean and mean until they have achieved some scale; capital intensive companies have little choice when it comes to starting and scaling:  they use other people’s money and therefore have larger outcome requirements; they must be certain to hit financeable milestones with current funding.

This market environment will be very challenging for companies that SHOULD be in one end of the barbell but have ended up in the other.  For example, start-ups that have raised too much capital relative to the state of their business and market will be challenged in this environment. Capital intensive start-ups that have yet to hit demonstrable scale or financeable milestones and need to raise more money will be challenged in this environment. The barbell problem is going to create a much more pragmatic environment with respect to which companies need which type of funding.

Venture Capital in 2009

One quick point of order: I am not a VC but I get the dynamics pretty well. And I have invested in a handful of early-stage companies over the past few years; some with VCs, some ahead of traditional venture capital.

If one considers the amount of total venture capital raised from 2006-2008, and then take a look at the last three quarters of 2008 in the context of the larger macro-economic environment, current liquidity issues in traditional limited partner institutions, and the generic venture business model, there are some interesting implications for the not too distant future. This is the first in a series of posts that takes a look at what’s going on in the supply chain of venture capital.

Total venture capital raised over the past 2 years

Total venture capital raised over the past 2 years

The NVCA reported that $35.5 billion was raised across 327 funds in 2007; $27.9 billion was raised across 253 funds in 2008. During the last three quarters of 2008, you can see a decline (red, dashed arrow) mid-year and then a very sharp drop as the economy started slide (to put it mildly) in Q4 of last year.  During Q4 of 2008, the total amount raised was $3.3 billion compared to $11 billion in the same quarter the previous year.

With a bit of extrapolation, it’s not hard to imagine that 2009 could be a year in which $10 billion or less! is raised across the entire industry.

Here’s why I believe that number is about right:

First, I believe that traditional limited partners are experiencing a liquidity crisis. More on the data and what this means in a future post. But, in short, the businesses that fund the venture capitalists are short on cash for that purpose. Not only are the short on cash, but they’re over-subscribed in their commitments to venture capital funds.

Second, in many cases, these same institutions analyze their investment portfolio, per asset class, on 10-year rolling averages.  Guess what year rolls off next year?  1999 is gone from the average and that was a pretty good year in many venture capital funds.  In fact, with 1999 out of the 10-year analysis, it’s very possible that the over-all weighted returns go from positive to negative.  Pretty obvious what happens if an asset class shifts from positive to negative when it comes to how investors choose to allocate any new funds they may have to put to work.

So what is the implication?  I think that 2009 may look like a $10 billion year at most and 2010 will put up an even smaller number; perhaps only $3 – $5 billion in total.  What this means for the industry is that there is a looming venture capital crisis the likes of which the industry has never seen. It’s going start becoming increasingly obvious and play out over the next 24 months. Many, many venture firms are going to go away.   The cost of capital will go up.

UPDATE: April 18, 2009

There have been a number of recent articles on this topic from TechCrunch as well as VentureBeat.  Even as far back as October, 2008, Business Week blog has reported on mounting tension from the VC world:

(Tom) Crotty hopes the atypical investment approach will insulate Battery (Ventures), but he nonetheless sees a reckoning coming—specifically toward the end of 2010. He points to 2000 as the “last really good year” for venture capital. Looking back, “the one-year, three-year, and five-year indexes are all going to be terrible,” Crotty says. “And once 1999 and 2000 fall off, the 10-year will be, too. It’s going to be painful.”

If the 10-year investment period hits at or below the S&P 500, portfolio managers are going to wonder why they’re investing in such a risky asset class. Crotty estimates that 20% to 30% of the money going into venture will go elsewhere, and that is going to be bad. A lot of firms will go under.

To re-state my concern from the original post:  the VC-start-up supply chain will be disrupted for the asset class performance issues noted above AS WELL AS the general liquidity issues in limited partner land.