Words of Advice from One VC to Another

Someone at a recent dinner asked me to tell some Chicago VC stories.  As the market begins its pendulum swing back in the other direction, it got me thinking about being a VC in good markets and bad. Here are some words of advice I gave to my fellow VCs:

In 1997 I helped co-found Kettle Partners.  The dot com mania was in full swing and the markets were white hot.  I was a new VC and fought hard to compete for the top deals.  Another VC friend and I both were competing for a “hot” deal and we won it.  Victory. Afterwards my friend called me up pretty upset that he didn’t get to participate.  I thought that I was doing the right thing for my LP’s to fight for as much of that deal as I could get.  What I soon came to realize was that deals come and go.  Venture funds can come and go.  But, good relationships transcend decades and last a life time.

Look we are all competitive,  We all want to be part of the next great thing.  Turns out that it is not a zero sum game.  What I came to realize is that what is important is to maximize for the long-term and not the short-term.  That maximizing our position in one deal, may not be in the best interests of our LP’s across the life cycle of a fund.

As we all know, the market finally imploded in 2000.  The dot com mania was over and the pendulum swung hard the other way - and with that cash pretty much dried up for a few years.  Back then it took significantly way more time and cash to prove product market fit and to get real traction for most companies.  We realized that being a small fund in a market where cash was practically non-existent was not a good business model and we did something shocking for a VC after deploying roughly half of our capital.  

We stopped investing.  We released our LP’s from their remaining commitments - and we stopped taking all fees.  Sure we could have milked it - but it was not the right thing to do for our LP’s - and our LP’s needs always come first.  We continued to sit on our portfolio boards for the following 7 to 9 years to protect our LP’s interests - because we had a fiduciary and moral responsibility to do so. Thankfully, we had a couple of big wins and the fund ended up in the top quartile for our vintage and we returned all our LP capital and actually earned some carry:).  A moral victory.

A few months after that we had a meltdown with one of our portfolio companies.  I had put the CEO into the company.  He was awesome at Enterprise sales, but the company was about to pivot and sell to carriers instead.  He was the wrong guy to sell to carriers and he knew it.  We had a board meeting one day and out of nowhere he says he is having trouble with his CTO and either she goes or he goes.  Hmmm.  Clearly he was not in control of the situation.  Note to self, if you are a CEO, never give your board an ultimatum.  We fired him on the spot.

I stepped up and became the CEO for 6 months.  Had to cut the employees from 80 to 40 people and completely retool the company to go after Carriers.  After doing a full assessment I hired the CTO to become the CEO and run the company.  Took 6 more years but eventually the company sold to Nokia for $120 million.  The lead investor, David Kronfeld of JKB Capital was so grateful, that even though we now had a defunct fund, even though he could have inserted pay to play provisions and crushed us across two more additional rounds - he never did.  He totally protected us.

Which got me to thinking about the coming years.  Greed is a powerful emotion.  When markets are strong, investors rush in and bid up deals to valuations not supported by basic business fundamentals.  And when markets go south, greed kicks in as investors overreact and plunge the knife in to take advantage of the situation.  

Like all of us, I’ve been on good boards and bad.  Have had great partners - and those who took advantage of every loop hole to leverage their own position at the expenses of others.  In my experience, bad things happen when different classes of shareholders have materially different terms and incentives.  Philosophically I much prefer when all parties have their interests more closely aligned.

The world is about to change.  The pendulum is going to swing back, and of course over correct.  Cash is going to tighten up considerably.  And when that happens, valuations will come tumbling down and desperate CEO’s will take the devil’s deal to keep their companies afloat.  Will be natural for us to want to take our pound of flesh.  To heap on lots of preferences - to mitigate the risk - and simply because we can and think we can get away with it.

But I would urge all of us to consider that it is not a zero sum game.  That relationships matter - and will transcend any one given deal.  And that the best way to protect and fight for your LP’s is to build a reputation built on trust and integrity so that across time both entrepreneurs and your fellow VC’s will want to work with you and invite you into their next deals as well.

So here is a final story that I think encapsulates the Chicago VC community.  I was talking with David and Jon from LakeWest partners a couple of nights ago, when they voiced regret that they weren’t able to get into one of our deals.  I hadn’t realized that was the case and immediately told them that in the future if we are ever both trying to get into the same deal, they should absolutely let me know - that I will fight for them to be included, or give up a little of our allocation so they could participate.

Because that’s how we roll here in Chicago:)