How-Venture-Capitalists-Evaluate-Potential---HBS-C

9-805-019REV:DECEMBER1,2004________________________________________________________________________________________________________________SeniorLecturerMichaelJ.RobertsandLaurenBarley,SeniorResearcherattheHBSCaliforniaResearchCenter,preparedthiscase.HBScasesaredevelopedsolelyasthebasisforclassdiscussion.Casesarenotintendedtoserveasendorsements,sourcesofprimarydata,orillustrationsofeffectiveorineffectivemanagement.Copyright©2004PresidentandFellowsofHarvardCollege.Toordercopiesorrequestpermissiontoreproducematerials,call1-800-545-7685,writeHarvardBusinessSchoolPublishing,Boston,MA02163,orgoto—electronic,mechanical,photocopying,recording,orotherwise—withoutthepermissionofHarvardBusinessSchool.MICHAELJ.ROBERTSLAURENBARLEYHowVentureCapitalistsEvaluatePotentialVentureOpportunitiesWeinterviewedfourventurecapitalistsfromleadingSiliconValleyfirmstolearnabouttheframeworkstheyuseinevaluatingpotentialventureopportunities.(SeeExhibit1forbackgroundinformationontheseventurecapitalfirms.)Allfourwereinterviewedindividuallyandwereaskedsimilarquestions,suchas“Howdoyouevaluatepotentialventureopportunities?”“Howdoyouevaluatetheventure’sprospectivebusinessmodel?”“Whatduediligencedoyouconduct?”“Whatistheprocessthroughwhichfundingdecisionsaremade?”“Whatfinancialanalysesdoyouperform?”“Whatroledoesriskplayinyourevaluation?”and“Howdoyouthinkaboutapotentialexitroute?”Thefollowingareexcerptsfromtheseinterviews.RussellSiegelman:Partner,KleinerPerkinsCaufield&Byers(KPCB)RussSiegelmanjoinedKPCBin1996aftersevenyearswithMicrosoftCorporation,wherehehelpedfoundandlaunchMicrosoftNetwork(MSN).BeforeworkingatMicrosoft,hewroteartificialintelligencesoftware.Siegelmaninvestsinsoftware,electroniccommerce,Webservices,telecommunications,andmediaandsitsontheboardsofVerticalNetworks,LilliputianSystems,Mobilygen,QuorumSystems,DigitalChocolate,andVividence.HeisoneofthemanagingpartnersoftheKPCBXIFund,whichclosedinFebruary2004.SiegelmanearnedhisB.S.fromtheMassachusettsInstituteofTechnologyinphysicsin1984andanMBAfromHarvardBusinessSchoolin1989.HowDoYouEvaluatePotentialVentureOpportunities?“Wehaveagenerallyunderstoodsetofthingswelookforwhenweevaluateaninvestmentopportunity.Themostimportantrequirementisalargemarketopportunityinafast-growingsector.Explosivegrowthmakesitdifficultforsomebodytocatchuporincumbentstorespond.Welikeacompanytohavea$100millionto$300millionrevenuestreamwithinfiveyears.Thismeansthatthemarketpotentialhastobeatleast$500million—ormore,eventually—andthecompanyneedstoachieveatleasta25%marketshare.805-019HowVentureCapitalistsEvaluatePotentialVentureOpportunities2“Thesecondfactorinvolvesacompetitiveedgethatislonglasting.ItcouldbeanetworkeffectlikeeBayoranoperatingsystemlock-inlikeMicrosoft,butthosearefewandfarbetween.Itisusuallyanengineeringchallengethatistoughenoughtobuildanedge,resultinginseveralyearsleadorlonger,ifwe’relucky.Welookforatoughproblemthathasn’tbeensolvedbefore.Thesolutioncan’tbesostraightforwardthatsomeonecanlookattheblackboardandsay,‘Iknowhowtodoit.’Wetendtoavoid‘scientificbreakthroughs’—we’renotgreatatevaluatingormanagingscienceprojects.Weknowhowtotaketechnology,commercializeit,andturnitintoaviablebusiness.“Wearealittleschizophreniconpatents.Personally,Idon’tcaremuchaboutpatents;theyareanice-to-havebutnotarequirement.Onlyacoupleofourcompaniesholdpatentsthatareworthmuch.Onceatechnologyispatented,it’soutthereandpeoplefigureoutawaytogetaroundit.However,wedoconductpatentsearchestomakesurenooneisblockingus.Wehaveseveralcompaniesthatwouldratherkeeptheirintellectualpropertyatradesecret.Noteveryoneagreeswiththathere;wehavesomepartnerswhoarefondofbigpatentportfolios.“Thethirdthingisteam.Therearelotsofaspectstotheteam.Welookforastrongtechnicalfounder—ifitisatough,technicalproblem—andasales-orientedentrepreneur.Thefounderistheanchor,morethanjustanideaperson,whounderstandsthewholethrustbehindthetechnologyandtheindustrydynamicaroundit.Theentrepreneurdrivestheotherpartsofthebusinessandsellsthevisiontoinvestorsandtootherearly-stageparticipantssuchasfull-timeemployees,partners,andpotentialcustomers.Welookforengineeringvisionandexecution,sales,andentrepreneurshipinateam.Typically,it’satleasttwopeople;sometimesit’sthree.“Intheearlystages,Itendtoinvestbehindanentrepreneur,notbehindaprofessionalmanagerastheCEO.Often,thepersonwhocanprofessionallymanageasaCEOinthelaterstagesofacompanyisnotaseffectiveintheearlierstages.Itrequiresadifferentskillset.Entrepreneurshavetohaveaclearsenseoftheopportunityandhowtobuildthebusiness.Thatiswhywe’rewillingtobetonthemandwhatwe’repayingthemfor.But,thebestonesarewillingtoreexaminetheirassumptionsandarewillingtoveerleftorrightorpivotallthewayaroundwhenthedatasuggeststhey’reheadedinthewrongdirection.Theyamblearounduntiltheyfindsomethinggood.Thebadonestypicallygetovercommittedorwedtoaparticularidea.Bytheway,professionalmanagers,whojointhecompanylateron,arethereverse.Oncethey’r