Ziad Sultan’s Blog

Organizations, including customers, don’t always do what is in their best interest

Last week, I wrote a blog post describing the 5 things that serial entrepreneurs typically do better than first time entrepreneurs when pitching to VCs. One of the lessons that readers found the most interesting was the concept of opening the enterprise black box, so I would like to expand on that, and use an analogy from the field of international relations.

In international relations, two competing schools of thoughts can be broadly defined as realist and liberal. A realist framework supposes that nations will always make decision that maximize their interests (power, wealth, resources, etc.). A liberal framework on the other hand, argues that a nation’s decisions can only be understood by looking at the model of government within the "black box".

The strongest liberal argument is the theory of democratic peace, which states empirically that no two democracies have ever been at war with each other (with almost no exceptions). Thomas Friedman puts in more colorfully in the Lexus and the Olive Tree by saying "no two countries that have a McDonald’s ever went to war with each other".

For liberals, the logical conclusion from the theory of democratic peace is that the nature of the government model within a country (in this case democracy) greatly affects its decisions, and that one can not treat countries as black boxes the way realists would suggest.

In entrepreneurship, I suggest the equivalent of a liberal framework when thinking about your business model, and pitching to a VC. In this case, the client organization is the black box that needs to be opened.

Very often, startups pitching to me make a very convincing case for why their client would be better off buying their product or service. Sometimes, it is even possible to mathematically prove that the value to the client (through either revenue or cost savings) clearly exceeds the cost. This is necessary but not sufficient.

The next step is to understand the inner dynamics of the client organization, and present a clear case, hopefully supported by early evidence, for why certain individuals within the company will become customers. Here are some of the many questions that need to be answered:

• Who exactly within the company has this problem or need?
• Are they already aware of it? Actively searching for solutions? (On Google for example)
• Would they be purchasing it for themselves of for someone else to use?
• Do they have the right incentives to fix this problem, and pay for a solution?
• Do they have a budget for this? Is it discretionary? Do they need high level approval?
• Are there obstacles to adoption? High switching costs from current solution?
• Do they need to convince other colleagues to for it to be useful? (eg. Yammer)
• Would there be a high career risk in case of failure?
• Is this a decision that needs to be taken at the business unit level, or the corporate level?
• Does your product upset the power dynamics within the company? (I’m considering writing a separate blog post describing some really interesting examples of this point!)

These inner dynamics are one of the most important reasons why a VC may turn down a deal. It is also one of the items on which we will perform the most due diligence. But more importantly, it is often a reason why many startups fail despite having an otherwise great product. Organizations don’t always do what is in their best interest.

For all these reasons, it is important to open the client organization’s black box when writing a startup business plan, when raising capital, and most importantly, when executing on your business plan to create a successful company.

Comments welcome, as always, in the section below.

Last week, I was kindly asked to be a VC judge for an MIT Sloan entrepreneurship class called “New Enterprises”, taught by Noubar Afeyan. The class combines MBA and Engineering students into teams, and the idea is for each team to develop a business plan for a startup over the course of the semester. When the first draft of the business plan is ready, the students pitch the idea to a panel of 3 VC judges for feedback.

There were about 10 teams in total and overall, the quality of the ideas presented, and the skills of the students presenting them were impressive as one would expect from an MIT / Sloan class. As a panel, we provided feedback on market estimations, business strategy, financial projections, and all the usual aspects of a business plan, as well as on the presentation styles of the students.

After the fact, I thought that comparing the presentations of MBA students to the presentations that I see from serial entrepreneurs would be a great way to draw conclusions about what experienced entrepreneurs learn over the years. Here are my five main conclusions from this exercise, based purely on the recent pitches/presentations I heard.

Experienced entrepreneurs seem to have learned to:

1. Define the problem more precisely. For example, if the problem is information overload, which is very broad, a student entrepreneur may try to prove that there is a problem by showing how many emails/tweets/etc. are sent everyday globally. This will be an impressive number, but does very little to convince an investor about the business. A more experienced entrepreneur might focus on a survey of CTOs at Fortune 500 companies saying they are losing productivity due to information overload, and would be willing to pay up to $xx per employee to solve it. (this is just a made up example, for illustration purposes)

2. Better assess the cost of customer acquisitions. I think this is one of the trickiest things to assess, especially for early stage startups, and even experienced entrepreneur can find it challenging. But I have noticed that students and first time entrepreneurs will have a less systematic approach to thinking about this problem, and will typically estimate a lower cost of customer acquisition, leading to the need to raise money again earlier than anticipated or to raising more capital overall than initially planned. Complementing the management team with someone who has done this before, and looking at startups with comparable business models are possible ways to refine your estimates

3. Open the budget black box. Who is it, within the client organization, that has the budget for your product or service? Is there even a budget item for it? Is that person the same person who has the need or incentives to purchase the product? It is tempting to think of a big organization as always doing what is in its best interest. But the truth is that sometimes the individuals who need to make certain decisions within the organization just don’t have the incentive, time, budget or other resources to make this decision, even if they should in the greater scheme of things

4. Have more realistic expectations regarding partnerships. Partnerships are a great way to get exposure, customers, synergies, etc. But the relationship is almost never symmetrical, and priorities between the partners will be different. So unless it is very clear what each party is getting out of the deal and how they are doing so, it can be tricky and sometimes even frustrating. Startups are intense workplaces, and if one of the two partner startups is focused on a more important issue at the moment, the partnership could drop far down in the priority list, leading to even more asymmetry

5. Get the idea and product out there early. When you have gotten the product out there and received a lot of feedback from beta users, maybe even made a few sales, and circulated it enough to get an impressive advisory board, etc.. it will reflect in the quality of the pitch. It is an understandable reflex, when you are a first time entrepreneur, to want to protect the idea. But when you have seen the startup story played out a few times and realized that the idea is only the beginning, and that execution will be the bigger part of the success story, then you quickly figure out that the feedback you get from putting your idea out there in the world usually far outweighs any of the risks. (Example: I am working on a project that I wanted a friend of mine to beta test. I sent it to him two weeks after I had initially planned. When he asked me about the delay, I told him I had waited until I was comfortable with it before sending it to him, and he replied: “it means you waited too long!” I completely agree)

I think this is an important topic, and I will be thinking about it more. In the meantime, I would love to hear any comments, and see whether people agree/disagree with these takeaways.

Note that more experience can also limit the way you think sometimes, but that topic probably deserves its own blog post!

Disclaimers: 1. I am generalizing way too much in this post, but it is only in the hope that these takeaways are helpful. 2. I focus on investments in early stage web/IT startups, and my comments are biased towards that focus 3. Most of my takeaways have to do with sales and marketing because I have observed that this is a key area where experience seems to make a big difference, at least in the pitch

Earlier this week, I attended a very informative event entitled “The Do’s and Don’ts of IP Due Diligence”. The main idea was for two IP Lawyers to give some background to VCs on patenting, and some tips on the right way to do due diligence in that area. I think it is worth sharing my top takeaways:

(This doesn’t constitute legal advice, just my personal summary of what was discussed)

1. There are three types of IP due diligence work: freedom-to-operate (FTO) research, patentability research, and strategic overview. FTO is used to make sure that a company’s operations are not infringing on any existing IP. Patentability research is used to understand whether a startup’s IP is likely to become patent-protected, and strategic overview is when one tries to understand the competitive landscape and each player’s present and future advantages from an IP point of view.

2. What makes IP law and due diligence complex is the fact that patents are far from perfect, to say the least. When a patent application is filed, the USPTO (patenting office) needs to look for anything (prior art) that may invalidate the patent. But given the large volume of patents, the deep expertise required, and the limited resources available, many patents are granted that can later be invalidated when someone (a competitor for example) does find invalidating prior art that was missed by the USPTO.

3. Patent trolls are non-practicing entities (NPE) that own or claim to own patents (that may or may not be valid), and who threaten to take legal action against companies that allegedly infringe on their IP in the hope that they can make large amounts of money in settlements. The frustrating dilemma for companies is that defending themselves is often more expensive than settling even when they are right. Trolls often use techniques similar to spam, accusing many companies and holding on to the ones that respond. The lawyers’ advice was to ignore anything that may look like a troll accusation, and run it by your lawyer right away.

4. This brings me to a tricky one: “the less written communication, the better”. I know it sounds kind of shady at first, but the advice came from experts and I wanted to pass it along. While attorney-client privileges guarantee confidentiality, they may need to be waved later (at a company’s own choice) in order to prove that their was no willful infringement for example. At that time, the lawyers’ rule of thumb was that the less you have written, the better. They cited several examples of clients of theirs who had lost over $1M due to a single email they had replied to. On a related note, another piece of advice is that communications about IP between two companies, or between VCs and startups should go through their lawyers.

5. While you can prove that a patent is invalid, by finding prior art that invalidates it, you can never really prove that a patent is valid, because you don’t know if someone will find invalidating prior art at a later date. So all you can get for patentability is an opinion. The math equivalent to this is something I heard way too many times during my studies: “a counterexample is a proof, but an example is not”.

6. Patents should be driven by commercial value and incremental business opportunities, not by incremental improvements in technology.

7. The four suggested steps to create commercial value through IP were: a - identify the barriers to entry in your business; b - obtain more than one patent per barrier; c – make sure your patent claims are mapped to competitors or potential competitors; d – identify areas of future innovation and attempt to patent around them.

Last week I attended a fascinating two-day conference on marketing and branding called BRITE at the Columbia business school. The name stands for “Branding, Technology, Innovation” and the event brings together thought leaders from academia, business,  and the blogosphere to discuss how technology and innovation are changing the ways in which companies build and sustain their brand.

One of BRITE’s key themes this year was online communities. Since this is one of my main areas of focus as a venture investor, the insights provided by the conference speakers were directly relevant to my work.

Below are some of my key takeaways from BRITE. More comprehensive notes are available here. A nice summary of Day 1 from David Rogers is available here.

Before I begin, I would like to mention one of my favorite quotes by George Bernard Shaw which Yaron Samid mentioned during the conference:

The reasonable man adapts himself to the world; the unreasonable one persists in trying to adapt the world to himself. Therefore all progress depends on the unreasonable man.

1. Customer service is the new PR

A new generation is being created that will never dial a 1-800 number again. Customers expect their experience to be pleasant, fast, and free. If a company fails to meet their expectations (or exceeds them) the customers will blog, tweet, post comments, create facebook groups, and invent new ways to express their feedback using social media.

It is increasingly important for companies to pay full attention to that process and influence it positively by investing in proper customer service and in contributing to their own online communities. Today’s angry customers are very loud, and happy customers are a company’s best brand ambassadors.

“Your customers are your ad agency” (Jeff Jarvis)

2. Many more opportunities exist in crowdsourcing

We often think of online communities as a connected group of people brought together mostly for discussion, collaboration, or social interaction around a central topic. But today’s online communities are often a great mechanism of production.

Jeff Howe, who was the conference speaker on this topic, has published a new book called (you guessed it) Crowdsourcing. Interesting examples from his presentation included iStockPhoto’s crowdsourced photography, John Fluevog’s open source shoes project and Dell’s idea storm.

I will add uTest, a company in which Longworth Venture Partners has recently invested. uTest brings together a community of QA professionals, and allows companies in need of software testing to crowdsource the work using a pay per bug model.

There will be more processes currently residing within the enterprise that will eventually be successfully croudsourced. Which one is next?

Jeff Howe spoke about the coffee break worker, and the power of designing a crowdsourced model that allows people to produce/contribute in less than 15 minutes, while on a coffee break.

3. “Spray and pray” advertizing is dead

Seth Godin was among the speakers at the conference. He mostly spoke about his new book Tribes, but the main takeaway for me was: “the idea that you can interrupt people over and over is dead”.

Research using eye-tracking technology suggests that we have mastered the art of tuning out ads on a web page. Advertizing needs to work its way into the content if it is to be effective.

4. You don’t create online communities, you facilitate them

Francois Gossieaux gave an interesting talk about best practices for company-run online communities. According to him, the social platform of a community is more important than the technology platform: “if you can’t get your community to work on a bulletin board, you probably can’t get it to work regardless of the technology you use.” Examples given by Francois included Walmart’s eleven moms program and Fiskar’s Fisk-a-teers.

From Jeff Howe’s talk: “ask not what your community can do for you, ask what you can do for your community”.

5. A product launch is no longer an event but a process.

Companies need to shift from the build to last to the build to adapt paradigm. It is a far better strategy to get to a quick release of an early beta, collaborate with users and listen to them for improvement and innovation, than to spend much longer trying to build the “perfect” product. As Jeff Jarvis would say: what would Google do?

Random final remarks

• Avner Ronen, CEO of Boxee, joked that “90% of social media users are either there to get laid or to get business!” His presentation was great, by the way.
• Adam Nash, SVP of Product at LinkedIn, says professional recommendations on the network are up 65% since the beginning of the year, as members put in extra efforts to help their friends find new jobs.
• Finally, I can’t remember why Seth Godin mentioned this, but the following building is the corporate office of Longaberger, a basket company. Pretty funny…

Earlier this week, I attended a Corporate VC Summit, at the British Consulate in Cambridge, MA. The event was very well attended, with most leading corporate VC groups represented in the audience and panels. I am a non-corporate VC myself but very much enjoyed some of the panel discussions, and would like to share some of the most interesting takeaways from that event.

1. Strategic investing

Corporate venture capital investors are also referred to as “Strategic Investors”. This implies that there is a strategic agenda for their financing of a new company, in addition to the obvious financial motivations. Strategic motives can take various forms, such as

• gaining privileged access to new entrepreneurial technologies (treated as external R&D)
• enabling the formation of an ecosystem around the parent company and its products
• securing some advantage over non-investors in case of M&A opportunity down the line

2. Corporate VC involvement

When involved with startups, corporate VC programs can use the parent company to provide certain benefits, such as

• synergetic use of complementary capabilities and resources
• stronger bargaining power with suppliers
• access to established distribution networks
• endorsement on the future viability of the venture

When it comes to board seats and shareholder activity, most corporate VCs with whom I have spoken are happy to take a less active role and let their independent counterparts take the board seat and handle the more active shareholder tasks.

3. Corporate VC commitment

During the panel, doubts were expressed about the reliability of corporate VC investors in the long run. It was argued that changes in the strategy of the parent company, or in its leadership, can have drastic impact on the portfolio and on the scale of future investments.

Panelists agreed that there was an increased volatility due to the organizational nature of the programs, but countered that many independent VC fund are equally likely to disappear if they are unable to raise a new fund, which introduces a comparable level of volatility.

Entrepreneurs in the audience also worried that corporate VCs are more likely to abandon ship early and focus on their core P&L during difficult times.

4. Dynamics of co-investing with corporate VCs

Corporate venture capital groups often try to co-invest with independent VC funds. This provides a validation of the potential for financial returns, in addition to the strategic potential which they have identified.

Independent venture capital funds have mixed feelings about co-investing with corporate VCs. On the one hand, they can be useful operational partners, and represent a good exit strategy down the line. They are also an early validation of potential customer buy in. On the other hand, they are less active, and are more likely to cut their losses when a venture has difficulties raising money. Their incentives may also not be completely aligned depending on the strategic interests driving the investment.

5. Effects of the economic downturn

In a downturn, venture investors who still have significant reserves of cash are in a good competitive position as capital gets scarce. Independent VC companies who have recently raised a new fund are able to compete in a less crowded market and are benefiting from their fundraising timing.

This is also true for corporate venture capital programs who still have access to cash. Corporate VC Panelists in this position were unanimous in saying that they are receiving phone calls from independent VCs who have historically preferred to bring in other independent VCs as co-investors. “We have more friends today than we used to”, one of them humorously pointed out.

There was at least one consensus across entrepreneurs, corporate VCs, and independent VCs: “more than ever during these difficult economic times, we need to all be pulling together”

March 20th update: Google may be launching a venture arm of its own, joining the likes of Amazon and Intel according to VentureBeat.

Thank you for visiting my blog!

As a venture capital investor, I have the privilege of continuously being introduced to cutting edge technologies, meeting passionate entrepreneurs, and attending conferences on exciting new topics.

Based on this constant flow of ideas, I have created this blog to share thoughts and initiate discussions around startups and venture capital.

I look forward to some lively exchanges in the near future… In the meantime, please make yourself at home, and feel free to find me at:

http://www.twitter.com/ZSultan

http://www.longworth.com/team/sultan.html

http://www.linkedin.com/pub/dir/ziad/sultan

http://www.facebook.com/people/Ziad-Sultan/580475365

Sincerely,

Ziad