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Great boards are more about chemistry than control

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The chemistry must be respected

Inc.com has advice for early-stage companies: the partners with whom you choose to work are more important than the need for control.

By now everybody has a big stake in your success and would like to feel consulted on the major decisions you’re making with their money.  It surprises me that this is even controversial but in this day-and-age it sometimes is.  I know there are bad investors who do bad things. There are just as many bad entrepreneurs who do bad things.  As with most of life, it’s more about whom you choose to work with, what their reputation is from others and how well you’ve vetted them more than an absolute need for control.

Or as we once put it:  the fate of control is that always seems too little or too much.

Getting this piece right isn’t so much about control as it is about chemistry.  If VC-CEO partnerships are like marriages (as is often said), then the issue of control needs to mirror that of a healthy marriage.  It’s not about 100% control, or even 51% control – it’s about playing to each others’ strengths and making the concessions and adjustments that a given situation demands…  It’s hopefully a long term relationship, and so over time you each learn when to take your shot and when to pass the ball…

Once the honeymoon is over, will you collectively put forth the constant effort required to sustain the relationship?  How will you resolve conflict?  Are communications open and largely free of clashing egos?  Does the quality of the arguments make the outcomes better?  U2 credits their longevity to a “group ego” that trumps everything else.  Can you develop what Fred Wilson of Union Square Ventures calls “shtick tolerance?”  You don’t have to accept everything about your partner – outside of integrity/honesty – but you must be able to more or less tune some things out over the long haul.  You’re patient with their shtick because they’re patient with yours.  It’s hard work.

Predicting interpersonal chemistry isn’t always easy.  Most venture firms will have a good “rap”, but it’s absolutely essential for entrepreneurs to verify that through their own rigorous due diligence:

Entrepreneurs who are raising growth capital (i.e. bringing on a long term partner) as opposed to selling their businesses (i.e. get the best valuation) should invest a lot of time conducting due diligence on their prospective financial partner.  A credible partner will let you (indeed, encourage you) to talk to as many of their previous entrepreneur partners as you want to get a feel for what they are like to work with.  Entrepreneurs should ask for references from successful investments, unsuccessful investments and current investments.  Ask for the venture firm’s entire list of previous and current investments and randomly call a number of them.  Find some independent sources on your own who weren’t provided as references but know the venture firm…

The chemistry between entrepreneur and venture partner in private companies is more cooperative, longer-term, and (mercifully) not subject to the quarterly reporting pressures of public companies.  Both will have real “skin in the game” and the same incentive to understand the nuances of the business and focus on long term value creation.

The Long Engagement

One of our most-read posts here at NVSE is The Fate of Control (December 2009).  In it we cite a phrase coined by Fred Wilson’s at AVC – “shtick tolerance” – as a key to any successful long term relationship.  As we blogged in that decade-ago December:

You don’t have to accept everything about your partner – outside of integrity/honesty – but you must be able to more or less tune some things out over the long haul.  You’re patient with their shtick because they’re patient with yours.  It’s hard work.

Fred is back with another outstanding post, once again on the subject of long term relationships. Here’s an excerpt from The Long Engagement:

What I would prefer to see, and do see in many cases, is a founder who takes the time while they are not raising money to build a number of relationships with potential investors and then engages those investors in a process when it is time to raise capital. I like to call this process the “long engagement”.

It might sound like a lot more work than the fast and furious fundraising process that many founders are running these days.

But I don’t think it is a lot more work. Building relationships over a six to twelve month period can take the form of an occasional face to face meeting, emails back and forth, and even a few visits to the office by the investor. And none of that has to have the pressure of a pitch, an ask, and a price.

We think Fred is spot on. In most cases our relationship with an entrepreneur starts early – months or even years in advance of an investment. Ideally everyone involved has sufficient time and opportunity to explore the fit and potential of the chemistry that will prove crucial to success. Here’s how we put it in a March 2013 post, Due diligence: mine, yours, and ours:

Entrepreneurs who are raising growth capital (i.e. bringing on a long term partner) as opposed to selling their businesses (i.e. get the best valuation) should invest a lot of time conducting due diligence on their prospective financial partner. A credible partner will let you (indeed, encourage you) to talk to as many of their previous entrepreneur partners as you want to get a feel for what they are like to work with.

Entrepreneurs should ask for references from successful investments, unsuccessful investments and current investments. Ask for the venture firm’s entire list of previous and current investments and randomly call a number of them. Find some independent sources on your own who weren’t provided as references but know the venture firm…

Establish a solid foundation for the relationship early: Will you share the same vision? Agree on ground rules?

Once the honeymoon is over, will you collectively put forth the constant effort required to sustain the relationship? How will you resolve conflict? Are communications open and largely free of clashing egos? Does the quality of the arguments make the outcomes better?

Astroball > Moneyball

Regular readers know that we’ve often covered the limits of decision models, the importance of chemistry, and what makes a team work well together.  And that we’re baseball fans (especially of our Rays).

recent review of “Astroball” in The Wall Street Journal. covers that same ground with the terrific story of the 2017 World Series champs.  Astros GM Jeff Luhnow figured out how to get scouting and analytics to work together and combine that with team building to go from last place to World Series champs in 3 short years.

It was no easy task, “(B)ut it was done, and the team made a series of sound, even brilliant, choices as it drafted, traded and signed players.”

An excerpt:

This roster-creation, all by itself, did not bring home the championship. Building an exceptional team is one thing, but making it work as a team is another. “Fault lines” exist in all complex organizations—including baseball teams. If these lines can be bridged or eradicated, a team is likely to win more ball games. To use another bit of old-fashioned terminology, a team needs chemistry.

Carlos Beltrán, the veteran outfielder signed by the Astros after the 2016 season, immediately took on the role of chief chemist. Among other things, he created a postgame ceremony that awarded prizes for excellence in the field and instituted a postgame “court” for those who failed to attend: The fine was $500. Mr. Beltrán also had a singular ability to study opposing pitchers and determine their “tells”—gestures and small changes in behavior that signaled whether or not the next pitch would be, for example, a breaking ball or a fast ball. Finally, Mr. Beltrán had a strong desire to close the gap between the English and Spanish speakers.

His biggest ally in this quest was Alex Bregman, who professed to speak perfect Spanish. In fact, it was far from perfect, but Mr. Bregman worked hard to communicate with his Spanish-speaking teammates, including going out of his way to befriend first baseman Yuli Gurriel, who joined the team in 2016 after coming to the United States from Cuba and who spoke no English at all. Mr. Gurriel was exactly the sort of player who can become isolated and resentful in many American clubhouses. But Mr. Bregman refused to let that happen. As Mr. Reiter explains, “The two yammered at each other in Spanglish all day long.”

Add to all this the signing of pitcher Justin Verlander, acquired during the 2017 season, and a dash of good luck, and there’s no reason why any of us should have been surprised that the Astros won their World Series right on schedule. Mr. Reiter’s superb narrative of how the team got there provides powerful insights into how organizations—not just baseball clubs—work best.

We have previously suggested  that in baseball there’s just a slight correlation between more analytics and more success.  It remains tough to eliminate the usefulness of having more money than other clubs, and with technology and best practices so widely disseminated and articulated (in baseball, at least) the early Moneyball advantages may have been arbitraged away.  So excellent teamwork or a hot stretch of cluster luck can make the difference.

The fan inside us is fascinated by new thinking on the topic, and the prospect of advantages to be gained in the short term, but over the long term our conclusion remains the same:  big data may help make accurate predictions or guide knotty optimization choices or help avoid common biases, but it doesn’t control events.  Models are useful in predicting things we cannot control, but for those in the midst of the game – players or entrepreneurs – the results have to be achieved, not just predicted.

Successful people invest in relationships

Good article in Entrepreneur about how true success is not possible unless you build great relationships.  The piece hits several themes that we believe are critical to a successful vc-entrepreneur marriage: maintaining long term relationships, communicating good news and bad, promoting honesty in business, how useful failures can prevent epic ones, and maximizing board effectiveness.

The chemistry between entrepreneur and venture partner in private companies is more cooperative, longer-term, and (mercifully) not subject to the quarterly reporting pressures of public companies.  Both will have real “skin in the game” and the same incentive to understand the nuances of the business and focus on long term value creation.

You will spend a great deal of time, effort, and money together with a new partner, so the chemistry ought to be productive and enjoyable. It should add conviviality in the good times and take the edge off the bad times.

Here are a few highlights from the article “How Successful People Build Exceptional Professional Relationships.”

They help without having to be asked.

People who build great relationships pay close attention so they can tell when others are struggling. Then they offer to help… but not in a general, “Is there something I can do to help you?” way. Instead they come up with specific ways they can help.

That way they can push past the reflexive, “No, I’m okay…” objections and then roll up their sleeves to make a difference in another person’s life.

And they do it not because they want to build a better relationship — although that is certainly the result — but simply because they care.

They take the undeserved hit.

She’s willing to accept the criticism or abuse because she knows she can handle it — and she knows that maybe, just maybe, the person who is really responsible cannot.

Few acts are more selfless than taking the undeserved hit. And few acts better cement a relationship.

They answer the question that was not asked.

Where relationships are concerned, face value is usually without value. Often people will ask a different question than the one they really want answered… Behind many simple questions is often a larger question that goes unasked. People who build great relationships listen carefully to discover what lies underneath so they can answer that question, too.

They step up when they have acted poorly.

Responsibility is a key building block of a great relationship. People who take the blame, who say they are sorry and explain why they are sorry, who don’t try to push any of the blame back on the other person… those are people everyone wants in their lives, because they instantly turn a mistake into a bump in the road rather than a permanent roadblock.

They know when to dial it back.

People who build great relationships know when to have fun and when to be serious, when to be over the top and when to be invisible, and when to take charge and when to follow.

Great relationships are multifaceted and therefore require multifaceted people willing to adapt to the situation — and to the people in that situation.

They value the message by always valuing the messenger.

Smart people strip away the framing that comes with the source — whether positive or negative — and consider the information, advice, or idea based solely on its merits.

People who build great relationships never automatically discount the message simply because they discount the messenger. They know good advice is good advice, regardless of where it comes from.

And they know good people are good people, regardless of their perceived “status.”

 

Dead cats and iterative collaboration

Today is Erwin Schrödinger’s (he of the famous half-dead cat) 127th birthday.  We found this terrific excerpt from his 1933 Nobel Prize address:

If I am to have an interest in something, others must also have one. My word is seldom the first, but often the second, and may be inspired by a desire to contradict or to correct, but the consequent extension may turn out to be more important than the correction, which served only as a connection.

Though the tone of that quote echoes Sheldon Cooper of The Big Bang Theory, the content echoes a topic we like to cover here:  iterative collaboration.

From Hayek Was Right – Why Cloud Computing Proves the Power of Markets:

Many things about our company turned out differently than we had expected… The Hayekian knowledge problem is not a mere abstraction. Our innovations that have driven the greatest economic value uniformly arose from iterative collaboration between ourselves and our customers to find new solutions to hard problems.

Success is often achieved in incremental, adaptive fashion – with failure counted on to make a brief cameo at some point along the way. We love the collaborative imagery of a “correction” being a “connection” to the “extension” of an idea. Perhaps the great scientist ought to have received a Nobel for nerd poetry to go along with the one in physics.

Here is an explanation of his “thought experiment” that does, and doesn’t, kill a cat:

 

For more on the topic of iterative collaboration, please see:

CEOs are from Mars, VCs are from Venus – redux

This article in Entrepreneur echoes (and borrows the title of) a post from our first month of blogging (November 2009):  CEOs are from Mars, VCs are from Venus?

Back then we cited a joint study conducted by the NVCA and Dow Jones which outlined several factors that contribute to a good long-term partnership for long-term growth, and highlighted two data that we found insightful band mildly humorous:

Do you respect me or my money?

  • 54% of VCs cite mentoring the CEO as a critical value-add; only 27% of CEOs see the value.

The money will always be important.  After all, entrepreneurs should pick a financial partner who can provide additional capital as needed as their companies grow.  But the best (sadly, not all) venture partners provide much more than money – valuable contacts, “been there, done that” experience when facing tough business issues and a sympathetic sounding board for entrepreneurs working under great pressure.

As was the case with another contributor at a different publication, the author of the Entrepreneur piece is either subconsciously thinking mostly about early-stage venture financing or is perhaps painting with too broad a brush.  But he still makes a few valuable points:

Ultimately, Gray’s [author of the 1992 book Men are from Mars, Women are from Venus – ed] advice for better relationships applies: If founders and capital providers invest the time to understand their objectives deeply, they will have a productive relationship.  The key is to find activities where they can make the other party better off.

Or, if you prefer, as we once put it in The fate of control (also from 2009):

It’s more about chemistry than control. How you react during the inevitable challenges of building a business together will define the relationship. Over time you learn to play to each other’s strengths and make the concessions and adjustments that a given situation demands.

Related Stories:

Conversations about valuations

This article on valuation from the Houston Business Journal is written from the point of view of middle-market investment banking, but it’s also relevant to term sheet negotiations between entrepreneur and venture capitalist.  Higher EBITDA doesn’t automatically lead to higher multiples (and higher valuations).

The reality is that valuations are much more complex and are primarily a function of the underlying fundamentals of a business. These fundamentals might include growth opportunities, recurring revenues, customer and product diversity, entry barriers, proprietary products and high levels of free cash flow.  Our experience tells us that different buyers can have widely divergent views of value based on their relative assessments of these underlying fundamentals

It is important for private business owners to understand valuation drivers and to develop the financial and operating data that will enable buyers to properly assess the underlying fundamentals of their business.  More clarity for a buyer leads to a higher level of confidence and a more attractive valuation for the seller.

It also leads to a higher level of confidence in the relationship.  The early conversations about valuation (and control) begin to shape the personal chemistry crucial to a successful long-term partnership.  Clarity and transparency, which make it easier for everyone involved to observe how decisions are being made, are much more important to hopeful-future-teammates than either side trying to squeeze maximum value out of a single transaction.

If a good tone is set early and maintained consistently, over time everyone on the team worries less about who’s in control and more about how to create the best scoring opportunity.

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Related stories:

 

Our column in the Business Journal

On April 7 a syndicated column entitled “Why your company should avoid venture capital” ran in several City Business Journals.  The piece struck us as a bit uncharitable and off point, so we asked our hometown Tampa Bay Business Journal for the chance to reply, to which they graciously agreed.  Our column ran today and can be found here.  (Or if you prefer a .pdf, here.)

Early stage investors don’t always fit neatly into categories and take varied approaches to working with entrepreneurs, so one must be careful not to paint with too broad a brush when criticizing or praising.  However the industry as a whole is indisputably critical to the nation’s wealth and well-being.

20% of U.S. gross national product is created by companies that were formed through venture backing. Everybody knows Google and Facebook, and before them Apple and Intel, but there are countless lesser known venture-backed companies throughout the country who have contributed to economic growth and created high quality jobs.  Venture capital is the one asset class that consistently creates the next generation of great companies and jobs and it doesn’t ask for (or need) bail-out.

Is there such a thing as too much incentive for an entrepreneur?

incentivesWhen we’ve written on the subject of board performance, we’ve emphasized that private company boards often have greater chemistry and transparency because the incentives of the entrepreneur and investors are more easily and perfectly aligned than in public companies.

Here’s how we put it in 2010 in Communicating good news and bad:

In our experience, the relationship between entrepreneur and venture partner in private companies is more cooperative, longer-term, and (mercifully) not subject to the quarterly reporting pressures of public companies.  Moreover, venture investors have real “skin in the game” and have the same incentive as the entrepreneur to understand the nuances of the business and focus on long term value creation.  As a result, the communication of good news and bad tends to be more forthright and in real-time, enabling partners (assuming they are good partners!) to understand intuitively the right kind of counsel and support to offer during both the good times and during the inevitable challenges of building a business.

Not too long ago we came across a great piece at HBR Blog Network on the importance of aligned incentives.  In There Is Such a Thing as Too Much Incentive for Entrepreneurs, N. Taylor Thompson makes the case that there are instances in which  an entrepreneur ought to “take some money off the table”:  when lack of diversification in his wealth creates a difference in economic incentive between himself and his investors.  If all his money is tied up in the startup, it could (quite reasonably) cause him to “prioritize exit probability above expected value because of diminishing marginal utility and loss-aversion.”

In other words, if all his money is in the company he founded, but it’s just one of several investments for the venture firm, the pressures and logic of decision-making within the partnership can be different.

From the HBR piece:

Behavioral economist Dan Ariely has conducted a set of experiments to gauge the relationships between economic incentives and performance. In one experiment, he offered participants payments for pressing alternating keys on a keyboard; in another, he offered payment for math problems – and, in both he varied the incentive so that participants could earn either up to $30 or up to $300. For key-pressing, stronger incentives led to better performance. For math problems, incentives decreased performance.

Ariely’s interpretation is that simple tasks requiring no cognitive engagement respond as expected to increased incentives, while cognitively complex tasks peak and then show decreasing performance, as increasing incentive distracts from cognitive performance…

Taking a small amount of money off the table aligns incentives much better to focus on making a big, world-changing impact. And diversifying also can remove the performance-destroying stress that comes with overly strong incentives.

To be clear, aligning incentives remains critical to startup success; my argument is simply that a modicum of diversification helps both entrepreneurs and investors. Taking money off the table isn’t about getting rich, it’s about freeing entrepreneurs to focus on doing something great – not just good enough.

While we (also quite reasonably) prefer to have our capital directed toward growing the business, we understand there are times it makes sense to achieve partial liquidity for founders who want to continue building the business but would also like to realize a portion of the value they have created to date.

On a related note:  buying out a minority or absentee partner’s interest can also often better align incentives and remove a barrier to rapid growth.

Is good old-fashioned intuition out of date?

intuition2Is There Still a Role for Judgment in Decision Making?  Harvard Business School Professor James Heskett wonders if recent advice to eliminate decision-making biases might have gone too far in an effort to supplant independent judgment with data and probabilities and decision trees:

The replacement of customs and biases with data, “big” or “small,” has been intended, at least in part, to drive out such things as tradition, habit, and even superstition in endeavors ranging from child rearing to professional sports.  After all, wasn’t the book and film, Moneyball, at least in part a glorification of the triumph of statistics and probabilities over intuition and managerial judgment in professional baseball?  …

In fact, if there is a sense that one gets from all of this work, it is that we are our own worst enemies when it comes to making and implementing good decisions.  We need tools to correct the errors and biases of our own judgment.  This is puzzling, because we are frequently reminded that the ability to exercise judgment is what sets humans apart from other forms of life.  (Perhaps judgment is what leads us to adopt recommendations such as those of these authors.)

Every leader has internal biases, some of them subconscious or hidden, which can create especially tricky traps that complicate sound decision making.  So it is important to think systematically and design the decision-making process to account for the zoo of biases managers face.  Astute management of the social, political, and emotional aspects of decision making can help account for the underlying biases of the participants.

On the other hand qualities such as judgment, engagement and strong communication skills are critical attributes because interpersonal chemistry plays a role in any decision involving more than one person.  What we’ve oft said about boards is true of any team:  processes and best practices may be important, but great teams rely on ‘robust social systems’ and mutual accountability among its members to ensure that they function properly.

As we argued in Thinking consciously, unconsciously, and semi-consciously:  the best results often come from a combination of deliberation and intuition.  Too much deliberation can become analysis paralysis; and studies show that those who rely on intuition alone tend to overestimate its effectiveness.  (They recall the times it served them well and forget the times it didn’t.

Furthermore, the more complex and detailed the process the greater the likelihood managers will mistake process for purpose and manage to the rules without exercising any judgment.  In the wake of the last financial crisis, BoE Director of Financial Stability Andrew Haldane argued that this had been precisely the case with regulators, who tiptoed right up to the hot red line at which a crisis can be triggered.

Mr. Haldane deployed an analogy about a Frisbee-catching dog to explain how increasingly complex (and sometimes frivolous) attempts at regulation push the limits of data or modeling or even the nature of knowledge itself.  The dog can catch the Frisbee despite the complex physics involved because the dog keeps it simple:  run at a speed so that the angle of gaze to the Frisbee remains roughly constant.

So while we still do value “good old-fashioned intuition,” it’s also unwise to rely only on one’s instincts to decide when to rely on one’s instincts.  The dog’s doing just fine, but if it involves more than a Frisbee he might want to crunch some numbers too.

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