Silicon Valley Watcher - at the intersection of technology and media

Last week I got a chance to speak with the former head of Google China, Kai-Fu Lee about why he left the search giant and what he will be doing. Mr Lee joined Google in 2005 from Microsoft, to become president of Google China. His mission was to increase Google's reach in China against the domestic competitor Baidu.

Microsoft tried to stop Google from hiring Mr Lee but Google won the legal tug of war. At the time, Mr Lee wrote: "I need to follow my heart." [Kai Fu Lee: I need to follow my heart ZDNet.com]

Similarly, leaving Google, Mr Lee told me that he needed to follow his heart and take on a role where he can create a tremendous amount of value.

He is setting up an investment fund, Innovation Works that will make very early investments in Chinese startups. The fund will also provide the young companies with back-office support and other services so that the entrepreneurs can concentrate on developing technologies and services. The size of the fund is initially set at $115 million.

Here are some notes from our conversation:

- There is a large amount of capital in China waiting in the wings ready to invest in later stage financing for startups. But there is very little seed or angel investments.

- My goal is to provide those angel investments, and to quickly get companies up and running. Within 9 to 12 months those companies can attract later stage investments.

- The angel community in China is very different. It is very inexperienced and it often has ridiculous expectations. For instance, angels will sometimes insist on being repaid their money if a startup fails, trying to say it was a loan when the investment documents show otherwise.

- Angel investors are a very rare breed, they are self-selected, they have to learn how to do what they do and to network. I hope to be able to train others and to create a community of angel investors.

- There is a tremendous amount of enthusiasm and talent among Chinese entrepreneurs.

- Silicon Valley has managed to create a culture of openness to ideas and also to capital. In that way, ideas and capital can often find each other. China does not yet have this type of culture.

- There is some advantages to companies that are Chinese. This is especially true in the area of media such as search and social networks. These can be ideological areas and often require a license. We will be making investments in these areas as well as other sectors.

- Chinese startups are generally a lot more humble and understated and that can help.

- I will also be investing my own money.

- I'm not sure if Chinese entrepreneurs or developers from Silicon Valley will be drawn back to China because of this venture. If they are, there will be less need for my help.

- The timing is right for my move.

- Because of my roles at Microsoft and Google people trust me. I hope to become a matchmaker for talented entrepreneurs and capital.

Silicon Alley Insider has an interesting post: New York VCs Spend 90% Of Their Money Out Of Town.

The article quotes ChubbyBrain, a site that tracks VC investments, which found "Only 10% of NYC Area Venture Capitalist Investment Has Gone to NYC Startups."

That's about $1.8 billion in the second quarter of 2009 going into investments outside of NYC, the majority to Silicon Valley based companies.

It's no wonder that Silicon Valley continues to attract companies because this is where investments are made. This is despite an often repeated mantra that: "innovation can be carried out anywhere."

It is true that innovation can be carried out anywhere, but innovation in Silicon Valley gets funded. As New York City VCs might say it: mantra shmantra.

Mike Arrington at Techcrunch has a great post on standard legal docs for startups that can save them as much as $50k in legal fees when taking investment monies. The Funded Publishes Ideal First Round Term Sheet.

The legal docs were prepared on the behalf of Andeo Ressi, founder of The Funded, a site that ranks VCs. They are designed to protect founders from some of the predatory terms used by VCs.

Georges van Hoegaerden, a serial entrepreneur, writes that "The Silicon Valley emperor has no clothes."

...Silicon Valley has become the emperor who wears no clothes. Many Venture Capitalists (VCs) like the emperor will hold their head high and continue their procession for the sake of protecting their management fees.

...the simple fact remains that very little disruptive innovation is born. And without disruptive innovation (and the risks that such innovation incurs) it is just a matter of time before the Limited Partners (LPs) recognize that the emperor's procession is coming to an end.

Mr Hoegaerden says that the fault is with the VCs -- many don't have the entrepreneurial experience to do their job. And they will always look to blame others and never themselves.

He writes that "innovation is not the problem," the problem is ineffective VCs

I just spoke with Bob Ackerman, founder of Allegis Capital, and he is very concerned about innovation in Silicon Valley, primarily because of the cumulative impact of US government actions and regulations.

Here are some notes from our conversation:

- I'm very worried about the seed corn, that we won't have that next crop of innovative companies five, ten years in the future.

- Innovation is in trouble because of restrictions on H1B visas; unfavorable tax policies regarding stock options; the failure to change Sarbanes-Oxley in regards to startups which increases costs; and the government investing billions of dollars picking winners and losers, such as the bailout of the automakers. It's all building into a crescendo that harms innovation.

- I'm afraid that Washington doesn't understand venture capital and what we do. The Treasury department wants to regulate VC firms in the same way as hedge funds and private equity. This is wrong. VC firms use no leverage, while hedge funds and private equity leverage funds at huge ratios and look for short term gains. VC firms should not be regulated in the same way, it will hurt the smaller VC firms which are the most productive. This is a cottage industry.

Forbes reports on "What private equity investors want."

- predictable business model.

- scalable business model.

- a misunderstood business model "therefore undervalued by the marketplace."

Basically, he's looking for a company with a solid business model with recurring revenue and a low valuation. That sounds like a low risk set of features, yet he sees Silver Lake as a risk taker.

"We're at a point in the cycle where we feel like we're being paid to take risks."

But he wants to moderate the risk by making sure valuations are low.

While companies would like to keep their valuations from July 2007, Roux said that a term of art in the industry now applies: "the valuations have begun to season."

He doesn't sound like a risk taker to me. And with $9 billion to invest, he won't be investing in startups.

Richard Garnick is from Boston but he likes to pepper his language with Hindi phrases that describe his aggressive mantra for transforming poor performing businesses.

He's Chairman and and CEO of Conjoin Group, a newly formed company that plans to invest as much as $200 million over the coming year in transforming five to ten mid-sized companies.

And the Hindi phrases are because of his background as the top North American executive for the giant Indian IT outsourcing firm Wipro Technologies, and from time spent establishing offshore operations in India.

Despite the poor economy he sees lots of opportunities.

"There are a lot of solid businesses that were funded in the 2001 to 2006 period but never managed to reach 'escape velocity' and scale up. Now, their owners are tired of their stagnant performance but have been unable to change the business. That's where we come in."

Mr Garnick will take an ownership interest and spend as much as $20 million restructuring the company.

He's looking for businesses with solid recurring annual revenues in the $50 million plus range. His team will come in and analyze every aspect of the business and implement changes to reflect best business practices. Anything that can be digitized, and that is part of a repeatable business process, is outsourced to India.

Why can't businesses do this themselves?

"Many have leadership that doesn't know or understand what can be done in terms of outsourcing. And there are many political obstacles towards change within companies. We bring in our own leadership, we align ourselves with the goals of the owners, and we implement best practices that can reduce operational costs by at least 50 per cent, and as much as 75 per cent."

Also, mid-sized businesses don't have the capital to bring in a McKinsey team to do the analysis, which can run to $10m or more. Conjoin has its own practice, staffed with ex-McKinsey people, to perform this work at less than half the cost.

Here are some further notes from our conversation:

Vinod Khosla is one of Silicon Valley's most successful VCs. I was at the recent SDForum Visionary Awards where Mr Khosla was one of four winners of the 2009 awards.

His acceptance speech was short and very good. Excellent advice for entrepreneurs.

Also, he talks about failure, which I have long advocated is Silicon Valley's strength.

A couple of years ago I met with a delegation of Russian diplomats, VCs, and government officials. They were visiting Silicon Valley and wanted to meet with me as part of their tour. They were looking for ways to create several Silicon Valley-like regions in Russia.

During our meeting, I told them I would tell them the secret of Silicon Valley. I paused. They all leaned in a little closer...

[Guest post from Georges van Hoegaerden, an accomplished entrepreneur, CEO and venture catalyst "turned conservationist of the technology asset class." His articles also appear at http://venturecompany.com. Here are extracts from a longer essay: How LPs should deal with VC. ]

By Georges van Hoegaerden

The technology sector which is my passion for the last 30-years is at the beginning, not the end of its emergence. Perhaps the top-level indicator of the innovative runway we have ahead of us is the following: more than 5/6 of the world's population does not yet use a computer connected to high-speed/broadband internet today. And all should and will, given the right technology.

That's where technology innovation comes in; not just in connecting people to the internet but in deploying innovation that uses the internet as a distribution mechanism. The way we use the internet today is rudimentary, and many new technology stacks will emerge to improve its impact on everyday citizens.

On Sand Hill Slave, Slave Girl gets her mid-year performance review . . .

In my case, partners always catch me for the review when I’m in the middle of something that has my complete and undivided attention.

Partner: I have time for that review now.

SlaveGirl: Okay, can you give me a few minutes? I’m wrapping something up...

Partner: Well, I’ve only got a few minutes-

Sensing his tone, I immediately close out my YouTube window and scamper into his office.

Continues . . .

Sand Hill Slave: Even Though I Walk Through the Valley in the Shadow of Tech, I will fear no VC...

I recently caught up with Jurgen Popp, one of the top European angel investors. He was in town attending a VC conference and also tending to some of his US investments, including the rapidly growing Smart Health Buyer -- a US version of a very successful German startup.

From his perch in Zurich, Switzerland, Mr Popp gets to mix in European and US VC circles. And because he is an angel investor, he is often able to say things that others can't. Here are some notes from our meeting:

- I recently attended a large VC conference in San Francisco. The VCs all seemed interested in what types of new fees they could charge their investors rather than looking for new startup ideas.

- There were about five angel investors at the VC conference and it was easy to spot each other because we were the only ones asking questions about business rather than about fees. We all ended up sitting at the same table.

- The US VCs love to portray themselves as risk takers but they are not. It's the entrepreneurs that take the risks.

- There is very little VC activity in Europe right now, it seems to have virtually disappeared.

- There's a lot of activity among VC firms selling and buying portfolios, but a lot are being sold at 15% to 25% on the dollar.

- The way some of the US VCs behave they are killing innovation. They will join together to drive down valuations and take as much equity as they can from the founders.

- There are a lot of companies waiting in the wings to IPO. But I wonder if it is worth it for some of them. If they raise $50m on a $200m valuation much of that money will go in fees to bankers and lawyers.

- I believe there will be a rebound in VC investing in 2010 because by that time there will have been a rebound in stock markets -- maybe a doubling of where we stand today. That will free up money to be invested in startups.

- I'm already seeing a bit more activity. More people are calling, and there is a lot more interest in investing in small companies. That will grow over the next few months.

I'm so happy. My favorite bitch goddess, Sand Hill Slave is back!!!

[Guest column by Greg Gianforte, CEO of RightNow Technologies and a serial entrepreneur.]

By Greg Gianforte

Raising venture capital for early stage start-ups seems to be the prevailing path for most entrepreneurs; however, most would-be founders should reconsider.

Here are some reasons why:

- If you start by selling your concept to potential prospects (rather than stock to VCs), you will either end up with initial customers or a conviction that your idea won't work. Why raise money and then find out which one it will be?

- Raising money takes time away from understanding your market and potential customers. Often more time than it would take to just go sell something to a customer. Let your customers fund your business through product orders.

- Adding VCs to the mix early gives you an additional set of masters you must serve in addition to your customers. It is always hard to serve two masters, especially in a startup.

- With no money you can't make a fatal mistake. This is a blessing. Without VC money, you are forced to figure out how to extract funds from your customers for value you deliver. Ultimately that is the only thing that really matters.

- Money removes spending discipline. If you have the money you will spend it - whether you have figured out your business model and market or not.

-Raising VC money determines your exit strategy. You will either sell the business or take it public. What if you end up with a very profitable, modest sized business that you want to just run? That is no longer an option once you raise VC money.

- You sell your precious equity very dearly before you have a proven business model. This is the worst time to raise money from a valuation perspective. I know this is a contrarian view. And some of you are saying that might be fine for a small company.

Don't forget Dell, HP, Microsoft all originally started without VC funding; you can build a big business with bootstrapping and without VC money. At RightNow, we doubled our revenue and employees every 90 days for two years before we took any outside money, and even then the employees retained more than 75% ownership after raising $32m.

- - -

[I see a lot of companies that are seeking VC money, or have VC money but need more, as if that would make their business viable. VC money isn't always smart money and it isn't always the smartest thing to do. I republish Greg's column at least once a year because it contains lots of common sense.]

Greg Gianforte is the author of: Eight to Great: Eight Steps to Delivering an Exceptional Customer Experience

His previous book is: "Bootstrapping Your Business: Start and Grow a Successful Company With Almost No Money."

If you would like to contribute a quest column please let me know: Tom(at)Foremski.com.

[Guest post from Georges van Hoegaerden, an accomplished entrepreneur, CEO and venture catalyst "turned conservationist of the technology asset class." His articles appear at http://venturecompany.com.]

The auto company's plan to fixing VC

By Georges van Hoegaerden

The National Venture Capital Association (NVCA) has released its recovery plan (4-pillar plan) to fix Venture Capital that is eerily similar to that of the auto companies. It focuses on the prolongation of (their) life rather than on the quality of its product; the ability to spawn meaningful innovation.

Now I am sure Dixon Doll, from his perch atop a $1.6B Venture firm, means well but his purview is severely limited by his role as chairman as one of the most closely held investment clubs in the nation. Its members, ninety-something percent of the U.S. VCs are simply not incented to present all options for improvement, and certainly not one that would include self-cannibalization.

Nothing in this plan covers the stimulus and meritocracy required to spawn and monetize disruptive innovation. The plan mentions entrepreneurs, as the real value creator in this equation - in passing - only once (slide 11) amongst its thirty slides. The plan seems to forget that the entrepreneur is the real value creator, not the VC.

[Guest post from Georges van Hoegaerden, an accomplished entrepreneur, CEO and venture catalyst "turned conservationist of the technology asset class." His articles appear at http://venturecompany.com.]

Idiot CEOs

By Georges van Hoegaerden

That's how one of the many CEOs that contact me recently described his colleagues who submit to Venture Capital (VC).

This alternatively funded CEO describes other CEO's that seek VC funding as idiots -- with a 1 in a 1000 shot at a lousy valuation (52% Round A, 25% Round B and 15% Round C). He continues that many of the serial entrepreneurs trumpeted by VC's have no money themselves despite "successful" previous exits.

He is not alone about the ineffectiveness of Venture Capital, I frequently hear from other successful entrepreneurs about it. And the situation may get worse before it gets better. The economy is offering VCs even more excuses to turn the screws, and control of companies is gained in more ways than a simple equity stake.

I believe technology investing today is largely a sub-prime asset class as described in a plethora of sub-prime articles in this blog, and find many entrepreneurs discouraged by both the process as well as the outcome of fundraising, even when that yielded a round.

Because of the ineffectiveness of VC and the rampant false positives and false negatives I refuse to believe VCs (and the NVCA collectively), who suggest that the sum of Venture Capital equals the sum of technology innovation. We see great entrepreneurs actively pursuing more creative investment vehicles (high-net-worth individuals, private equity firms, investment bankers, sovereign funds...anyone with money), and rightfully so.

In the meantime, oblivious to recognizing their own flaws, VCs are further descending down the sub-prime spiral by restricting investments to compliant entrepreneurs, evidence that they remain clueless about the fundamental risk management of high yield returns.

Smart CEOs should simply refuse to work with many technology investors for the following reasons:

VC firms are keeping their powder dry these days and that means very few new ideas are being funded. Bob Ackerman from Allegis Capital was recently on CBS 5 speaking with KPIX reporter Sue Kwon.

A few key points from the interview (thanks to Steve Kaufman):

- Stiff U.S. regulations and tax policy is slamming Silicon Valley VCs. “It’s killing the goose that laid the golden egg,” he said. The evidence is not merely the decline in U.S. fund-raising but the concurrent increase in VC funding offshore – a record $8 billion was invested in Indian and Chinese startups last year. Many of startups that corralled the money were started by entrepreneurs who were educated in America and then worked for U.S. technology companies before returning home. “They are returning to their roots, and the capital is following them,” Ackerman said, adding that this trend is delivering body blows to the traditional wellspring of U.S. technological innovation.

- Even though some of the greatest technology companies, such as Cisco, were created during economic downturns, local VCs have become exceedingly risk-adverse. Ackerman says 75-80 percent of VCs have stopped investing in new startups. Instead, they’re focused on mitigating failures among startups they have already backed and are investing fresh capital only in those they deem most promising. They’re missing the boat because it’s almost impossible to determine which startups will ultimately succeed. One Ackerman-backed startup, IronPort Systems, founded in the middle of the dot.com bust in 2001, was acquired by Cisco in 2001 for $830 million.

- VCs have been spoiled by evolutionary industry trends. This decade, as VC funds grew bigger and bigger, VCs became more hands-off and less hands-on, paying insufficient attention to most of the entrepreneurs they backed. VCs need to return to their roots and work much more closely with entrepreneurs, sharing their successes, failures and experiences to improve the overall possibility of success.

- If these trends are not soon reversed, Silicon Valley will completely lose its waning reputation as the world’s greatest technology innovation center, initially created by the convergence of great universities, a disproportionately large number of local VCs, a strong entrepreneurial culture and the lack of stigma in failure. All this explains why the Valley, at least until recently, consistently attracted so many bright Indian, Chinese, Russian, British and French engineers as the technology haven for the best and brightest. As noted above, this long-standing trend is now in serious jeopardy.

Here's the interview:

http://cbs5.com/video/?id=48599@kpix.dayport.com

Investments in the IT industry fell to their lowest level since 1998, a 39 per cent drop compared with the year ago period. Overall, US venture capital investments fell 30 per cent, compared with the year ago period, to their lowest level since 2005 reports Dow Jones Venture Source.

"The data confirms what we've being hearing anecdotally for some time that many venture capital firms are circling the wagons to weather the downturn and are focusing more on the health and vitality of current portfolio companies rather than new investments," said Jessica Canning, director of Global Research for Dow Jones VentureSource.

Healthcare also fared badly, dropping 42 per cent from a year ago.

The bright spot was energy investments which more than doubled from the 2007 Q4.

Here are the 2008 Q4 details:

Deals: 554

Investment: $5.5 billion down 30 per cent from 2007 Q4

Total 2008

Deals: 2,550

Total 2008 investment: $28.8 billion down 8 per cent from 2007

Here are the sector details:

Scott "Dig" Scheper is an analyst at a venture capital firm in Orange County. He recently put together this short presentation on lessons in venture capital. He has some excellent advice for startups such as don't wait in the car park to pitch again!

I wasn't able to attend the recent Under the Radar Dealmaker LA Roundtable on the VC Outlook 2009 but TechZulu was there. Here are some video segments from the conference:

Jason Nazaar, Founder, DocStoc (Moderator)

David Travers, Associate Rustic Canyon Ventures
Brian Garrett, Managing Director, Cross Cut Ventures
Jim Armstrong, Managing Director, Clearstone Venture Partners
Mark Suster, Partner, GRP Partners

This is a guest column written for Silicon Valley Watcher by Greg Gianforte, CEO of RightNow Technologies and a serial entrepreneur:

Raising venture capital for early stage start-ups seems to be the prevailing path for most entrepreneurs; however, most would-be founders should reconsider.

Here are some reasons why:

-If you start by selling your concept to potential prospects (rather than stock to VCs), you will either end up with initial customers or a conviction that your idea won't work. Why raise money and then find out which one it will be?

-Raising money takes time away from understanding your market and potential customers. Often more time than it would take to just go sell something to a customer. Let your customers fund your business through product orders.

-Adding VCs to the mix early gives you an additional set of masters you must serve in addition to your customers. It is always hard to serve two masters, especially in a startup.

-With no money you can't make a fatal mistake. This is a blessing. Without VC money, you are forced to figure out how to extract funds from your customers for value you deliver. Ultimately that is the only thing that really matters.

-Money removes spending discipline. If you have the money you will spend it - whether you have figured out your business model and market or not. -Raising VC money determines your exit strategy. You will either sell the business or take it public. What if you end up with a very profitable, modest sized business that you want to just run? That is no longer an option once you raise VC money.

-You sell your precious equity very dearly before you have a proven business model. This is the worst time to raise money from a valuation perspective. I know this is a contrarian view. And some of you are saying that might be fine for a small company.

Don't forget Dell, HP, Microsoft all originally started without VC funding; you can build a big business with bootstrapping and without VC money. At RightNow, we doubled our revenue and employees every 90 days for two years before we took any outside money, and even then the employees retained more than 75% ownership after raising $32m.

- - -

Foremski's Take:

I see a lot of companies that are seeking VC money, or have VC money but need more, as if that would make their business viable. VC money isn't always smart money and it isn't always the smartest thing to do. Greg's column needs to be republished from time to time because it remains relevant.

Greg Gianforte is the author of a new book:Eight to Great: Eight Steps to Delivering an Exceptional Customer Experience

His previous book is: "Bootstrapping Your Business: Start and Grow a Successful Company With Almost No Money."

If you would like to contribute a quest column please let me know: tom(at)SiliconValleyWatcher.com.