[Dave Heal's] Observations & Reports

Book Reviewish Substance: The Startup Game, ch. 1-2

I’m making my way through the canonical* venture/startup literature and thought I’d try out a few different ways of reviewing the books. Epic poetry, rap homage, and Serious Book Review are all on the table for future iterations of this feature.

*By “canonical” I mean I asked a few friends and mentors in the industry to recommend stuff to read and these books were mentioned by more than 1 person.

For this first go around I chose William Draper III’s The Startup Game: Inside the Partnership between Venture Capitalists and Entrepreneurs and will be writing up one post per chunk of the book, where chunk is defined as the number of pages I read before falling asleep. I imagine this will amount to 2 -3 posts for the entire ~225 page book with the potential for a wrap-up post if there’s a sufficient amount of synthesizing that such a summary would be worth doing.

William Draper III is the meat in the single-decker sandwich that is the Draper Family Venture Capital Dynasty, which started with his late father (Bill, Jr.) in the mid-20th century with the formation of Draper Gaither Anderson, the West Coast’s first VC firm, and continues today with his son Tim, the founder of the iconic Silicon Valley firm Draper Fisher Jurvetson. If that family sandwich analogy makes you uncomfortable, instead imagine a family of Joe Montanas terrorizing the NFL for 40 years. Except instead of the NFL, it’s venture capital. You get the idea.

The sticker on the side of the book says “biography.” And although a good biography can be worth reading, the genre is littered with so much self-indulgent dreck that I did feel my forehead crinkle a bit with consternation when the book started out with a seemingly overlong anecdote about a quaint dining establishment. I steeled myself in anticipation of the portrayal of the quirky but resolute diner owner who would serve as a narrative foil for the entrepreneurs that we would meet in the rest of the book. And there is a bit of overwrought Gladwellian scene-setting in the first few chapters, with longish strings of adjectives describing people we don’t quite care about yet. It reminded me a bit of that Uncle–or dinner guest of unknown provenance–who has great stories but an anti-ear for detail. So, kind of like Thomas Friedman except with good stories. Draper does ultimately reveal himself to actually have been up to something with the inclusion of the first 10-20 pages, but there was just enough homespun fluff to get a guy worried.

Also probably turns out I was being a bit of a snob.

As someone who used to spend a lot of time reading Difficult Fiction, academic philosophy and other varieties of similarly wonky prose, I still sometimes catch myself needing something to be hard in order to feel like I’m learning. Although this book isn’t high concept or written with a whole lot of verve, it’s full of great information that would probably just be obscured by a more academic delivery. Draper’s family was there at the creation of the VC industry in Silicon Valley. He participated in or had front row seats for many of the legendary tech financings in the past few decades. The guy, unlike yours truly, decidedly does not need to dress up his story with a bunch of flowery adjectives or literary pretense.

For those familiar with the VC industry, there isn’t tons of new information in these first few chapters. But Draper’s retelling has the benefit of being informed by actually being present for much of the interesting history. His father’s firm, Draper Gaither Anderson was not only the first West Coast VC firm, but it was the first to use the now de rigueur corporate form of the limited partnership (in 1959). But the LP didn’t take off for a while. During the 60s and 70s (and even into the 80s), limited partnerships were still in the minority. Most funds were publicly traded closed-end funds, mutual funds whose shares must be sold to other investors rather than redeemed from the issuing firm, or SBICs, a new corporate form created by legislation passed during the Eisenhower administration.

In the late 70s and early 80s, money began to flow into the VC industry due in large part to the opening up of the industry to money from pension funds. Draper says on page 45 that “in 1994, the floodgates opened when the law changed and allowed pension fund managers to invest in venture capital partnerships.” I don’t know whether this is a typo or whether he has some other regulation in mind, but the generally accepted finger-from-the-dyke moment in the increase of the capital supply was the 1979 amendment to the so-called “prudent man” rule governing pension fund investments. A 1998 paper by Paul Gompers and Josh Lerner, What Drives Venture Capital Fundraising, details the history:

One policy decision that potentially had an effect on commitments to venture funds via supply changes is the clarification by the U.S. Department of Labor of the Employment Retirement Income Security Act’s (ERISA) prudent man rule in 1979. Through 1978, the rule stated that pension managers had to invest with the care of a “prudent man.” Consequently, many pension funds avoided investing in venture capital entirely: it was felt that a fund’s investment in a start-up could be seen as imprudent. In early 1979, the Department of Labor ruled that portfolio diversification was a consideration in determining the prudence of an individual investment. Thus, the ruling implied that an allocation of a small fraction of a portfolio to venture capital funds would not be seen as imprudent. That clarification specifically opened the door for pension funds to invest in venture capital.

To illustrate what this meant: following the rule change the percentage of total venture capital commitments contributed by pension funds went from 15% (in 1978) to more than 50% in only 8 years.

Draper tells the story of struggling to come up with enough money to start his own VC firm shortly after leaving DGA in 1962. Eisenhower’s Small Business Investment Company Act of 1958 established federally guaranteed risk-capital pools that became one of the dominant investment vehicles in the VC world:

By the time I left DGA in 1962, I had scraped together about $25,000 to invest in a new venture capital company. I had no other assets besides my $40,000 house, which had a $20,000 mortgage on it. Given that thin capital base, setting up my own venture firm seemed like little more than a pipe dream. But about that time, Al Pyott, a friend at Inland Steel [where Draper had worked before quitting to join his father’s nascent firm], sent me a copy of President Eisenhower’s “Small Business Investment Company Act of 1958.” I read it carefully and learned that if I could come up with $150,000 and invest it in an “SBIC,” the government would lend me up to $450,000 for ten years at five percent interest–in other words, three-to-one leverage. Bingo!

SBICs still exist today, but as Draper would soon discover, they are hampered by regulation that prevents them from becoming an engine for massive growth. As one example, investments in any one company were capped at $60k (not overall but per firm).

One bit of Silicon Valley history that I wasn’t aware of prior to reading the book was the role of Fred Terman, Stanford’s Dean of Engineering (and later Provost), in turning Stanford into an engineering powerhouse and magnet for entrepreneurial types. He single-handedly convinced Stanford, Draper says, to put massive resources into turning the engineering school into the best in the world, thereby kickstarting the Great Egghead Migration to Silicon Valley.

Much of the wisdom Draper shares comes in the form of advice that now seems old hat but which Draper had to glean for himself back in the days before there was an army of prolific VC bloggers. Draper talks about his investment in Raychem as equal parts faith in the company’s patented, heat-shrinkable insulation and a strong belief in the team led by found Paul Cook. This emphasis on the quality of the founders instead of their ideas is one that you’ll see repeated by almost all of the most successful venture capitalists. They make investments in people, not things. Companies frequently change tack more than once between an idea’s inception and its deployment as product. So it’s initially preferable to have a group of sharp, industrious people working on a dumb idea than a group of dumb guys working on a smart idea.

As with all books of this type, there is an editorially mandated list of distilled insights. I expect there will be a few more of these before we’re done, but the first such list is Draper’s Five Key Dimensions of VC, which leads off the second chapter on “How It [VC] Works.”

  1. The funders
  2. The team
  3. The pitch, the product & the market
  4. The deal
  5. The relationship

The Funders

This is a fairly self-explanatory element of venture capital. Draper gives a crash course in the history of VC from the early days when funds were almost exclusively based in New York and run by wealthy families with names that you’d recognize (the Rockefellers, the Whitneys, etc.). Next in the evolution was the formation of what most folks consider to be the first modern venture capital firm, American Research and Development (ARD), which was formed in the aftermath of WWII by MIT President Karl Compton and HBS Professor Georges F. Doriot. Institutional investors were not yet on board with VC, hence the structuring of the firm as a publicly traded fund that was marketed mostly to individuals. Draper notes that the choice to make the firm public would ultimately be its undoing because of the strict regulation associated with public companies and the “impossible problem of trying to value a passel of private stockholdings for public shareholders.”

The Team

Two quotes about “the team” suffice to sum up this segment of the chapter:

  1. “Nothing is more important. In fact, nothing is even a close second.”
  2. “There are no strong companies with weak management.”

For an entrepreneur’s similar take on the theme, check out item #2 from Elad Gil’s 4 Ways Startups Fail:

2. Team implosion
Lack of clear decision making? Founders constantly fighting? Hiring a bunch of jerks that irritate everyone? A lot of companies end up imploding due to bad team dynamics leading to a lack of clear direction, internal infighting and backstabbing, and a terrible working environment.
Ways to mitigate:

  • Make sure you and your co-founders have clearly defined roles and there is a single person ultimately in charge who can call the shots.
  • Make sure you and your co-founders can communicate openly, have mature and frank discussions (can you give each other constructive feedback?), and are aligned on where you want to take the company (does one person want to sell early and the other wants to build a long term global business?).
  • Have a high bar for culture and team fit for early hires. Correct hiring mistakes quickly.

The Product, the Pitch & the Market

I don’t want to spoil the joy of reading the entire book for you, so I’ll just note that Draper says you need to know these things well.

The Deal

This section contains some fantastic material on the types of deals that get struck, both between entrepreneurs and VCs and among entrepreneurs/founders. The bit of gold to be found in this section is the story Draper tells of one early-stage company’s rather unsophisticated valuation method:

An unimpressive team of young entrepreneurs came into my San Francisco office and made their presentation for a company that needed $3.5 million to get started. When they finished, I asked what they thought was a fair deal. They said that the company was worth $7 million and that two-third for them and one-third for us sounded about right. I asked how they had arrived at the $7 million valuation. The answer, which the CEO delivered with a straight face: ‘There are seven of us, and we figure that we are worth $1 million each.” I asked them why they didn’t pick up three more employees on California Street before they came in the door…”

Burn!, as the kids say.

Draper notes that, regarding the internal split of equity between the founders, if one founder is taking drastically more than the other(s), that’s a red (he says “yellow”) flag. For an extended discussion on the perils of founder equity, check out Mark Suster’s recent post The Co-Founder Mythology and Nathan Kaiser of npost with The only wrong answer is 50/50: calculating the co-founder equity split.

The Relationship

This section’s first sentence rhetorically asks, “Does the relationship between the entrepreneur and the venture capitalist go beyond money?” No points for guessing that the answer in almost all cases is “yes.” The one “practitioner story” from this section that caught my eye was Draper’s mention of his investment in OpenTable and the frequent strategic wrangling that he engaged in with the CEO, Thomas Layton.

When a reservation is made with OpenTable, each restaurant pays $1 per person. Draper wondered why they didn’t charge $2. Or why they didn’t have the restaurant pay up front for the computerized reservation system instead of leasing it to them.

Or why don’t we just sell them our software and get ouf of the hardware business entirely? They all love us, and right now we are too capital intensive.

This back and forth is used to illustrate the point that venture capitalists are supposed to be business advisers, not just piggy banks in ill-fitting, outdated sport coat and jean combinations. They’re supposed to bring their own entrepreneurial experience, or their wealth of industry knowledge, or their financial acumen to bear on the problems faced by their portfolio companies.

Earlier in this recollection, Draper recalls asking the hostesses at various restaurants around San Francisco what they thought of OpenTable.

After making the investment in OpenTable, I would ask the hostess how she liked OpenTable whenever I saw the computerized reservation station near the entrance fo the restaurant. She would always reply something along the lines of, ‘We love it. We can’t live without it. It has made reservations and our lives so much easier.’

If you were on the Internet last fall, this high praise may be creating a bit of cognitive dissonance for you. In October 2010, Mark Pastore of the restaurant Incanto asked Is Open Table Worth It? from the restaurant owner’s perspective. His answer:

Only one of the dozen or so I spoke with said he felt that OpenTable increased the value of his restaurant and that he wouldn’t imagine opening a new project without it. The rest were less than happy. The recurring themes were the opinion that OpenTable took home a disproportionate (relative to other vendors) chunk of the restaurants’ revenues each month and the feeling of being trapped in the service, it was too expensive to keep, but letting it go could be harmful. The GM of one very well known New York restaurant group, which spends thousands of dollars on OpenTable each month, put it to me this way, “OpenTable is out for itself, the worst business partner I have ever worked with in all my years in restaurants. If I could find a way to eliminate it from my restaurants I would.” Another high-profile, 3.5-star San Francisco restaurateur told me he feels held hostage by OpenTable. For the past several years, his payments to them have been substantially more than he has himself earned from 80-hour workweeks at his restaurant. But he believes that if he stops offering it, his customers will revolt and many would stop coming to his restaurant. So he keeps paying, but carries a grudge and wishes for something better.

Around the web there was and is a ton of complaining about OpenTable out there. Although as Pastore’s critique notes in good politicking fashion, it’s tough to deny that they’re a successful company by most metrics. Obviously OpenTable’s financial health is ultimately wrapped up in what both customers and restaurant owners think of the service. But the fact that this vignette already seemed dated was interesting to me and, I think, highlights the pace of change in the tech scene these days.

In the rest of chapter 2, Draper gives his opinion on the controversial subject of taxation treatment for the carry (usually between 20-30% of the profits) that constitutes most of the VC’s take-home pay. The issue is whether the carry should be taxed as capital gains (more favorable to VCs) or ordinary income.

I believe that capital gains tax treatment has worked extremely well, resulting in a huge boost to the economy as well as giving incentives to the individuals involved.

Draper also discusses one of the unique characteristics of his firm Sutter Hill, which is structured as an “evergreen partnership” and essentially means that it is an open-ended vehicle with no “artificial” expiration date. Most limited partners invest in a venture fund for a period of 10 years, and they’re usually not able to take that money out before the 10 years is up and the fund expires. Sutter Hill doesn’t raise separate funds–the nomenclature for the standard structure involves labeling each fund with a roman numeral, so a fund’s 4th fund is usually Unnamed Venture Fund IV, which was preceded by Unnamed Venture Fund III. Instead, they value the whole portfolio every four years and allow the LPs to take money out at that time.

This structure is one of the reason why the fund does so well, he says, in part because his firm’s structure better aligns the interests of the LPs and the GPs (the general partners/venture capitalists) and that the “series structure” of other funds often hurts the individual portfolio companies when the fund terminates. Maybe I’m missing something important here, but I don’t understand why this would be so. Most of the money in each “series” fund is invested in the first few years. So by the time termination of the fund is even on the horizon, we’re talking about companies that will likely be either obviously thriving or obviously on their way to the deadpool. His point does not seem to be that the condensed fund raising period at the end of the fund distracts the VCs from providing value but rather that the actual termination or threat of termination is the harm.

He probably has a point that the nature of the series structure–in which the first few years are spent doling out the money and the latter stages are spent managing the portfolio companies while simultaneously engaging in a new round of fund raising for the next fund–probably encourages VCs to push money into companies too quickly at times. But it’s unclear to me how a termination date 10 years into the future is the Sword of Damocles that Draper implies.