Entrepreneurs and Venture Capitalists

Stephen DeAngelis

March 30, 2010

Entrepreneurs looking for capital and ventures capitalists looking for good ideas are natural partners; but not necessarily loving ones. Although entrepreneurs and venture capitalists would appear to be (as they say) a match made in heaven, there is a natural tension that arises between them. Entrepreneurs want control over and maximum benefit from their ideas while venture capitalists want grab as much of the gold as they can for offering to put up the money. Entrepreneurs often think that venture capitalists get too much equity for fronting the money and venture capitalists often believe they get too little. However uncomfortable and adversarial that relationship, entrepreneurs need venture capitalists and venture capitalists need entrepreneurs. Ironically, successful entrepreneurs often become venture capitalists themselves. One such entrepreneur turned venture capitalist is Gary Crocker [“Utah entrepreneur Gary Crocker’s passion is to lend a hand,” by Lois M. Collins, Deseret News, 15 February 2010].

 

Crocker began his journey to riches as a salesman for Baxter International. He sold medical devices to hospitals in the Boston area while simultaneously trying to get an MBA from Harvard and raising a family. His big break came when his entrepreneurial father-in-law, “James L. Sorenson, asked him to come home to Utah and sell Sorenson Research.” Collins reports what Crocker says happened next:

“In a bidding war, Abbott paid around $108 million ‘and that was my introduction to negotiating valuations of companies.’ Abbott liked the Utah men and kept on not only Sorenson as titular head of the company, but hired Crocker as vice president of marketing and product development. Within a few years though, ‘inculcated with the entrepreneurial spirit,’ Crocker ‘naively thought I can do that.’ With a manufacturing vice president and a research engineer, he left to lead a company that made open-heart surgery bypass catheters that used a nutritious solution to cool tissue. The company, Research Medical, eventually captured most of the market and Forbes five times called it one of the best 200 small companies. He also co-founded TheraTech, which delivered hormones using wearable patches. For more than a decade, Crocker was happily ensconced pushing the frontiers of those companies’ science.”

In the late 1990s, Collins reports that Crocker “sold Research Medical to his old employer, Baxter, for what was then a Utah record for a life science company: $235 million. Watson Laboratories later bought TheraTech for $340 million.” At that point, Crocker turned from entrepreneur to venture capitalist. Collins concludes the story:

“Crocker took his share of the profits and founded Crocker Ventures, with its focus on early-early development. It’s higher risk than a regular venture capital operation, but his passion is finding interesting things early and then helping researchers develop them. Without such investment, many great ideas would never make it past the drawing board. ‘The tragedy for most life sciences is investors want in and out fast,’ Crocker says. He takes a longer view.”

Deciding which ideas or companies to back is always a bit of gamble. Another entrepreneur/venture capitalist and op-ed contributor to the Financial Times, Luke Johnson, believes that entrepreneurs make good venture capitalists because they generally have good instincts [“A good gut feeling is the secret weapon,” 3 March 2010]. Johnson begins his column with a few questions: “What is the significance of instinct in business? Does a reliable gut feeling separate winners from losers? And is it the most valuable emotional tool any entrepreneur can possess?” He then provides answers to his questions:

“My observations of successful company owners lead me to believe that a highly analytical attitude can be a drawback. At critical junctures in commercial life, risk-taking is more an act of faith than a carefully balanced choice. Frequently, such moments require decisiveness and absolute conviction above all else. There is simply no time to wait for all the facts, or room for doubt. A computer program cannot tell you how to invent and launch a new product. That journey involves too many unknowns, too much luck – and too much sheer intuition, rather than the infallible logic that machines deliver so well. As Chekhov said: ‘An artist’s flair is sometimes worth a scientist’s brains’ – entrepreneurs need right-brain thinking. When I have been considering whether to buy a company and what price to offer, I have been blinded too often by reams of due diligence from the accountants and lawyers. Usually it pays to stand back from such mountains of grey data and weigh up the really important issues – and decide how you feel about the opportunity. It can be fatal to let small negative matters put you off an acquisition that you know in your heart is a wonderful deal. It might mean you spend your life dreaming about the brilliant chances you missed because you let overcautious advisers frighten you. Never allow quantitative drawbacks to defeat overwhelming qualitative arguments.”

Johnson isn’t arguing against sound business plans in favor blind emotion; rather, he is arguing that in situations where the go/no go decision isn’t crystal clear gut instincts can play an important role. He concludes:

“This phenomenon offers a huge competitive advantage for entrepreneurs over institutions and corporations. Large organizations must maintain committees and systems, all of which abhor abstract notions like gut instinct. You cannot teach such a methodology as part of an MBA, or set down the formula in a textbook or on PowerPoint. But the business establishment requires research and data, and checks and balances, all of which militates against the sort of novel solutions and bold moves that really create unexpected value. Gut feel is the freelancer’s secret weapon. … Intuition is at its most powerful when combined with confidence. If you possess this mighty duo of talents, you can carry others with you, even though you cannot necessarily provide concrete evidence that you are right. If you are to launch projects before others, invent new products or seize opportunities ahead of the pack, you must be willing to act – at least in part – on a hunch. Experience will teach each of us when to follow our innate judgment, and when to call for more technical back-up. It is difficult to generalize about creativity and insight – many of us are born with plenty of imagination, but some work out a method of channeling it in a productive way while others suppress that part of their mind. Unfortunately, visionaries sometimes lack skill at articulating their views and cannot marshal the documents to justify their opinions, so the sceptics master the debate. That is why pioneers so often leave large companies to do it for themselves. As Billy Wilder, the Hollywood director, said: ‘Trust your own instinct. Your mistakes might as well be your own, instead of someone else’s.'”

These are hard times for some venture capital firms since investors are harder to find and so are good ideas. Some VC firms are so desperate for ideas that they have created in-house incubators for entrepreneurs [“6 Months, $90,000 and (Maybe) a Great Idea,” by Ashlee Vance and Claire Cain Miller, New York Times, 28 February 2010]. Vance and Miller explain a concept call entrepreneur-in-residence:

“This coveted position, called an E.I.R. in Silicon Valley shorthand, is emblematic of the valley’s economy of ideas. Most E.I.R.’s receive a monthly stipend of up to $15,000 to sit and think for about six months. In return, the venture capital firm usually gets the first shot at financing the idea that emerges from this meditation. ‘The E.I.R. takes out some of the risk because they are known quantities,’ said Adam Grosser, a partner at Foundation Capital. ‘They have a track record of success and a proven ability to disrupt a market with their ideas.’ Venture capital firms have been struggling to find a company that will make them not just rich, but fabulously rich. … The entrepreneur-in-residence model has gained prominence as a calculated way for a venture capital firm to nurture a successful company into being and to increase the odds of solid returns. The firms often tap someone who has successfully started and sold a start-up, hoping that lightning will strike twice.”

Promoting creative ideas that lead to the founding successful businesses is not just good for entrepreneurs and venture capitalists it is good for the overall economy as well. When start-ups hit it big, entirely new market segments emerge and thousands of new jobs are created. Vance and Miller report that “Silicon Valley has had a knack for finding at least one of these remarkable pairings just about every decade. They’re the creators of new industries — chips, PCs, servers, Web sites and ad-fueled search systems — on which others build.” They continue their report with a couple of success stories.

“The investment firm New Enterprise Associates, for example, hit it big last year when the storage giant EMC bought Data Domain for $2.3 billion, the largest acquisition in 2009 of a venture-backed technology company. (The average deal that year was just $144 million.) The Data Domain story grew out of a chance encounter. Kai Li, who would be a co-founder of the company, was on sabbatical from his job as a computer science professor. He had been thinking about some ideas for a start-up when he ran into an old friend from New Enterprise. A couple of chats later, he was an E.I.R. Similarly, the biggest public offering of a venture-backed technology company in 2007 was that of MetroPCS, which raised $1.2 billion. It was started by Roger Linquist when he was an E.I.R. at the venture capital firm Accel. A host of other flashy companies have recently emerged from the E.I.R. ether. Zimbra, an e-mail software start-up, was sold for $350 million to Yahoo in 2007. (In a very different economic climate this year, it was sold again to VMware for a reported $100 million.) Then there’s Cloudera, one of the most-watched start-ups in Silicon Valley. It seeks to bottle the analytical smarts on which Google and Yahoo rely to understand their users’ behavior and sell the product to large corporations dealing with torrents of data. Cloudera came into being at Accel, where a pair of E.I.R.’s worked after having left Yahoo and Facebook. Venture capital firms are closely held, so there is no data on the number of companies that the E.I.R. process has created — or on how many of them have succeeded. But top firms say a new company is formed about 50 percent of the time. The rest of the E.I.R.’s will either take on a job at an existing company in the venture capital firm’s stable or go their own way.”

According to Vance and Miller, EIRs have been around since the early 1980s and the program remains strong. However, they note that when entrepreneurs-in-residence fail to the deliver the breakup can be awkward and the fallout negative.

“Leading venture capital firms today may have two or three E.I.R.’s on the payroll at any one time. An E.I.R. typically has an office, an assistant and what people in Silicon Valley almost always refer to as a ‘nominal fee’ of $10,000 to $15,000 a month. It’s enough to tide over the elite business people whom investors are looking for, so that they aren’t worried about lacking a day job for six months. … In exchange for the office and the stipend, the E.I.R. provides a few basic services. He or she becomes part of the audience for start-up road shows, sitting in on the daily presentations that other companies pitch to the venture capital firm and advising the investors about the ideas’ merits. In addition, the E.I.R. agrees — via contract or, more often, tacitly — to give the venture capital firm the first shot to invest in an idea. ‘It is as ruthless and profit-oriented at the end of the day as anything else a V.C. does,’ said Adam Gross, a former E.I.R. at Redpoint Ventures. This arrangement provides E.I.R.’s with a few major advantages over other entrepreneurs. The masses have to go to great lengths just to get in the door of a venture capitalist’s office, while E.I.R.’s work there daily. They can sit in on Monday-morning partner meetings and pitches, and they can consult with the partners in the lunch line. And, when E.I.R.’s are ready to test an idea, they can tap the vast network of contacts that the venture capital firm has built over time. This could include persuading a large company to provide feedback on a product or polling a host of companies about their technology problems.”

The connectivity provided to an E.I.R. is invaluable. It certainly beats having to wear out shoe leather while pounding the pavement and knocking on doors. Vance and Miller report that “the process adds a touch of human companionship and vibrancy to an otherwise lonely, sedentary endeavor” and exposes entrepreneurs to vast array of ideas and models that can be used to stimulate thinking. They also note that the concept doesn’t appear to work as well outside of the traditional VC environment.

“Business schools like Harvard and Wharton have E.I.R. programs, as do big companies like Hewlett-Packard and Adobe. The Department of Energy started one as well, to try to transform ideas formed at national laboratories into seedlings for companies. But people trying to replicate the process are not always as successful as those in Silicon Valley. [Michael] Bauer, [and E.I.R. at Foundation Capital], worked on the Department of Energy’s E.I.R. project at Oak Ridge National Laboratory in Tennessee. ‘It was fascinating but also very disappointing,’ he said. ‘I looked at 1,500 invention disclosures and walked away from 1,500 ideas.’ His office at Foundation Capital is full of oscilloscopes and other gadgets, which makes it an oddity in the E.I.R. world, where most people just sit in front of their computers. He has built a replica of a city block on a desk to test his top-secret energy ideas. Foundation Capital has bought into his plans, and Mr. Bauer and his team are now leaving the nest and getting their own offices. While the expectations are high for his ideas, Mr. Bauer maintains that the E.I.R. programs work precisely because failure is allowed in Silicon Valley.”

In fishing parlance, “If you ain’t losing lures, you ain’t really fishing.” Almost every entrepreneur has had ideas that haven’t turned out as well as he or she hoped they would. Because entrepreneurs are generally optimistic, they aren’t normally deterred by disappoint. There will allows be a creative tension between entrepreneurs and venture capitalists; but, in the end, they know they need each other.