Entrepreneur Corner

(Editor’s note: Serial entrepreneur Steve Blank is the author of Four Steps to the Epiphany. This column originally appeared on his blog.)

Over the last 30 years Wall Street’s appetite for technology stocks have changed radically – swinging between unbridled enthusiasm to believing they’re all toxic. Over the same 30 years, Venture Capital firms have honed their skills and strategies to match Wall Streets needs to achieve liquidity for their portfolio companies.

You have to wonder: does the VC you have on your board today have the right skill set to help you succeed in today’s economic environment?

One of the biggest mistakes entrepreneurs make is misunderstanding the role of venture capital investors. There’s lots of lore, emotion, and misconceptions of what VC’s do or don’t do for entrepreneurs. The reality is that VC’s have one goal – to maximize the amount of money they return to their investors. To do this they have to accomplish five things:

1) Get deal flow – via networking and legwork, they identify likely industries, companies and teams with the potential for rapid growth (less than 10 years),

2) Evaluate those companies and teams on the basis of technology, market opportunity, and team.  (Each VC firm/partner has a different spin on what to weigh more.)

3) Invest in and take equity stakes in exchange for capital.

4) Help nurture and grow the companies they invest in.

5) Liquidate their investment in each company at the highest possible price.

VC’s make money by selling their share of your company to some other buyer – hopefully at a large multiple over what they originally paid for it. From 1979, when pensions funds began fueling the expansion of venture capital, the way VCs sold their portion of your company was to help you take your company “public.” Your firm worked with an investment banking firm that underwrote and offered stock (typically on the NASDAQ exchange) to the public. At this Initial Public Offering your company raised money for its use in expanding the business.

In theory when you went public, everyone’s shares were now tradable on the stock exchange, but usually the underwriters required a six-month “lockup” preventing company insiders (employees and investors) from selling. After the end of the lockup, venture firms sold off their stock in an orderly fashion, and entrepreneurs sold theirs and bought new cars and houses.

Five Quarters of Profitability

During the 1980’s and through the mid 1990’s startups going public had to do something that most companies today never heard of – they had to show a track record of increasing revenue and consistent profitability. Underwriters who would offer the stock to the public typically asked for a young company to show five consecutive quarters of profits.

There was no law that said that a company had to, but most underwriters wouldn’t take a company public without it. (On top of all this it was considered very bad form not to have at least four additional consecutive quarters of profits after an IPO.)  While there was an occasional bad apple, the public markets rewarded companies with revenue growth and sustainable profits.

What this meant for entrepreneurs and VC’s was simple and profound – and is entirely unappreciated today: VC’s worked with entrepreneurs to build profitable and scalable businesses. In this time, a successful business was one that had paying customers quarter after quarter, not one that was flipped or hyped to the market despite a lack of earnings or revenue.

Venture Capitalists on the board brought a firm their expertise to build long-term sustainable companies. They taught companies about customers, markets and profits.

The world of building profitable startups as the primary goal of Venture Capital would end in 1995.

The IPO Bubble – August 1995 – March 2000

In August 1995 Netscape went public, and the world of start ups turned upside down. On its first day of trading, Netscape stock closed at $58/share, valuing the company at $2.7 billion for a company with less than $50 million in sales. (Yahoo would hit $104/share in March 2000 with a market cap of $104 billion.) There was now a public market for companies with no revenue, no profit and big claims.

Underwriters realized that as long as the public was happy snapping up shares, they could make huge profits on the inflated valuations – regardless of whether or not the company should have ever been public.

Some companies didn’t even have to go public to get liquid. Tech acquisitions went crazy at the same time the IPO market did. Large companies were buying startups just to get in the game at the same absurd prices.

What this meant for entrepreneurs and VC’s was simple– the gold rush to liquidity was on. The old rules of building companies with sustainable revenue and consistent profitability went out the window. VCs worked with entrepreneurs to brand, hype and take public unprofitable companies with grand promises of the future. The goals were “first mover advantage,” “grab market share” and “get big fast.” VCs or entrepreneurs who talked about building profitable businesses were told, “You just don’t get the new rules.”

To be honest, for four years, these were the new rules. Entrepreneurs and VCs made returns 10x, or even 100x larger than anything ever seen. (No value judgments here, VCs were doing what the market rewarded them for, and their investors expected – maximum returns.)

And since Venture Capital looked like anyone could do it, the number of venture firms soared as fast as stock prices.

Venture Capitalists on boards developed the expertise to get a firm public as soon as possible using whatever it took including hype and spin – because the sooner a company got its billion dollar market cap, the sooner the VC firm could sell their shares and distribute their profits.

The boom in Internet startups would last 4.5 years – until it came crashing down to earth in March 2000.

The Rise of Mergers and Acquisitions -– March 2003 -2008

After the dot.com bubble collapsed, the IPO market (and most tech M&A deals) shut down for technology companies. Venture investors spent the next three years doing triage, sorting through the rubble to find companies that weren’t bleeding cash and could actually be turned into businesses. With Wall Street leery of technology companies, tech IPOs were a receding memory, and mergers and acquisitions became the only path to liquidity for startups and their investors. For the next four or five years, technology M&A boomed, growing from 50 buyouts in 2003 to 450 in 2006.

What this meant for entrepreneurs and VCs was a bit more complex– the IPO market was all but closed (with the Google IPO in 2004 as a brilliant exception), but it was possible find a buyer for your company. The valuations for acquisitions were nothing like the Internet bubble, but there was a path to liquidity, difficult as it was. (Every startup wanted to believe they could get acquired like YouTube for $1.4 billion.)

VCs worked with entrepreneurs to build their company with an eye out for a chance to flip it to an acquirer. The formula for exits was a variation of the formula they used in the Internet bubble, morphing into: brand, hype and sell the company.

In the Fall of 2008, the credit crisis wiped out mergers and acquisitions as a path to liquidity as M&A collapsed with the rest of the market.

So what’s left?

2009 – Back to The Future

The bad news is that since the bubble, most VC firms haven’t made a profit. It may just be that the message of building companies that have predictable revenue and profit models hasn’t percolated through the VC business model. (Perhaps in direct proportion to the number of “freemium” and “eyeballs” web deals funded.)

It may be that the venture business will have to return to the old days of helping entrepreneurs build companies – not hype them, not spin them, but actually make them worth something to customers and investors.

The question is: Do VC’s still have what it takes to do so?

Next time you sit in a board meeting with your VCs, step back a bit from the moment and listen to their advice – like you are hearing them for the first time. Are these VC’s who know how to build a company?  Is the advice they are giving you going to help you build a repeatable and scalable revenue model that’s profitable quarter after quarter?

Or were they trained and raised in the bubble and M&A hype and still looking for some shortcut to liquidity?

Image by Stephen K. Willi via Flickr.

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Tags: IPOs, Mergers and Acquisitions, Venture Capital