Friday, October 3, 2008

Entrepreneurship in Tough Times

I think it's too early to assess the real impact of the Great Wall Street Meltdown of 2008 on the venture community and on the startup companies we fund. One thing seems clear: with the IPO market disappearing and the M&A market effected by the diminished currencies of the potential buyers, the exit opportunities are certain to be attenuated.  The blowback from this attenuation -- and an overall reduction in risk tolerance by investors across the board -- will likely take the fun out of fundraising for a while.

This will also have an immediate and palpable effect on pre-money valuations. Venture tolerance for risk is deeply entangled with our ability to acquire ownership, the price we pay for that ownership, the cost to maintain that ownership over time, and the availability of exits.  If the market for follow-on financings gets soft, and it takes much longer to get companies liquid, then we will have to assume greater downstream dilution, or increased and prolonged pro-rata investment to maintain ownership, with the increased risk that brings.
The really hard-sells in this environment are typically the "build an audience and think about business models later" plays.  These companies are generally hit the hardest by the diminishing venture risk-tolerance. I'm not sure this is entirely justified, particularly if the company has a low burn rate, but the rationale seems to be that it's harder to flip these no-revenue plays for their strategic advantage alone (vis YouTube) when the buyers' currencies get whacked, and it's impossible to take them public in a contracting market focused on economic fundamentals.  
But it is not all gloom and doom.  I have personal experience launching and managing a startup to success in the last downturn. JAMDAT raised its first round of venture investment in early 2001.  We raised a series B in 2002 and a series C in 2003, before going public on the heels of Google in October 2004.  So I have some scars from financing a company during times like these, as well as the pleasure of seeing it all work out in the end when the market recovers.
Based on that experience, I want to offer three lessons from the JAMDAT playbook for entrepreneurs dealing with a the fear-tainted venture capital environment:
1) Focus the burn.  I am not arguing for lay-offs and contraction, hunkering down in the bunker with canned goods and ammo. But you need to be spending every dollar you have in single-minded pursuit of the things that are going to increase shareholder value and the likelihood of future financing. 
We kept JAMDAT at around 30 employees and a $400K burn for two and a half years, until our revenue model became clear.  If the team needed a feature and we wouldn't fund it, they got creative -- outsourced to India, formed partnerships with independent developers. We grew expenses and headcount in response to actual financial opportunities. 
There were some tough times -- the US carriers delayed launching the services that enabled our business by 6-9 months (which was the blink of an eye for them, but devastating to our carefully-managed cash position).  You have to plan ahead -- getting caught with no cash and having to appeal to your existing investors for bridge financing, or having to raise money when you are on your knees, is a recipe for entrepreneurial disaster.
2) Manage for Long-Term Competitive Advantage.  This is not the time to be chasing every possible tangential business opportunity, or funding pet projects and speculative R&D. This is the time to pursue your chosen strategy with insane focus. We used to evaluate everything we did at JAMDAT with the following question: is this going to create long-term competitive advantage for our publishing business? 
We were pursuing a risky strategy -- it assumed that color screen phones with embedded operating systems and bill-on-behalf models would predominate in the cell phone markets in the US and Europe.  That was non-obvious in 2001/2.  But we were right; and the fiscal discipline and strategic focus that we embedded in our DNA during the uncertain period allowed us to get to profitability and market dominance rapidly after the worm turned.  We had eliminated all the fat and distraction, and we were able to execute much more efficiently when the business took off.
3) Don't Fool Yourself.  Raising money in these environments really sucks. In the spring of 2002, we initiated our series B -- a full 8 months before we were scheduled to run out of cash. Just to be on the safe side.  Every tier 2 and tier 3 VC we pitched announced that they were "only doing down rounds."  We were literally thrown out of one VC's office -- asked to eat the lunch that had been ordered for us elsewhere -- because we had the temerity to suggest that, having funded JAMDAT at a post-bubble valuation and having shown good progress, we should not be lumped in with, or whatever other dead dot-comedy they may have funded in the 1999 greed-orgy.
The key is that you have to be honest with yourself about your business. You have to talk the talk and walk the walk on risk reduction and focus.  You have to be honest about your opportunity.  In this environment, you won't be getting away with top-down, "if-we-only-get-1%-of-this-huge-market" fantasies, or bullshit pro forma P&Ls with 70% EBIT margins in year 3. 
The VC who kicked us to the curb was an idiot -- he was so focused on the deal that he couldn't see the opportunity. That happens a lot in these funding environments. But don't blame the VCs for seeing through your bad business, either.  An investor may have the stomach to take a flier and see if it works out in a frothy market, but not now.

No comments: