Is Your VC a Chicken or a Pig? Part II: The Role of the Lead Investor – From Term Sheet to Closing (and Beyond)

In Part I we talked about the critical importance of focusing your fund raising efforts on identifying a lead investor – a “pig” – and reaching agreement on a term sheet with them before you spend significant time lining up “chickens” to “follow” along in the deal. Today, we’ll look at what role your lead investor plays post-term sheet agreement when it comes to getting your deal closed.

The first role of the lead investor post-term sheet is working with the company to build out the investment syndicate: that is, to find and close on chickens/followers. The lead becomes, in effect, a part of your pitch team – albeit, without abandoning its primary role as an arms-length investor/skeptic.

The “selling” role of the lead includes identifying, prioritizing, and even pitching potential followers. That typically includes folks the lead brings to the table from its own network as well as appropriate candidates the company suggests. While the company will still be front and center in pitching chickens, the lead is usually the primary due diligence source for potential followers, both “deal” and “legal” due diligence, and actively shares their own thinking on why the deal is compelling with various chickens.

This dual role, working with the company to build the syndicate while also being the principal due diligence resource for the syndicate, makes managing the company/lead relationship complicated as well as critical. The lead, at this point, wants the deal to happen and is committed to making it happen. But only to a point. The lead’s enthusiasm is tempered by its continuing obligation to act in the best interests of its own investors. In addition, its credibility is on the line with other investors, which is something that can cut both ways in terms of how it reacts to any bumps in the road on the journey to closing.

The lead also manages the “deal” part of the deal: that is, the concerns of followers about the terms of the deal. On that score, the lead should focus on convincing followers that the term sheet is “good to go” as is. Indeed, the company should resist any material changes to the term sheet based on follower concerns, just as it would if the lead was the only investor. The whole point of agreeing on a term sheet was to finalize the material terms of the deal. As a practical matter, one or more immaterial changes to accommodate a valuable follower may be acceptable. Any material changes, though, should be viewed as putting in play changes the company might want in exchange, or even grounds for the company backing out of the deal altogether.

The lead also manages the legal process associated with negotiation of closing documents and related legal requirements. Typically, there is one counsel for the investment syndicate, and that counsel works through the lead investor and is paid by the company out of closing proceeds from the financing. (If a follower wants to have an independent legal review, they should pay for it, and that counsel should work through the lead and its counsel in terms of communicating any concerns to the company.) If a lead can’t persuade followers to work through the lead and its counsel, that’s a good sign that the lead is not up to the job.

Once the deal is closed, the lead is usually the “point” investor for the rest of the investment syndicate. If the investors have a director on the Board, it will usually be someone from the lead investor. (Someone that should have been identified at the term sheet stage). When the company has news to share with the investors – good, bad, or indifferent – the lead is usually the first to get it, and often has input on what to share with the rest of the syndicate, when, and how. As with the period of time from the term sheet to the closing, this dual role of investor/advisor can be complex and must be managed carefully.

Lead investors make deals happen, and typically play central roles even after the closing. Smart entrepreneurs know that raising money is first and foremost about getting a credible lead’s name on a solid term sheet. Be a smart entrepreneur: don’t waste time and energy collecting followers until you’ve got a lead for them to follow.

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Is Your VC a Chicken or a Pig? Part I: What a “Lead” Investor is, Why You Need One, and How to Find One

One of my favorite clichés involves chickens and pigs. More specifically, it observes that as interested as chickens may be in breakfast, it’s the pigs that are really committed.

That’s a good way for startup entrepreneurs to think about courting venture capital investors. Collecting a flock of very interested venture investors – chickens – is fine and dandy, but you won’t make much progress towards getting a deal done until you’ve got a pig at the table. So don’t waste a lot of time chasing chickens around until you have a pig corralled. You know you have got a pig in hand when you have a solid term sheet with a “lead” investor inked.

Truth be told, most VCs think of themselves, or at least present themselves, as lead investors. I suppose most probably do lead a deal now and again. That said, though, in any given deal, there is generally only one lead investor. (Co-leads are fairly common, but even in those cases one of the co-leads in fact plays the role of the lead.) That is, one investor who not only wants “in” the deal but wants to “own” the deal.

The first big role of the lead in a deal is to let the relevant chickens know that someone has pig-like interest in the deal. That someone likes the deal enough to put up a big bunch of capital (usually the biggest chunk) and to do most of the heavy-lifting of getting the deal done (which, as we’ll see, is no small thing). That resource commitment, coupled with the signal to the market that a credible (well, hopefully) investor is that serious about the deal, is typically the inflection point when the chickens start getting serious about actually committing some eggs to getting the deal done.

If getting a lead investor lined up is the sine quo non of getting a venture financing done, how do you go about it? Simple. Qualify potential investors as leads before you spend too much time with them. Limit your initial investor solicitations to folks you think are possible leads and folks you think might be sources of referrals to possible leads. When you get a meeting with an investor, if there is any potential interest at the end of the meeting be certain to ask if yours is a deal the investor would consider leading (and if not, can they refer you to any investors who might be).

Step two is to avoid wasting time with investors who are not qualified leads until you have a signature (or handshake) on a term sheet with a lead investor; a term sheet that outlines all of the material terms of the investment. Depending on who the lead is (their reputation in the market), and how big a piece of the deal that the lead is taking (how many other investors with how much more money will it take to fill out the syndicate), agreement on a solid term sheet is the point where most interesting investment opportunities become likely deals.

Next time, we’ll talk about what roles lead investors play after the term sheet is signed.

 

Should You Take Your Startup To Silicon Valley?

I’ve advised many flyover country entrepreneurs that if their sole goal in life is to raise the most money for their startup, at the best price and in the shortest period of time, they should move to Silicon Valley. That is where good entrepreneurs raise the most money in the shortest order and at the best price on a pretty consistent basis.

Lately, I’ve been thinking more about that advice, and while I generally stand by it, I’ve come to the conclusion that there is an important exception: a class of startup entrepreneur that, in fact, is usually better off launching in flyover country than Silicon Valley. The idea of an exception to the “move to Silicon Valley to get the best deal” advice came to me as I started thinking more closely about a corollary to that advice, to wit that if, having moved to Silicon Valley you can’t raise capital, at least you will have found out faster that your startup is not VC-worthy.

It’s that last word, “worthy,” that hit me as needing more thought. Over the last couple of days, it gelled that some entrepreneurs might fail to raise capital in Silicon Valley – not because their startup is not worthy of investment, but because they are not ready to play on that particular stage. In which case, going to Silicon Valley may result in failing to get a startup financed not because it was a bad idea, but because venture capital’s Broadway was not where it should have started out.

Here’s the deal. For entrepreneurs that know how the venture capital business works (in reality, not just in theory); have a track record that suggests real knowledge of what makes the best startups tick; and have meaningful entrepreneur, investor, and service provider networks that include a few solid Silicon Valley contacts, taking their startup to Silicon Valley makes sense. (Again, with the qualification that getting the best deal as fast as possible is the only factor in the decision.) For other flyover country entrepreneurs, maybe not so much.

My thinking in this area was kick started a couple of weeks back when I met with a 20 years-old-ish Northeast Wisconsin entrepreneur who had what seemed like a pretty good idea for an app. With less than $50k, he had taken it as far as 10,000+ users and some very good press. He had pretty much everything you look for in an entrepreneur: vision, passion, integrity, flexibility, an ability to make things happen with minimal resources, and a desire to learn. But, when we talked about the possibility that he should pick up and move to Silicon Valley, it occurred to me that if he did he would most likely be eaten alive.

What this entrepreneur lacks that would be a huge problem for him in Silicon Valley won’t be hard for him to learn here in Wisconsin if (as I am sure he will) he puts his mind to it. He doesn’t know either the substance of the venture capital business or the lingo (which is surprisingly important, particularly when a VC knows you are from the sticks). While he has great entrepreneurial instincts, he has not lived, even vicariously, in the high impact entrepreneurship world. Right now, the number of folks in his network who do have that knowledge and experience, and those connections, can be counted on the fingers of one hand.

These may seem like small things, but they are important things and things that pretty much every entrepreneur who gets funded in Silicon Valley has. They are things that folks like gener8tor have made a business out of providing to their portfolio entrepreneurs (and in fact lots of other entrepreneurs). And things that a small but real cadre of Badger folks with that kind of experience and those kinds of networks are eager to share with folks who are otherwise as compelling as the young man I met with several weeks back.

So, if you are an otherwise Silicon Valley-worthy high impact entrepreneur in flyover country, but don’t have a solid understanding of the ways and lingo of the venture capital business, a well-grounded understanding of what separates the startup winners from the losers, and a decent network of folks that have those things that you can leverage all the way to Silicon Valley – don’t go to Silicon Valley. At least not yet. Learn what you need to learn here, connect with the right folks, and when you are ready to play on the Silicon Valley stage, well, decide what your priorities are then.

 

 

Building Your Startup Team: Complementarity and Chemistry

Most professional venture investors believe the best predictor of startup success is the quality of the team. Good teams can and do fail, but as team quality drops below “awesome,” the chances for success drop very fast. Thus the cliché that most investors will gravitate to an “A” team with a “B” opportunity over a “B” team with an “A” opportunity.

There are a lot of reasons team quality is so critical to startup success. The incredibly stressful startup environment is the biggest. Startup teams need to accomplish difficult goals with minimal resources in terms of time, capital, and people. Additional stress accrues as outside forces – competitors, markets, technologies, etc. – evolve and force teams to make significant adjustments, often including basic “pivots” (business model, for example) on the fly.

If the extraordinary stresses of the startup environment explain the importance of getting the team right, they also offer a clue to what makes a superior startup team. At the foundational level, what separates the superior startup team from the merely good startup team is complementarity and chemistry.

Complementarity is pretty straightforward in concept, if not always in execution. Within the confines of available resources (financial) and the constraints of team chemistry (more later), you need to make sure the team includes top-tier players at the mission critical startup tasks (i.e. the tasks that need accomplishing in the current round of funding), as well as the flexibility to successfully “wing it” with respect to important ancillary functions.

The trick to building a complimentary team lies in recognition of, and dealing with, the well-established HR principle that when people get to choose who they work with – or who works for them – they tend to choose people like themselves. Now, if you are a founder, and thus most likely very confident of your own near-perfection, that might not seem like a problem. If you’ve got perfection, why not clone it if you can?

Consider if Apple had been founded not by Jobs and Woz, but by Jobs and … Jobs. If you know the Apple story, you know what a catastrophe a Jobs/Jobs founding Apple team would likely have been.

The bottom line is that however perfectly suited you may be for leading your startup to fame and fortune, building a team of clones is seldom the best way to go about it. Instead, look for people with different skill sets. And as much or even more so, different personalities and perspectives on business, technology, and life. The most successful startups – even those like Apple in the years after Jobs returned from exile that were dominated by a leading personality – build leadership teams with diverse skills, experiences, perspectives, and personalities. Just ask Tim Cook.

And that leads to the second, and harder to execute, aspect of assembling a superior startup team: chemistry.

It’s not enough to assemble a team that “covers the waterfront” in terms of skills, experience and personality. You need to make sure those folks can also form very strong bonds with each other (thus the “chemistry” analogy). Because in the constantly changing world of the startup, relationships between key players on the team are going to be under almost constant stress as company circumstances evolve and people have to adjust to changing opportunities and challenges. As anyone who studies morale in the military will tell you, folks in foxholes are motivated more by their loyalty to the folks around them than to “the cause” as such.

On that last point, one of my favorite quotes from an entrepreneur came when he was asked what he would tell his team at the beginning of his next startup journey. He replied: “Folks, we are going on a very long and difficult journey. On this journey, we will carry our wounded – and shoot the deserters.”

The quality of the team has long been the most important factor for most venture capital investors, for good reasons. As you think about assembling your team, particularly in the early days, don’t make the mistake of hiring folks because they look like you, or because they are a perfect skills fit. Look more for folks who compliment your skills and personality – and that look like the kind of people you want on your side when the going gets very tough. Because it almost certainly will, likely many times.

Things Entrepreneurs Should Know (About Venture Capitalists)

If ever there was a prototypical “love-hate” relationship, there is a good chance it was between an entrepreneur and a venture capitalist. It’s the perfect kind of relationship for the love-hate dynamic: lots of pressure; big egos; mutual dependence; and over-lapping but different and evolving relationship objectives and constraints. Unfortunate as it may be when things get ugly: surprising it isn’t.

While ugly entrepreneur/VC relationships are inevitable, there are more of them than there should be. As both a VC and a VC-backed entrepreneur I’ve seen a lot of entrepreneur/VC relationships get ugly that shouldn’t have; or at least shouldn’t have as soon as they did. Many times, entrepreneur/VC relationships break down when one side – and it is more often the entrepreneur side – doesn’t appreciate some of the realities that shape the attitudes and requirements of the other side.

And so this brief review of some of the realities of the world venture capitalists inhabit, and how those realities impact their relationships with entrepreneurs. Some are deeply ingrained in the nature of the venture investing business; some seemingly arbitrary rules of thumb. And yes, in almost every case subject to the occasional exception that most often proves the rule.

  1. Venture Capitalists are Fiduciaries. Venture capitalists manage money entrusted to them by their own investors (commonly referred to as “Limiteds”). That makes them fiduciaries, and that, in turn, means they are legally bound to act solely in the best interests of their Limiteds. Thus, as much as they may like and respect their portfolio entrepreneurs, their Limiteds have first call on their loyalty. A VC with any integrity at all (and you surely would not want to work with a VC lacking integrity, right?) will, when faced with a choice of doing the best thing for her Limiteds or doing the best thing for her portfolio company, pick the Limiteds every time.

    The fiduciary character of the VC/Limited relationship manifests itself in all sorts of ways beyond the obvious “should I invest more capital to save this company that I want so much to succeed, or would that be a bad move for my Limiteds” sort of situation. For example, entrepreneurs are often bemused by the emphasis VCs put on dotting every “i” and crossing every “t” in the deal documents. Well, that’s because while they personally might think a particular “t” does not need to be crossed, they have to think of their Limiteds – more specifically, what their Limiteds might think if not crossing that particular “t” turned out to be costly.

    More generally, being a fiduciary makes VCs very sensitive to making and managing deals within the real if not always well-defined parameters of the then current market. So, for example, I once knew a very prominent VC who thought that the whole idea of anti-dilution price protection was silly (I actually agree with him on that). That said, he got it in every deal he did for his fund. Why? Because if he didn’t his Limiteds would want to know why every other VC got it for their Limiteds, and he didn’t get it for them.

    The bottom line here is that entrepreneurs are well-advised to remember that as much as they may think of their VC as their VC, she is in fact first and foremost her Limiteds’ VC. And if she is any good at all, as much as she may like and respect you, in terms of her priorities her Limiteds are at the top of the list.

  2. Venture Capitalists are … Entrepreneurs. You heard that right. VCs are entrepreneurs just (well mostly) like you. They put together a business plan and take it on the road to raise money from mostly very sophisticated institutions. If they deliver the goods, they will likely find it easier to raise capital for their next fund. If they don’t they will probably find themselves in another line of work.

    Beyond just generally helping you have some empathy for VCs, realizing how their life and yours have so much in common should tell you something about their nature. Look in the mirror. Do you have a big ego? Are you often wrong but never in doubt? Are you a tenacious bulldog when it comes to building your business? Do you have at least one serious personality … quirk?

    Well, so does your VC. Which is to say, as difficult as you may find them to work with at times, you can be pretty sure they feel the same way about you.

  3. Venture Capital Funds Pivot, Too. If there ever was a startup that evolved exactly according to plan – from the first money in to the exit – you can be sure it was one of those exceptions that proves the rule. The same goes for venture funds. VCs leave funds unexpectedly. Markets evolve, and investment strategies evolve with them. Unexpected opportunities and challenges come up, and with them changes in resource (capital and people) allocation. Stuff happens and funds change, just like startups.

    When stuff happens at a VC fund, portfolio companies can suffer. One of the saddest VC/entrepreneur stories I know involved a company where I was an angel investor and director. The entrepreneur was really good, and really wary of brining a VC into the business. He bootstrapped and invested most of what he had made in a prior deal. Finally, with a good product, cash-flow positive operations on $5 million revenue, and great press, he concluded (rightly, in my opinion) that to come out as a leader in the market and really scale the business he needed to bring in some capital.

    So, he took $10 million from a very reputable venture fund at a good price, working with a partner who had followed the company and made noises about wanting to invest for several years. The first three months post-close were fantastic. And then .., the VC left the fund for greener pastures. The fund assigned a junior associate to the deal, and started looking at how to get out sooner rather than later. The company ultimately failed, largely, I believe, because what looked like such a sweet entrepreneur/VC pairing turned sour.

    Ok, the general point is that your relationship with your VC and her fund will evolve. Sometimes for the better. Sometimes for the worse. It pays to stay attuned to what is going on in your VC’s life, and her fund’s life. Is her star – and the funds’ – rising or falling? How much dry powder does the fund have? How much of that is for your deal? How is the rest of your VC’s and her fund’s portfolio doing? Knowing all of this, of course, doesn’t mean you have a lot of influence on it. But it can give you some inkling about how your relationship with your investors is going to evolve, for better or worse.

  4. Venture Capitalists are Business Partners not just Investors. Entrepreneurs are all over the map on the notion that VCs bring more value than just cash to the table. In my view, good ones do. But that really is not the issue here. The issue is that whether or not you think your VC has anything to offer besides money, you can be sure your VC believes she does, and in any event she is going to have some serious things to say about how you manage your business. And it doesn’t really matter how much of your company she owns: as folks who have run afoul of a bank loan covenant can attest, you don’t need to have an ownership interest to have a controlling interest.

    The point here is that you should be very careful, as you put together your deal with a VC, not to get so focused on the economics that you miss the management implications of the deal terms. Make sure you talk with your lawyer about control issues like class voting rights; Board seats and observer rights; fiduciary obligations (which can cut different ways in different circumstances); any voting agreements or side letters with investors; and most of all the extent and nature of the “Protective Provisions” in the deal documents. You’ll almost certainly find that there will be things you will not like in these areas, some of which you will likely not be able to change. But you can often change some of them at the margins at least, and even when you can’t it is better to know about the realities of control before your VC asserts them at a crucial moment.

  5. Venture Capitalists Don’t Do NDAs. Having been a serial entrepreneur I get why entrepreneurs think VCs should sign Non-Disclosure Agreements. Having been a VC as well, I get why VCs don’t do NDAs. And, well, the VCs are right. If they signed an NDA with every entrepreneur they took a business plan or pitch from, you can be sure they would spend most of their lives in court defending claims that they “borrowed” some entrepreneur’s idea and used it in another deal. (And that does – very rarely, I think – happen).

    Now, the VCs don’t do NDAs shtick would be a really big problem if it did not have such an easy solution: don’t tell a VC, until a term sheet is signed and final due diligence is in process (if then), anything that is really proprietary. If that seems impractical, consider this: You can sample my secret sauce without me sharing the recipe. For example, I can show you data demonstrating how my device detects metal fatigue, and likely even tell you some of the concepts about how it works, without telling you anything that would allow you to recreate my device.

    Seriously, there is no reason to share real, valuable proprietary information in your business plan or pitch to VCs. You can have a “black box” at the heart of your value proposition if you have sufficient indications of credibility (team, data, etc.) surrounding it. How strong those indicators need to be depends on how extravagant your claims are for your black box. If you have a device for sampling someone’s breath and diagnosing an infection, put a credible scientist beside it with some relevant literature and some early data and you’ve told me more than enough to get my due diligence going. If your telling me that your black box violates the second law of thermodynamics (I’ve seen plans like that a couple of times), you’ll likely have to show me a lot more: perhaps, say, that Stephen Hawking is your CSO.

  6. The 20-50% and 10x Rules. Valuation is what most entrepreneurs focus on in negotiations with VCs (often to the detriment of equally important issues like control and exit provisions). Entrepreneurs, of course, want higher valuations (thus less dilution), and can be very creative coming up with fancy spreadsheet forecasts and financial analysis.

    I must say I have seen some very slick spreadsheets supporting valuations for startups. Most of them, though, confuse precision with accuracy, and fail to deal with two fundamental realities of how VCs look at valuation. And in the process, provide a plethora of trivial details for folks to pick apart.

    The first valuation reality, and probably the best known, is that a Series A investor’s approach to valuation is very practical and simple: show me a model, from my investment to the exit, that I can believe in and that gets me at least $10 back for every $1 I invest. What they want to see is a list of likely buyers; the metrics for the likely sale; and some sense of how much additional dilution they will suffer to get there.

    That is a “big picture” kind of analysis that just doesn’t require a very detailed spreadsheet. It’s an analysis that places a lot more importance on the accuracy of assumptions than their precision, and limits the number of cells in the sheet to debate about. So why not save the time and expense of the finely detailed and precise spreadsheet model that reaches a conclusion only loosely correlated with what the investor thinks is important?

    The more overlooked valuation rule is the 20/50 rule. Most VC investors want to see an A round where the investors acquire at least 20% of the company, but no more than 50%. VCs want some minimum stake that reflects their centrality to the business. Most of them think that minimum is 20%. That may be arbitrary and capricious, but it is what it is.

    On the other hand, most VCs don’t want to see the founders and their team give up more than 50% of the equity in the A round because they want the founders and the team to have sufficient incentives to maximize the valuation of the company well past the A round. Again, 50% may be just a number, but it is pretty commonly “the” number in terms of maximum dilution at the A round.

    The trick with the 20/50 rule is how it can impact valuation when the size of the VC Fund is mismatched with the size of the needed A round investment.

    Most venture funds have a rule that limits how much of their capital can be deployed in any one company. That number is commonly 10%. So a $30 million fund is usually thinking that it can invest up to $3 million in any one company. Further, most VCs, given $X to invest in one portfolio company, will want to make sure some minimum fraction of X – let’s say 1/3 for an example – is available for the round after they first get in the deal.

    Ok, so let’s assume our VC’s Fund is $30 million. They want to put $2 million into you’re a round, and they have another $1 million lined up from another investor that will follow them into the A round. So they have $3 million for the A round.

    If you apply the 20/50 rule, you’ll find that to get the minimum 20% ownership for the A round investors, the maximum pre-money valuation is $12 million. If you want a significantly higher pre-money than that, you are probably better off looking for another lead investor with a deeper pocket; perhaps the smaller fund will follow in the higher priced deal.

Now, as I noted at the outset, the various rules and such noted above are, like most rules not found in physics or mathematics books, subject to exceptions. Maybe your deal should be one of those exceptions. But even if your deal should be an exception, the chances it will be an exception will be maximized if you know the whats and whys of the rules before you start trying to convince a VC to break them.

Back to the Future? Venture Investing in Flyover Country

The term “Venture Capital” covers a lot of ground, even when confined to the traditional institutional funds at the heart of the industry. Funds come in many flavors based on factors including stage of investment, industry focus, geography, and propensity to lead or follow in deals.

I’d like to suggest another basis for classifying venture investors, one that I think is absolutely critical when considering the unique opportunities – and challenges – of investing in places outside of the major established centers of venture capital investing. Places like where I grew up, and after twenty years in Silicon Valley and North Carolina, returned to some years back: Wisconsin.

My classification is based on two alternative paradigms for investing capital and managing investments: Nurturing and Managing.

The Manager Venture Investing Paradigm

The Manager paradigm dominates the venture business today (certainly in terms of capital deployed and public mindshare). It is characterized by large funds, many in the billions of dollars (see Softbank’s $100 Billion fund for the current outer limits of the industry) with multiple levels of investment professionals, many of which do not have early stage operating experience or even STEM educational credentials. The “value add” Manager investors provide is largely in terms of the later stages of expansion and exit planning and execution.

The Manager paradigm is ideally-suited to the contemporary Silicon Valley venture capital scene and in terms of number of deals and capital deployed the large majority of Manager paradigm investing occurs in Silicon Valley and a handful of other major venture capital hubs. Today’s large funds simply can’t efficiently make and manage smaller deals. Even those that operate affiliated “seed” funds typically make larger initial investments than their traditional seed fund peers, and limit those investments to deals that they perceive as having mega deal potential (and capital needs) going forward. As a result, the Manager paradigm funds are much less likely to invest in raw entrepreneurs who need a lot of hand-holding on basic operational blocking and tackling. Their deep pockets also make them more likely to focus on capital intensive growth/brand-driven exit metrics than profitability.

Now, the Manager paradigm may get all the headlines, and skew the statistics such that Silicon Valley round deal sizes and valuations or as much as an order of magnitude or even more than the comparable figures in flyover country markets, but it is not the only venture investing paradigm. In fact, it was preceded by a very different and still important, if no longer as publicly prominent, paradigm.

The Nurture Venture Investing Paradigm

The modern venture capital era began in the late 1940s and hit its stride in the 1970s.  Throughout that period, and into the 1980s, even the largest venture capital funds seldom exceeded $100 million and most were only a fraction of that. The prototypical Nurture VC was someone with industry operating experience as well as a STEM education. Further, these smaller funds had minimal junior staff compared to the layers of analysts, directors, junior partners, etc. that make up the bulk of the investment professionals at today’s larger venture funds.

The early decades of the venture business were characterized by something else, besides smaller funds: less experienced entrepreneurial teams. With the industry’s small size, and even with fairly rapid growth in the 1970s, it took awhile for the “serial” entrepreneur to emerge as a regular part of the deal flow. It was probably not until well into the 1990s that most venture-backed Silicon Valley startups included founders and senior managers well-versed in the art of building a high impact company from experience at prior venture backed emerging companies.

When you put all of these factors into a pot and stirred them up, you came up with the Nurture venture investing paradigm. An investment model based on VCs focusing on startups where they could add a lot of value to the deal in terms of the basic nuts and bolts of defining and building the business. Indeed it was a time where the venture investor was often involved – as for example Brook Byers and Genentech – in the actual conception of the business, recruitment of the founding team and formulation of the business plan. Sometimes well before it was even clear there would be any resulting investable deal.

The industry’s structure during the ascendancy of the Nurture paradigm had other implications, among the most prominent of which was the emphasis on profitability as an exit metric. This was not because Nurture investors were any smarter than today’s Manager investors, who by comparison are far less concerned with early profitability. Profitability was part of the Nurture paradigm simply because the typical Nurture fund – even when factoring in syndication of investments – simply did not have sufficient capital to support a portfolio company burning tens or hundreds of millions (or as per Uber recently billions) of dollars of capital a quarter.

The Nurture paradigm led to venture capital’s first golden age in the 1980s. It also sowed the seeds of the Manager paradigm which arrived on the scene in the later half of that decade. The Manager paradigm was launched, ironically enough, when some of the great Nurture firms started raising the first wave of mega funds with hundreds of millions of dollars and, before long, even billions of dollars to deploy.

Implications for Flyover Country Venture Investing

If there is still a meaningful role for Nurture funds in Silicon Valley, there is very little room – today – for Manager-modeled funds outside of Silicon Valley and a handful of other of the larger venture investing centers. And that is something that too many folks in flyover country just don’t understand. And something that is making it even more challenging than it needs to be to foster the emergence of a meaningful high impact entrepreneurship and investing sector in still nascent and emerging flyover markets.

I saw the problem in North Carolina circa 1990, and I see the problem in Wisconsin, today. Regional folks who want to foster a vibrant high impact entrepreneurship and investing community look to Silicon Valley and, seeing how the Manager venture investing model dominates the headlines, conclude that we should be doing the same thing here. That we should invest as if our entrepreneurs had the same kind of “been there, done that” startup experience and networks that their Silicon Valley counterparts enjoy.

Well, they don’t. The opportunities and challenges of venture investing in Wisconsin in 2017 are indeed comparable to the opportunities and challenges of venture investing in Silicon Valley. But Silicon Valley circa 1975, not 2017.

What places like Wisconsin need, in terms of venture investors, is Nurture VCs, not Manager VCs. We need small funds, run by hands-on partners who bring their own “been there, done that” high impact startup operating and investing experience to the game. People who are willing to get down in the trenches with entrepreneurs to help shape raw talent and ideas into fundable deals; and who are willing and able to start doing that even before making an investment. Venture investors who can proactively help their portfolio entrepreneurs achieve profitable operations supporting attractive exit opportunities with lifetime risk capital needs that don’t exceed even the average A round in today’s Silicon Valley.

Unfortunately, instead of Nurture funds led by experienced startup entrepreneurs and hands-on investing professionals helping raw entrepreneurs with good ideas build modest companies that offer solid investment returns with limited capital, what I’ve seen here in Wisconsin is mostly investors with little or no venture backed startup operational or seed/early stage risk capital investing experience casting about for the kind of startup teams and capital-ready deals that fit the Manager venture investing paradigm.  Teams and deals that we just don’t yet have enough of in Wisconsin to support a sustainable high impact venture-driven startup community.

Don’t get me wrong. I think – know – that Wisconsin and places like it have the raw entrepreneurial talent and capital to become small but important and sustainable centers of high impact entrepreneurship and investing. But getting there is not going to happen unless and until the folks who want that to happen understand that right now we need Nurture venture investors, the kind that built Silicon Valley, not Manager venture investors in the mold of those who get the headlines in Silicon Valley today.

Consumer Product or Medical Device? (Or Maybe Toy?)

By Paul A. Jones and Joel E. Henry, Ph.D. (Managing Partner, Michael Best’s Missoula Office)

So when is a consumer product – say a little matchbook-sized box you wear on your wrist that keeps track of your pulse over the course of the day –a medical device?

“What difference does it make?” you might ask. Well, if you are developing that little box for market, quite possibly tens of millions of dollars of added development and testing expenses, a couple of years more development and testing time, and millions of dollars of legal fees, regulatory expenses, insurance premiums, and misc. other costs both before market introduction and after. Not to mention likely a different distribution model, a higher price point, and lower volumes.

Alas, having perused FDA Guidance on distinguishing consumer products from medical devices (including some recent draft Guidance), and talking about the matter with some of my colleagues who spend substantial time practicing in the medical device regulation space, my take is that there is a lot of gray area around this question. Which is to say, there are a lot of current and soon-to-appear products out there for which good arguments could be made that they are consumer products – and good arguments could be made that they are medical devices. And that in some cases, the answer might even hinge on whether the manufacturer labels the product a toy. And that’s a problem.

While it takes pages and pages of regulation and guidance to get there, basically the distinction between a consumer product and a medical device – according to the FDA, which is to say the people that matter here – is pretty simple: the application of the distinction, less so.

First, the distinction. If the purpose of a product is to process inputs which are collected by the product from a person (a substance, for example sweat or blood, or data, for example a pulse) and use that to diagnose or suggest treatment for a medical condition, you have a medical device. Thus, for example, a personal ECG consumers can purchase without a prescription for the purpose of determining if they should see a doctor about an arrhythmia is a medical device, and is regulated as such. And that is true regardless of the intended use (well, I think so: more later).

Now, on the above logic, you would think that a product you wear on your wrist that keeps track of your pulse would be a medical device. I mean, the only real reason to have such a device – beyond a gee whiz sort of curiosity – is to monitor your physical activity for purposes of improving (or at least monitoring) your health. Clearly a medical device, right?

Well, no. The FDA has said, in its guidance on medical devices, that it will not deem a product a medical device if it’s only intended use is to encourage or maintain a general state of health or healthy activity, and the use of the product does not entail any significant risk to the user or third parties. Thus, your smartphone app for keeping track of your pulse isn’t in fact a medical device according to the FDA. This class of products would include (among many others) things that monitor calories burned or suggest healthy menus to control weight.

On the other hand, if your exercise monitor claims it can help you manage your Type II Diabetes, you’ve got something that is a medical device and that the FDA will consider to be a medical device. (You can see, I think, how this could get confusing.)

It gets more confusing. Our exercise monitor that is marketed as a tool for helping manage Type II Diabetes is in fact a medical device according to the FDA, and thus subject to regulation as such by the FDA. But the FDA, as a matter of policy, has indicated that it will not enforce those regulations with respect to such a medical device. That’s not a regulation but a policy. Which means it can be changed pretty much any time for pretty much any reason, without going through any rule making process or seeking industry or consumer input.

The thinking, here, is not to enforce the medical device regulations in the case of medical devices that present a low risk and are aimed at helping the consumer better manage a particular medical condition where the use of the device conforms to a generally accepted medical consensus. In this case, getting more exercise is a generally accepted mechanism for managing Type II diabetes. Another example of this kind of medical device would be a device that “coaches breathing techniques and relaxation skills, which, as part of a healthy lifestyle, may help living well with migraine headaches.” But, then again, FDA guidance says that it would regulate a medical device that listened to someone’s breathing to diagnose bronchitis (and yes, there is technology that does just that).

You can see, I think, how all of this can get pretty confusing. And we have not even talked about what “low risk” means (basically, if a product is invasive – that is it involves puncturing the skin or otherwise inserting something in the body as opposed to on it, or if it involves applying something (a laser, for example) to the body that could harm the user or a third party if not used correctly, you have a product that is not low risk).

If you think you can figure all this out on your own, here is a final twist; admittedly a pretty strange twist, but I think a valid one for purposes of illustrating how much uncertainty there is as the FDA struggles to adapt to a rapidly changing technological environment.

If you’ve ever had kids, you know that you can buy toy stethoscopes. These products, at least some of which are as functional as low end “real” stethoscopes, are not regulated as medical devices. They are marketed and intended to be used as toys, and include labels that they are not to be used for medical purposes.

On the other hand, traditional stethoscopes intended for medical use are medical devices (albeit regulated with a light touch). And “smart” stethoscopes – devices that enhance, manipulate, or interpret information generated by the stethoscope – are in fact regulated as medical devices (which, given the initial example of the personal ECG product, isn’t surprising).

So, what about a “toy” smart stethoscope? Before you say that labeling it a toy doesn’t work because it is clearly capable of performing a medical function, remember that so can a dumb toy stethoscope.

The answer? I am not sure. But there is, in fact, a “business card toy ECG” on the market. At least there is as this blog goes to press. You figure it out. And if you are smart, talk to your lawyer about your thinking before you run too far with it.