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I Moved My Blog! January 18, 2011

Posted by Lawrence Lenihan in Uncategorized.
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new address is http://www.lawrencelenihan.com

See you there!

Why a VC is A Great Seed Investment Partner May 17, 2010

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Later this morning, we are going to announce FirstMark’s seed investment program, FirstSteps.  Although we are making the announcement now, we recently closed on our 10th investment in this program which we started last year.  Since we started FirstMark in 1996, we have had a long history of creating companies from scratch and investing in them from an early stage.  In 2000, we started Outlooksoft in our basement and sold it to SAP for several hundred million dollars.  In our most recent fund,  we were the founders of Dovetail (a next-generation insurance platform) and EagleEye (comprehensive data and analytics solution for the insurance industry) and made seed-stage investments in Clickable, LiveGamer and WePlay.  All of these companies are now growing and maturing companies and several have progressed through one or more rounds of institutional funding.

You can read all about the FirstSteps initiative in the press release at http://www.firstmarkcap.com/node/1131, but the purpose of my post is to provide some insight into the answers for two critical questions: 1) why should a VC be doing seed stage investments and 2) why invest in New York City?

We’ve all read some good posts about the pros and cons of VC’s as seed investors versus traditional angels.  Let’s be clear where we are going to come out on this: a great angel is a great partner to have.  But a great VC is a great partner to have too!  We complement what an angel investor can bring to the table in terms of skills and expertise.  At times we might be more knowledgeable about the market, at others we might have a different and complementary perspective.  In addition, a great VC has seen literally thousands of companies and can apply incredibly valuable insight drawn from this vast experience to help an entrepreneur avoid potential (lethal) pitfalls and seize unique opportunities as they present themselves.  What works?  What doesn’t?  Who is a great strategic partner? Who will sink your company in support requirements? What kind of skillset do we need for our go-to-market strategy?  Where should we recruit the best head of marketing?  We have seen these questions play out hundreds of times in our company.  Believe it or not, history does tend to repeat itself and recognizing the patterns of success and failure is a key attribute of a great VC.   A great angel will have great relationships.  A great VC will have great institutional relationships.  Moreover, in addition to having a big chunk of our personal wealth on the line in our funds, we do this for a living day in, day out. We have a fiduciary obligation to our investors to do everything we can to make an entrepreneur successful, and that is a strong commitment.

If you’re successful, we’ll be there for you down the line too.  If you pick the right VC, you’ll have someone there beside you to provide funding for you as you build your company.  We won’t try or demand to take all the follow-on round – that’s not what we do.  In fact, we have begun telling our companies recently that, like an angel, we won’t lead the follow-on round of funding for the company, but we will commit to being a follow-on investor in an institutional round of funding.  We will typically look to guarantee a minimum percentage of the follow-on round, but we won’t put ourselves in the position of negotiating price and terms from a position of control.  That is not our style and it is not fair to the entrepreneur.  This is the best of both worlds for the entrepreneur: he knows he has a partner to support him in the next round of funding, not fight him and he has that long term funding commitment if he can continue to execute and build value in his company.

The relationship between entrepreneurs and investors is delicate at anytime, but especially so at this stage.  Picking the right partner is one of the most important decisions that you will ever make as an entrepreneur.  You need to know what you are getting when you pick your partner.  We feel so strongly about this transparency that we have put it in writing in a thing we call the Funding Bill of Rights  (http://lawrencelenihan.wordpress.com/the-funding-bill-of-rights/ )  The entrepreneur has rights and so does the VC.  If we are both in alignment, you cannot have a more formidable partner.

But this is not a  question of either or – almost every one of our ten seed investments as part of our FirstSteps program has one or more angel investors.  Angel investors are incredibly valuable partners in our investment process.  First, they often know the entrepreneur much better than we do since, in many cases, they have worked with them personally before.  Great angels bring unique market insight and complementary relationships.  They bring a perspective that we might not have.  For Angels, we ensure that they will have a partner who will participate in the future when they can’t.  They also have someone on whom they can rely to be there day in and day out, helping to ensure that the company is making progress.

But why does this make sense for us?  It’s simple really.  As the markets change, so must we.  Companies can now be developed for a fraction of the cost than they could just a few years ago and get to market in a fraction of the time.   The impact of this dynamic is that companies develop sooner and grow faster with less capital.  That means that we venture capitalists have to adjust our business model and be able to invest earlier and in smaller amounts.  Ironically, although we are investing closer to the inception of the company than we ever did before, many of our seed investments have far more traction than our Series A investments in the earlier part of this decade!

Seed investing makes for a particularly good strategy in New York City.  Enabling the “capital-lite” nature of company development today is the cloud computing infrastructure that powers companies with purely variable computing infrastructure cost coupled with the vast reach of connectivity of the internet that gives companies the opportunity to connect to every person on the planet who matters to them (2 billion + and counting!).  Now compbine this connectivity and this infrastructure platform with the dynamic changes that are accelerating rapidly across our country’s most important industries: Banking, Healthcare, Insurance, Media, Advertising, Entertainment, Education, Retail and Communications.  The result from the collision of these two waves will be the upheaval of these industries and a new generation of companies that will be created to lead our nation forward.

The New York City region is one of the largest generators or consumers of the services of these industries in the world.  The people who create, shape and influence these industries are here.  Where else in the world is there such a concentration of knowledge, skills, capital and decision makers?  These new companies that will form will rely on the expertise of the people who know these industries and can apply technology innovations to address these business opportunities.  If you want to start a chip company, you should do it in Silicon Valley (or Asia!), but if you want to start a company that will change the most important industries on this planet, you’ll do it where the skills, knowledge, insight and expertise reside: New York.

By taking our expertise and relationships in these industries honed over the past 14 years of our existence and coupling it with an investment program that enables us to assist great entrepreneurs in building these future-changing companies from their formation, we hope to continue to increase our contributions to affirming New York City as the  world’s business capital!

Article 8 – Common Ground May 10, 2010

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Sorry for the disappearance – I had to wrap up my NYU Ready, FIRE! Aim class and I have been buried in presentations and businesses.  Great students – I think you will hear about a number of them in the future as they build and grow the fantastic business ideas they developed during the class.

The common ground in Article 8 is the same common ground that we have touched on before: communicate before you make a commitment to be partners as entrepreneur and VC and communicate regularly and often during your partnership.  No surprises.

You can’t hold back: if you as the entrepreneur feel that you never want to sell, don’t take the money.  In my mind, it is unethical and unscrupulous to do so.  And, by the way, you can’t expect your VC to go along with you if you change your mind mid-stream.  That was never the deal.  On the other hand, VC’s can’t tell the CEO that they are fine building to being a big public company that will stand forever on its own if what the VC really wants to do is to have a quick flip. This notion also applies if suddenly the VC is in fundraising mode and needs a nice exit to demonstrate returns.  If that was not the deal going in, it is wrong to expect the entrepreneur to suddenly go along with the VC’s new plans if that was not part of the original agreement.

But remember, these “moral” agreements hold only so long as each party is holding up to all other agreements.  If the company is not performing, don’t expect your VC to have a bottomless cup of patience to offer – he/she won’t.  And, if this is the case, you can’t expect your VC to want to wait forever for an ultimate exit if a nearer term option becomes available.

Venture Capitalist Bill of Rights – Article 8: The right to achieve a timely exit April 15, 2010

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The key thing that you, the entrepreneur, needs to be aware of when you take a VC partners is that we are not in the business of building legacies and monuments of greatness.  We are in the business of generating returns for our investors.  If we help create the next Google, believe me, we are as proud of our involvement as you are of yours.  However, for us, this is a byproduct of our investment, not the goal.

We have a moral, ethical and legal commitment to our investors to deliver returns on their money.  When we sit down with our entrepreneurs, we make sure we all understand the goals that we are all trying to establish.  If you want to build a monument to yourself, that’s fine, but only if you can generate us a return and enable us to cash-out so we can send a check back to our LPs.    You took our money – you have a commitment to do so.  You know how we operate and that is the deal we struck.

As I said in the Entrepreneur Bill of Rights – Article 8, we are willing to ride your vision for a long time if you deliver and generate value for us.  Generating value means 5X + on our investment.  At that point, we are willing to let you go as far as you want to go. But at some point in time, you need to give us an opportunity to gain liquidity on our investment.  Our funds are 10 year funds, but our investors want cash as soon as they can.  After five years together, you owe us a chance to get liquid.  We might take it, but we might not.  But you should figure that at the 5 year point, we are going to start looking for a door to leave.  We have had investments that we have been in for 10 years – that is an exception, but it happens.

We were the first institutional investor in SecondMarket.  I truly believe that this company can change the world and I am very proud of my involvement in assisting the fantastic management team in achieving their vision.  Barry Silbert, the CEO, and I have very regular dialogues about what we want to accomplish here.  Because Barry and his team have achieved so much in terms of building this market-leading company to where it is, we are willing to let Barry go as far as he can with this company and create something truly amazing.

Barry came to the realization over time that he had no interest in building a public company.  On the other hand, he realizes that FirstMark needs to return dollars to our investors at some point in the future.  We have made a commitment to each other: I will not press for an IPO or a sale of the company so long as he can deliver an opportunity for my investors to achieve liquidity without compromising on the value of their investment.  In other words, we’ll accept an alternative means to liquidity, so long as it is not at a discounted price to an IPO or a sale of the company.

Fortunately for SecondMarket, they control their own destiny.  They have created a very innovative marketplace for private companies that will enable an alternative path for private company capital formation and liquidity that I believe will truly change the world.  You’ll here a lot more about this in the coming months.

But my primary point here is that Barry and I talked about it.  There are no surprises.  Barry knows where I am coming from and I know where he is coming from.  We are going to work together to make sure that we both achieve our objectives.  We are not looking for liquidity in the near term, but we both know what each of our long term objectives is and we are working now to ensure that we are both successful.

On the other hand, “lifestyle business” is not in our lexicon.  We don’t view building a company as an exercise in your personal self-fulfillment.  So, if you do, don’t take our money.  Moreover, if you don’t create value for us and we can’t generate a reasonable return on our investment, don’t expect us to be patient.  Remember Venture Capitalist Bill of Rights – Article 2?  We will spend our time where we can generate the most value.  Since there are only a finite number of boards we can sit on and since our LP’s really want cash in these troubling times, when it is apparent that there is no more value to be created in your company, we really have to begin to look to exit, one way or another.

I think many entrepreneurs are troubled by this, but remember: you didn’t live up to your part of the bargain.  You said you were going to generate value for us (the amount we need to satisfy our investors) and you didn’t.  It may or may not have been your fault: sometimes you just get a bad break.  We want to work with you to get the most out of the company we can – you should too!  But you can’t expect us to have the kind of unfailing loyalty that we would have had you built something special for us.  Are we fickle?  No, I don’t think so.  In my mind, fickle would be if we were unpredictable and acted this way.  We were clear up front with you and you should be clear after reading this Funding Bill of Rights where we would end up.

It’s for this reason that we have all the legal clauses we mentioned before.  Because you might change your mind or you might disagree and perhaps see value just around the corner after these eight years of turning up nothing.  We’ll get out.  It might be uncomfortable or even nasty if you take it personally, but we don’t act this way because we are jerks: its because we committed to our investors that we would generate a return for them or protect their investment when no return is possible.

Entrepreneur Bill of Rights – Article 8: The Right to Say When You Exit April 12, 2010

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When and how to exit is the most important question that an entrepreneur will have to answer.  It’s really important for an obvious reason: your company is most likely the biggest investment that you, the entrepreneur, and your family hold and your decision will impact your wealth, possibly for generations.  But, it’s also important for less obvious but equally impactful reasons like: what’s best for your employees? What’s best for the dream and vision that you hold for this company? What’s best for your customers? And, probably the most dramatic: what the Hell are you going to do with yourself after you sell???  Another question: Do you go public?  Prestigious, but do you really want to be the CEO of a public company and deal with the quarterly earnings treadmill? These are personal questions that you need to answer for yourself.  But the decision to sell is one that involves another party too: your venture capitalist.

As with all of these Articles, the dialogue between entrepreneur and venture capitalist is critical.  In diligence, when I, the VC and you, the entrepreneur, sat down and discussed our investment, hopefully we discussed what we both wanted to accomplish.  We probably did not have a discussion as detailed as saying “OK, in April of 2012, we will sell to Google”.  But we did discuss what you wanted to do with the company and I explained that I need to achieve some liquidity at some time in the future.  We shook hands and marched off into the future, arms locked, ready to take on the world.  At least, that’s what I hope we did because if you want to build a lifestyle business and I want to be on a public company board, we are going to have a very rocky relationship…

So, just to make sure we don’t run into that problem, I, as a good and diligent VC, probably put a couple of special clauses in the investment documents.  These clauses usually include a veto right on a sale of the company, a drag-along provision to make sure reluctant shareholders can’t block our big pay day, redemption rights etc.  But, another reason we put these clauses in is to make sure that you don’t change your mind.  More on that in my post on the common ground for this Article.

In all my years of being a VC, we have never sold a company when the entrepreneur did not want to sell. We also have never blocked a sale when the entrepreneur wanted to sell.  Why? Well, practically speaking, its hard to continue to run a business when the team wants to go. Also, I’m not sure how successful a sale or IPO would be if the management team clearly did not want to sell or go public!

Throughout these Articles of the Funding Bill of Rights, we have spoken about moral commitments and mutual obligations.  In my mind, this commitment on when and how to exit is the most sacred of all of them. 

This commitment stems from what you have done for us.  First, if you have delivered for us and built your business and created value for us, you deserve to call this shot.  We are well into the money, but we will continue to ride you for as far as you are willing to go.  We are also willing to sell if you feel it is time to go even if we see more value ahead of us.  That’s because you delivered for us and now we will deliver for you by letting you make this call.

But, at the end of the day, if you raised the right amount of money and made it last, you and your team probably own more than 50% of the business, so you can do whatever you want anyway!

Article 7 – Common Ground April 9, 2010

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The common ground here is a simple four step plan: 1) listen, 2) think, 3) respond, 4) repeat.  When you are launching a new business in a new market with a new product and a new business strategy, I can assure you that not everything is going to work.  Great innovative companies experiment, learn and grow.  If every experiment worked, they wouldn’t be experiments!!! So, we VC’s have to expect you, the entrepreneur, to fail on occasion.  Don’t hide the fact when something goes wrong – tell us so we can be part of the solution.

By recognizing this fact and having a regular dialogue (look at the definition again) there is nothing that we can’t achieve together!

Venture Capital Bill of Rights: Article 7 – The right to hear the truth as soon as it becomes known – clearly, directly and without spin. March 26, 2010

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Bad news is like a rotting fish – it does not get any better with age! 

Every very successful company that we have backed at FirstMark has not always performed flawlessly. They make mistakes, they hire the wrong people, the product breaks, etc.  But, what separates these successful companies from companies that fail, is that they learn from their mistakes.  The only way they can learn from their mistakes is that they examine fully and transparently what they did right and what they did wrong – they communicate and they listen.  In other words, there is a dialogue!  They listen to and communicate with their people, they listen to and communicate with their customers, they listen to and communicate with their advisors and yes, they listen to and communicate with their VC!

To have an effective dialogue, both sides need to know all the known facts and outcomes.  Great CEO’s realize this and they don’t hide bad news nor do they spin it.  In my book (as black and white and backward as it may be), spinning is an untruth and untruths are lies and lying is the same as stealing (see  http://lawrencelenihan.wordpress.com/2010/01/17/venture-capitalist-bill-of-rights-article-four-the-right-not-to-have-your-money-pissed-away/).  Someone once said that bad news should travel twice as fast as good news.  Unfortunately, for some CEO’s, bad news often takes a slow and circuitous route to reach its destination.

We VC’s have a right to know the bad news as soon as you do.  Its not fun or pleasant for us either.  But its important.  That way, we can be part of the solution, not part of the problem.  We don’t have a right to yell and scream at you.  That is not part of the rights accorded in this Article.  We might do it anyway out of the same frustration you feel because sometimes we can be immature (we are by no means perfect).  But sometimes we yell and scream because you committed something different to us and we feel betrayed.  You made us look bad to our partners and to our investors and now we need to figure out how to fix that problem too.  But in the end, we are in this together.

However, if you lie to us and don’t tell us the bad news its even worse.  We have had many CEO’s (and still have one or two) who are incapable of telling their board and their investors any bad news.  They shift metrics from meeting to meeting, selectively choosing those that show the business in the best possible light even though they know they are obscuring the bad news and only delaying the inevitable.  Why?  I don’t know.  Maybe they are hoping for a miracle (said before, “hope” is not a strategy!).   Maybe they really believe that things really are not that bad.   (As an aside, the worst offenders typically hide the results in the most beautiful, color-coordinated graphs that dazzle the imagination.  I mean if Michelangelo were a graphics artist,  these would be the PowerPoint slides that line the Sistine Chapel. The better the charts, the worse the news – always!)

This strategy is incredibly dangerous.  As I said, nothing goes right all the time, but recognizing when it goes wrong and then doing something about it is critical if a company is to be successful.  That means telling your board and investors and coming up with a solution and a plan!  You can’t do this by yourself nor do we expect you to do so.

Even if the long term benefits of truth telling don’t motivate you, try this one out: you owe us the truth, immediately.  That is part of your fiduciary obligation to your board and to your investors and to your shareholders.  This is serious stuff and there has been many a CEO, public company and private company, who has been fired for hiding things from his board. In fact, there a couple who have gotten into much more serious trouble than that.

We’re here to help.  Remember, that’s why you took our money!  Make us part of the solution, not part of the problem.  If you don’t tell us immediately or if you spin us, we will lose confidence in your ability to tell us the truth.  If we lose trust in your ability to tell us the truth, we lose confidence in your ability to run your company.  When we get to this point, we all lose.

Entrepreneur Bill of Rights – Article 7: The Right to a Two-Way Dialogue March 21, 2010

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dialogue |ˈdīəˌläg; -ˌlôg| (also dialog)

noun

  • a discussion between two or more people or groups, esp. one directed toward exploration of a particular subject or resolution of a problem : the U.S. would enter into a direct dialogue with Vietnam | interfaith dialogue.

verb [ intrans. ]

  • take part in a conversation or discussion to resolve a problem : he stated that he wasn’t going to dialogue with the guerrillas.

In Article 3, I talked about VC seagull board members who come in to meeting, spout out a bunch of uninformed nonsense and then head home, mission accomplished, much like a seagull does when he is finished decorating the end of a fishing pier.  This arrangement is not very helpful or fruitful for anyone.

As our grandmothers constantly reminded us, God gave us two ears and one mouth for a reason – listen twice as much as you talk.  This pearl of wisdom is great advice for everyone at any time in life, but it is particular insightful for VC board members – and CEO’s too!  Dialogue, as you can read in the definition, is between two or more people.  Talking without listening and engaging is not dialogue.  It is a lecture.

Being a great entrepreneur is not anathema to being a great listener.  In fact, I have found it to be a key trait of being a great entrepreneur.  The same holds for a venture capitalist.  However, not listening is anathema to having a great dialogue and I would argue very strongly that great companies cannot be built without great dialogue.  Too often, what a VC feels is dialogue is really lecture.  Like students in a classroom where a teacher drones on without interaction, a CEO and management team will react the same to a lecture rather than a dialogue with a VC.

I teach a course in entrepreneurship at NYU that has the same name as this blog (Ready, FIRE! Aim).  I decided to teach this course because, through my years of observations as a venture capitalist, I can certainly verify that being an entrepreneur cannot be taught in class or read about in books: it can only be learned.  There is never one right answer for any question for an innovative company creating a new market – the right answer is learned through experimentation and through dialogue.  Listening and learning and questioning and engaging are how great companies are built.

A VC can provide an enormous amount of value to the CEO/entrepreneur through one simple action – we can listen.  But, only by listening first, can we give good advice and counsel and “add value” with insight.  Too often we don’t.  VC is not code for “transmit only” – it needs to mean “transmit after receiving first!”. By listening we establish the foundation for dialogue and with dialogue, the foundation for a great company.

But like everything else, dialogue is a two way street.  There is not a successful CEO on the planet who is not a good listener.  I can point to truckloads who are not successful because they never listen and, because they never listen, they never learn.  Listening and engaging in dialogue does not mean you have to take the advice or agree with the insight given.  But, you should consider it.  Through consideration, you will be able to evaluate your conclusions through different points of view.  You might not change your mind, but I guarantee your conclusion is going to be better because it is more thoughtful.  Not all great CEO/entrepreneurs have taken money so they don’t have to listen to their VC, but I defy you to show me a truly great CEO who does not listen to someone.

But if you have taken our money, you need to listen to us.  VC’s have the right to be heard too.  You should not have chosen to take money from us if you don’t want to hear what we say.  If what we VC’s have to offer does not contribute to you building a great company, either you chose the wrong VC or you are not going to be as effective as you could be if you would just shut up and listen for once!

Article 6 Common Ground and Another Real-Life Situation March 12, 2010

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The common ground on these transactions is always based on communication.  Communication of goals, communication of objectives, communication of metrics and communication of feedback.  Even communication of something as basic as how you feel about each other!  Without communication based on mutually agreed goals, nothing positive can happen.  Either the CEO feels unjustly persecuted by the capricious whim of the investor, or the VC feels like he/she cannot get anything done without a wholesale change of leadership.

The CEO needs to be able to run his/her business.  We as VC’s can help, but we can’t (nor should we) run it for him/her.  VC’s stink at running companies because what makes us good investors (ability to do a ridiculous amount of multi-tasking, assimilate incomplete information and make the best decision in the shortest amount of time, be able to change on a dime to a position 180 degrees opposite based on incoming data, lots of responsibility but little accountability, etc) do not make for focused, well-executing operating business leaders (yes, some of these traits are positive in any leader, but not to the extreme that is embodied by how a VC has to function).  If a VC is running your business, you are in trouble! I think a good VC realizes that and understands that if you grab the steering wheel from the back seat, the car is probably going to hit a tree!

While we are not any good at running your business, we are pretty good at assessing whether you are any good at running your business.  When we made the investment, we were confident enough that you could run it that we wrote you a check.  But after that, you will prove it by running your company successfully.  If you can’t, we VC’s will weigh our options: coach you, bolster you with better people, sell the company or fire you.  Hopefully we have been doing the first two actions all along.  Frankly, I’d rather just sell the company if we can – replacing the CEO is bloody, not fun and is not a high likelihood for success if the business is really struggling.

The CEO can resist and often does.  At the end, we don’t have any recourse if the CEO has the share votes or the board votes to stop us from firing him.  At least not in the near-term.   In the longer term, if he is losing money, we can block a financing or use other contractual controls that we might have, but the CEO can be like a bank robber with dynamite strapped to his chest.  In the end, he can pull the firing pin and blow himself up, but the one who is always certainly killed in this situation is the CEO: he loses everything including his reputation.

That is not to say the VC’s haven’t been idiotic in replacing CEO’s.  I am sure we have on occasion.  Maybe many occasions in the industry.  But both sides really have to look at this situation as one where total value has to be maximized irrespective of hurt feelings, damaged egos or desire for vengeance and retribution.  A CEO with a large ownership position at some point has to realize that he is hurting himself the most by not making a change, provided, of course, that the assessment of failure is based on these objective measurements and not a personality clash.

I was in a situation with one of my companies where the company did not execute well for the first 18 mos of our investment.  After many meetings offering help, guidance, admonition, chastisement and ultimately, frustration, we told the CEO that we were forced to step-in.  We sent in one of our venture partners to work with him to gain an understanding of the situation and to determine where we were going wrong.  Our venture partner did a magnificent job sorting through the issues and putting us in a position where we could clearly and unemotionally understand where the business actually stood (Venture Partners are great operators – they help in the evaluation of investment ideas but they are real operators who often are working on their next business while with us.).

The CEO did not make all of the changes we suggested but he did make several.  He hired an excellent executive who helped turn performance around on the customer acquisition front.  Our Venture Partner, working with the a new CFO, created metrics around which we could determine what was going on in the business.  But, at the end of the day, we told the CEO that we were going to start a search for a leader with better skills for the strategy we were trying to execute.  He disagreed with the conclusion (he had a right – the company’s performance had improved notably).  Later we the management team created a strategy (because now we had better visibility into the business due to our efforts) that showed an opportunity for incredible growth.  The business started executing even more and turned profitable.

So, should we still replace the CEO?  After all, the business was doing much better.  In fact, was doing well.  But, I contend that, even more than before, we needed to replace him because, ironically, the strategy that the CEO and his team uncovered showed the potential for this business to be even greater than before.  With the right leader with deep experience in this new strategy (sorry I am being opaque, but I can’t discuss further), we could build something truly special.  This decision was not based on a judgment of incompetence – the CEO was a very talented executive with deep industry skills.  Moreover, we wanted him to stay since the CEO was a very critical part of the valuable assets of this business who had built the platform that now gave us this opportunity.  We just thought that a change would accelerate our development in the short window of opportunity we had.

The CEO disagreed with this decision, but he went along with the search process.  Several months into it, he came to my office and asked that we stop the CEO recruiting process. The humiliation, anguish and uncertainty of a CEO search was too distracting for him and the company.  The company was in a vulnerable position at this point and the recent success was tenuous.  We both knew that if he left, the company and our investment would go to Hell.  On the other hand, I still strongly felt that, without a new CEO with different skills, we would not have the same chance to build the 10x opportunity that we had hoped.

To his credit, he was a gentleman about it.  He did not storm into my office and make wild threats.  He simply stated that he could not stand by and hand over the reins.  He disagreed with my assessment about his abilities and the company’s future not being as bright as it could be with an executive more skilled in the areas that represented our new opportunity.  On the other hand, I disagreed with his assessment about his capability to achieve all the potential this company given this lack of experience in certain areas and I wondered why he, as a significant investor, would not want to build this company to the level it could achieve with talent better suited for the wonderful opportunity we have.

We were at an impasse, so the only common ground we could find was to agree for him to continue to execute on the current year’s plan with him at the helm and begin to explore a process to sell the company at some point in the future.  We will make money, but in my judgement not nearly as much as we could have.

Who’s right?  I don’t know – I hope its me.  I have certainly been proven wrong before.  Maybe we can execute on the rest of the year and we will both sit down and review the objective metrics achieved and, given this evidence I will change my mind. I hope so.  I’d like to think that my decision making and the actions I have taken were completely objective.  Given that I am human, probably not though!  I think one of the best traits that a person can have is to be able to recognize when you have made an error and admit it.  I hope that I am wrong here.  It’s not about who is right and who is wrong – it is about building something that is great.  I think that is why VC’s who are any good like what they do – we are builders and building something great is a lot of fun!  The CEO had gotten the company back on track.  Didn’t he deserve a chance to continue to run the company?  Seems so.  Did I want to continue this search because of our historical bias against him?  Maybe.  We’ll see how it turns out.

So you see, its easy to write about how it should be.  It just doesn’t happen that way all the time.  The only advice I have is to do the best you can with what you got…

An Actual Case Study Where I Could Have Done a Better Job March 7, 2010

Posted by Lawrence Lenihan in Uncategorized.
2 comments

Paul Haley, the founder a company that we backed, Haley Systems, posted a comment to my last posting.  I contacted Paul and asked him if he would mind if I created a post in my Bill of Rights.  He kindly agreed.  Here’s his question:

“Larry, I literally hear you on the last sentence! I most enjoy how this post reinforces the title of your blog. I would appreciate more of your thoughts on the board/VC’s challenge in guiding versus terminating a CEO struggling with the challenges you enumerate here, perhaps after you’re done with the Bills of Rights. More specifically, how do you assess how much to influence operations versus waiting for abject failure before acting? How active do you think a founder/entrepreneur or CEO should expect the board or VC to be? What are your thoughts on being an active VC? Under what circumstance do you think a VC should be as patient as this post might allow? (Perhaps you should write a book?-)”

Haley Systems had a very interesting rules engine that was a perfect fit with an investment thesis we were exploring around the next generation of code development.  We looked at a number of companies and found that Paul’s company was the best match.  We wanted them to attack the low-end of the market with a new table-driven product (our vision, not theirs).  The company had revenue and had been bootstrapped by Paul since inception.  We felt Paul was a brilliant technologist (I still think that – he’s one of the best) but we felt that with a more experienced CEO, the company would grow faster.

Replacing the entrepreneur/Founder/CEO was the first mistake we made.  Hiring a new, great CEO was not an easy prospect because the company was located in Pittsburgh, not a mecca for experienced software company leadership (but not devoid by any means – there are several very successful companies in this area and the number is growing).  The guy we hired had been successful in a prior company (although not as CEO) and he seemed to have the business skills that would enable Haley to grow rapidly.  We introduced him to Paul who agreed and Paul hired him.  We closed our investment and set out to build the business.

From the start, Paul and the CEO diverged on strategy.  We encouraged Paul to wait and let the CEO execute.  In typical “hired gun” style, the new CEO hired a couple of other execs in various functional roles who, also, were apparently successful in prior companies.  He added other staff as well.  We did less with more people, we lost track of our customer needs, we got caught up in big deals that went nowhere and, in the end, we fired the new CEO and his team.  Paul lost faith in the board and his investors, tried to right the ship, might have done more damage, maybe not.  Paul, who was in charge of developing the product, never launched a low-end product because it did not fit HIS vision.  A board member stepped in to run the company and we sold for a discount of the amount of capital we put into it.  Paul and his investors managed to come to an agreement on the split on proceeds that left everyone miserable.  Lots of fun.

For me, this was an important learning experience.  This happened in 2003 or so, but it was apparent already that the development of companies was changing.  The guys who cut their teeth on growing the typical client server company (big dev teams, salesforce, etc) could not make a change to the new business models that were developing (software-as-a-service, low cost sales, lower cost development, rapid iterations).  Watching these types of guys was like watching someone putting square pegs in round holes using big hammers that shattered everything!  Moreover, the CEO was a hired gun.  He could never garner the passion that Paul could for this business.  He had 10% of the business (if anything, he was a great negotiator), but truthfully, he viewed himself as more of an employee than the business leader.  He did not care all that much about dilution (he would go on to the next opportunity or get re-upped with more equity if he spent too much money) and his employees followed his lead.  It must have been devastating for Paul to watch this man run his company into the ground.  This investment was one of the final straws that made us change our investment criteria to backing only companies where we thought the Founder/CEO could go the whole way.  We have strayed from this on occasion and we have needed to bring in CEO’s in companies where WE were the founders, but, in general, this has been our modus operandi.

So on to Paul’s question.  Yes, we changed our investment criteria, but that does not mean we have been successful with every founder CEO since – we haven’t.  So, what do we do when we encounter this this situation?  The first step to solving any problem is recognizing that you have a problem!  This is easier said than done.  Typically, we like the CEO.  He or she might be a terrific person.  They have families.  They are trying really hard.  We believe in the company.  It’s actually really hard to recognize that you have a problem with your own company.  I would liken this situation to trying to believe that your child is not really the kind, wonderful, genius super model that you thought he is.   I don’t have this problem though, since my kids are just like that…

Discovery of the problem can come in several ways.  The best is to have sat down with your Founder/CEO prior to financing to discuss specific milestones against which success is measured.  But, as I said in the last post, companies never develop in a straight line.  However, the milestones do provide an opportunity to understand how the company is performing and what are the causes of the variance: Market? Product? Customer? Team? CEO?  The milestones provide a great framework to assess how the company is doing without being a binary (go/no-go) gate for the company’s future.

Typically, the awareness that the CEO is not performing is not discovered simultaneously by the board.  Many times, board members with close associations to the CEO don’t or won’t admit to seeing a problem.  They will defend the CEO for many reasons among them friendship, loyalty or simply trying to avoid confrontation.  Again, having pre-established milestones helps take many of the emotions out of this discussion.

Before there is agreement that the CEO must go, there is agreement that he/she should be put on notice that performance is not up to standard and the board tries to help with the situation in anyway it can.  This often falls to the VC board member along with a board member who was chosen by the entrepreneur/CEO.  With milestones, an objective conversation be held.  No accusations and counter accusations – just facts.  It gets emotional and its hard, but it’s the first step.  The board needs to tell the CEO that performance is not up to expectations and the board needs to offer the CEO all the help it can muster.  But, as I said before, the board and the VC does not run the company, the CEO does.  And in the end, the CEO needs to deliver the performance.

We strongly believe that we need to be active investors who add value.  We can certainly help, but our real ability to impact a deteriorating situation is to make changes, i.e. fire the CEO after all else fails.  We would certainly be looking to help the CEO all along the path leading up to this point in any way we can help.  But often, in these situations, the relationship between the CEO and VC has deteriorated.  Communication breaks down.  The CEO looks for other allies on the board.  So afraid of being fired, many times, the CEO seizes up and almost stops functioning.  Sometimes the best value we can provide is to just tell the CEO to go out and do the best he/she can – after all, what is the worst that can happen?  We will tell them we believe in him/her (if its true which it should be if we are all communicating about progress regularly) and to go take some chances.  Many times, failing CEO’s exacerbate the situation by becoming more conservative, ceasing to experiment, stopping learning.  Unless we can get the CEO back out there, failure is around the corner.

The real challenge though is to understand if the situation is the CEO or some other factor.  Firing the CEO must to be the last-ditch effort to save the company.  When the CEO is the founder too, firing the CEO it is like doing a heart and brain replacement surgery.  Probably with similar success rates in an early stage company.  Again, the factors behind failure can only be assessed through regular, objective dialog between both sides.

In the case of Haley Systems, we failed on several fronts.  I already mentioned that we hired the wrong CEO out of the gate.  Truthfully, we should never have invested and Paul should not have taken our investment.  He had a successful business that probably would not have gotten very big, but it would have been successful for him.  He was willing to give up the reigns, but having the founder hovering in the background with so much change is always very hard for everyone.  We hired the CEO without getting a plan out of him ahead of time (I will write about this in a future posting at some point).  We zigged, we expected him to zag.  He was  a terrible communicator and we never set up specific objectives beyond the financial plan.  We tried to counsel him, he never listened.  He had no passion or zeal for the market or the business and this lack of spirit spread everywhere else in the company.  We counseled him, we worked with him, we helped with sales, but in the end, he had to run the company.  We took a member of the board who had some time available and made him CEO.  He made as good a situation of it as he could but, by that time, we were in deep doody.   Our relationship with Paul deteriorated because he could not trust us to do the right thing since his company had gone nowhere but down since we became involved.  He worked to implement what he thought would work, often at cross-purposes to the acting CEO.  He never developed that low-end product until it was too late because he never shared OUR vision.  We initiated a sales process of the company and had interest, but the divisiveness was so apparent that either the potential buyers had no interest in getting involved in such a disaster or they knew they could get a great deal on the company. We sold the business, got some of our money back, settled with Paul and tried to make sure we learned from this situation (which we did – in spades!).

So, this is what it looks like in the real world.  It’s easy to write about it in some abstract framework like this Bill of Rights, but it is a lot harder in real life.  Like a great entrepreneur, a great VC should learn from every situation, good and bad.  We spend a lot of time with an almost forensic examination of what we did well and where we screwed-up.  With Haley, we screwed-up on many fronts.  Actually, the truth is, I did.  I think I learned from this and other situations and that is what I am trying to communicate in this blog.  Paul, thanks for letting me talk about it – please feel free to comment with your thoughts from the other side of the table.

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