similar questions, such as How do you evaluate potential venture opportunities? How do you

How Venture Capitalists Evaluate Potential Venture Opportunities

We interviewed four venture capitalists from leading Silicon Valley firms to learn about the frameworks they use in evaluating potential venture opportunities. (See Exhibit 1 for background information on these venture capital firms.) All four were interviewed individually and were asked similar questions, such as “How do you evaluate potential venture opportunities?” “How do you evaluate the venture’s prospective business model?” “What due diligence do you conduct?” “What is the process through which funding decisions are made?” “What financial analyses do you perform?” “What role does risk play in your evaluation?” and “How do you think about a potential exit route?” The following are excerpts from these interviews.

Russell Siegelman: Partner, Kleiner Perkins Caufield & Byers (KPCB)

Russ Siegelman joined KPCB in 1996 after seven years with Microsoft Corporation, where he helped found and launch Microsoft Network (MSN). Before working at Microsoft, he wrote artificial intelligence software. Siegelman invests in software, electronic commerce, Web services, telecommunications, and media and sits on the boards of Vertical Networks, Lilliputian Systems, Mobilygen, Quorum Systems, Digital Chocolate, and Vividence. He is one of the managing partners of the KPCB XI Fund, which closed in February 2004. Siegelman earned his B.S. from the Massachusetts Institute of Technology in physics in 1984 and an MBA from Harvard Business School in 1989.How Do You Evaluate Potential Venture Opportunities?“We have a generally understood set of things we look for when we evaluate an investment opportunity. The most important requirement is a large market opportunity in a fast-growing sector.Explosive growth makes it difficult for somebody to catch up or incumbents to respond. We like a company to have a $100 million to $300 million revenue stream within five years. This means that the market potential has to be at least $500 million—or more, eventually—and the company needs to achieve at least a 25% market share.This document is authorized for educator review use only by Dr Camilla Jensen, University of Nottingham Malaysia Campus until January 2017. Copying or posting is an infringement of copyright. [email protected] or 617.783.7860 Case Noes & Answer with Free Case File for HOW VENTURE CAPITALISTS EVALUATE POTENTIAL VENTURE OPPORTUNITIES by Michael Roberts Lauren Barley Case File Download Link at the end of this file. 1 / 3

805-019 How Venture Capitalists Evaluate Potential Venture Opportunities 2 “The second factor involves a competitive edge that is long lasting. It could be a network effect like eBay or an operating system lock-in like Microsoft, but those are few and far between. It is usually an engineering challenge that is tough enough to build an edge, resulting in several years lead or longer, if we’re lucky. We look for a tough problem that hasn’t been solved before. The solution can’t be so straightforward that someone can look at the blackboard and say, ‘I know how to do it.’ We tend to avoid ‘scientific breakthroughs’—we’re not great at evaluating or managing science projects. We know how to take technology, commercialize it, and turn it into a viable business.“We are a little schizophrenic on patents. Personally, I don’t care much about patents; they are a nice-to-have but not a requirement. Only a couple of our companies hold patents that are worth much. Once a technology is patented, it’s out there and people figure out a way to get around it.However, we do conduct patent searches to make sure no one is blocking us. We have several companies that would rather keep their intellectual property a trade secret. Not everyone agrees with that here; we have some partners who are fond of big patent portfolios.“The third thing is team. There are lots of aspects to the team. We look for a strong technical founder—if it is a tough, technical problem—and a sales-oriented entrepreneur. The founder is the anchor, more than just an idea person, who understands the whole thrust behind the technology and the industry dynamic around it. The entrepreneur drives the other parts of the business and sells the vision to investors and to other early-stage participants such as full-time employees, partners, and potential customers. We look for engineering vision and execution, sales, and entrepreneurship in a team. Typically, it’s at least two people; sometimes it’s three.“In the early stages, I tend to invest behind an entrepreneur, not behind a professional manager as the CEO. Often, the person who can professionally manage as a CEO in the later stages of a company is not as effective in the earlier stages. It requires a different skill set. Entrepreneurs have to have a clear sense of the opportunity and how to build the business. That is why we’re willing to bet on them and what we’re paying them for. But, the best ones are willing to reexamine their assumptions and are willing to veer left or right or pivot all the way around when the data suggests they’re headed in the wrong direction. They amble around until they find something good. The bad ones typically get overcommitted or wed to a particular idea. By the way, professional managers, who join the company later on, are the reverse. Once they’re in and there’s a proven business model, we want them to be committed and not to be exploring other business models.“So overall it’s a funny mix. When we review an investment opportunity, entrepreneurs have to have a pretty good story to tell about what they want to do. I think it helps to be cocky, there’s no doubt about it. You can be too cocky, sometimes we’re a little bit mindful of that . . . but if you’re not cocky enough, you’re not going to be successful in selling your idea.” How Do You Evaluate the Venture’s Prospective Business Model?“To oversimplify, I’d say there are two broad kinds of investment opportunities. In the first bucket, the market or product is somewhat understood. The company is doing a better execution or a better version of an existing product or service—with a twist—in a proven market. We are investing behind a business model that we are fairly sure we understand. We expect the business plan to reflect the anticipated business model and that it’s credible—it meets the ‘smell test.’ “Then, there are completely new markets or business models where we think we may know the bets we’re making, but in truth we have no clue. Friendster’s a good, recent example: explosive growth, potential network effects, and an unclear business model. We invested in it over six months ago. The business model is either advertising based or pay-for-contact, but we haven’t tried either This document is authorized for educator review use only by Dr Camilla Jensen, University of Nottingham Malaysia Campus until January 2017. Copying or posting is an infringement of copyright. [email protected] or 617.783.7860 2 / 3

How Venture Capitalists Evaluate Potential Venture Opportunities 805-019 3 yet. We identified the business model as a big risk when we invested. However, we thought Friendster had enough growth potential, and there were enough ‘game-changing’ aspects to it that we were willing to make the bet. When we invested in Amazon, it was clearly new. However, there was an early proof point because it was already selling books worth a few million dollars per quarter on the Internet. It was too early to tell if it could maintain significant margins or build a billion-dollar revenue company. But we knew something good was happening.“Here’s a case that didn’t work. We invested in a company that conducted a barter-type swap meet, online. It seemed like an interesting idea, a twist on eBay with potentially a different approach to the market. It didn’t work. To this day, I’m not sure if it was bad execution or a wrongheaded plan.We certainly have invested behind new ideas that didn’t work.“Timing is critical to successful venture capital investing, but it is not well understood. The timing of the investment and the rate the money goes in make the difference in the financial return. There are some companies where we invested too early. A later investor—perhaps one who entered after the first or second investment round—made the high returns. We’ve also invested too late: companies that were good companies, but they missed the window and competitors beat them to the punch. Our money was not as efficient as the money that was invested earlier in the sector. But it’s hard to fine-tune; it’s a gut thing.” What Due Diligence Do You Conduct?“Technical due diligence is a big part of the data we consider when engineering innovation is involved. One of our companies is trying to solve a really difficult engineering problem, one of the hardest engineering problems I’ve seen in my eight years here. We did a lot of technical due diligence on this opportunity. We had probably six meetings where professors from Berkeley and consultants we hired pored over every aspect of the technology. We invested partly because the smart guys said it couldn’t be done; it was really too hard to do. But after they looked at it, they said, ‘These guys have made good progress; they’re asking all the right questions; they have a reasonable, potential solution; and, if they can do it, it’s the only way because all the other avenues we know about are dead ends.’ “Another part of due diligence involves customers. With most of the opportunities we seriously pursue, the market data is unclear because the company has no customers and revenue. Frequently, we brief potential customers about the product concept, but often they haven’t met the company.Sometimes, they’ve met the company, but there’s no product. Sometimes, they’ve met the company but not under nondisclosure agreement, so they don’t have the full story. We have to filter all that.We have to ferret out what the customers’ real needs are and their willingness to pay. But it’s all sketchy and really hard to do. Occasionally, the companies have customers and revenue, so it’s easier to evaluate. Then the question becomes do we want to pay up for that in the valuation. It’s typically not in our sweet zone if the venture already has customers and a lot of revenue. But sometimes we do these ‘speed ups’—like Amazon—and sometimes they are very successful.“Then there’s a third kind of due diligence, the industry due diligence. There, we probe industry experts about the idea, the team, the market, and the market need. They are not the customers per se but either technical or business experts in our network or people we think might have an opinion on a proposed investment.“The fourth kind of due diligence is on the entrepreneur and team. We call their references and blind references. We spend a lot of time with them. We try to triangulate on how they’ve executed, are they honest, and are they people we want to work with.This document is authorized for educator review use only by Dr Camilla Jensen, University of Nottingham Malaysia Campus until January 2017. Copying or posting is an infringement of copyright. [email protected] or 617.783.7860

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