What Software VCs Want Today
Prominent investors from Mohr Davidow Ventures, Sutter Hill Ventures and The Carlyle Group describe the high standards that drive software venture investment today.
By Maryann Jones Thompson, Sand Hill Group
Jun. 13, 2005
Longtime technology business veteran Howard Anderson has been making news recently. He says the current venture capital model is dead and he's quit investing in his venture funds.
The software startups that received $5.2 billion in venture backing during 2004 might beg to differ. Software continues to receive more venture dollars than any other sector in the U.S. And as new technologies and new business models continue to appear, most venture capitalists continue to see new financial opportunities in software startups.
At Software 2005, three veteran industry investors took the stage to discuss what software venture capitalists are looking for today.
* Sam Jadallah, general partner, Mohr Davidow Ventures
* Greg Sands, managing director, Sutter Hill Ventures
* Allan Thygesen, managing director, The Carlyle Group
Dan Dorosin, partner at law firm Fenwick & West, moderated the panel and succeeded in focusing on the issues that matter most to startups looking for capital. Here are some of the venture capitalists' thoughts about today's criteria for investment in new software companies.
Management Team
All panelists agree: a startup's executives are still the most important determinant of whether VCs will invest in the company. "The no. 1 thing we look for is confidence in the management team," says Sutter Hill's Sands. He says there are still deals getting done with "two people and 20 PowerPoint slides" but those are the exception. Today, he looks for companies who are intellectually honest about what a startup has - and what it doesn't - in terms of key executives. "We want people to tell us, 'Here are the gaps on the team and here's when we're going to go hire them."
Market Size
Another factor that kills many deals is a relatively small potential market. "Sometimes a company's focus is so narrow and so vertical, that it doesn't make for a good venture opportunity," says The Carlyle Group's Thygesen. It isn't that it won't be a good opportunity for the founders. But Thygesen says that if a software startup won't earn $100 million in revenue during its lifetime (or possibly less for companies with non-license models), it may be difficult for it to become a viable independent company, and therefore, not a good venture investment.
Economic Sensibility
Startups need to be as focused on today's economic constraints as any other business. "There is a seismic shift going on in the software business," says Jadallah of Mohr Davidow. "That means there are very few dollars available for software spending. Customers are going to write small checks and you have to have a sales and marketing model to match to that."
Company Mission
Software startups need to be razor sharp about their mission and focus. "Be really crisp about what your company is trying to do," says Sands. "Some people come in and say 'Here are 3 things we'll do.' I say 'Pick one.'"
Fund Affinity
Resources are as scarce at venture firms as they are elsewhere in today's economy. Therefore, investments must be large enough to impact the performance of a particular fund. "One metric to look for is whether your deal supports a post-seed round that is 1/100th of the fund's size, plus a couple of additional rounds," says Thygesen. If not, it probably doesn't warrant taking up the time of a senior partner. "We sometimes pass up deals because we can't put enough money at them."
"We do about a deal-and-a-half per partner per year. We might do 3. We might do zero," adds Jadallah. "I want to make sure that the opportunity is worth my time - am I passionate about it?"
Firm Affinity
Each venture firm has different cultures, fund sizes and interests and it pays to know who does what. "You need to know your investor," says Sands. His firm might invest in a startup with only $50 million in potential revenues, depending on the deal.
Business Models
Open source and software-as-a-service are exciting but startups need to explain how they'll succeed long-term with relatively low revenue in the short term. "Subscription model software companies can potentially consume a lot of cash along the way," says Sands. "So figuring out how to make money earlier and being creative about how to do that is incredibly important."
Personal Connections
It is still all about who you know. "Having a sponsored introduction is a great 'in.' An introduction from another entrepreneur, CEO, angel, or sponsor can help a lot," says Jadallah. Entrepreneurs should also use these sponsors to help prepare for the meeting with the venture capitalist. "You only have one hour to hook me. Last year, 200 companies came in to meet with me - not counting the ones that didn't get in the door - and I did one investment. The odds are tough."
Thygesen says his firm reviewed 4,500 business plans - not all of them in in-person meetings - and completed 12 financings. "I personally don't look at a deal if it isn't a referral." But as you move from series to series, the story and the hook, changes. Thygesen says just because his firm did not invest early does not mean he wouldn't invest at a later stage, after a first beta product or customer exists and referencability is less critical.
Financing Plan
Startup founders should not be afraid to set forth their plans for how the company will progress. "Pencil it all out. Explain your model for series A, B, and C investors and show a rational model for how you and your investors will make money," says Sands who cautions against including an assumption of "irrational exuberance" in the financial markets.
Risk Assessment
Venture is a risky business. Sands advises startup founders to acknowledge that fact - and plan for it. "Identify your risk reduction milestones. Show where you are now and how long it will take to knock down that first risk. Then it'll take 18 months to knock down the second risk, and so on."
Sector Trends
"My focus is largely around infrastructure. Also individuals and how people work, how technology lights people up," says Jadallah. "I've been spending some time on the open source space but I'm very skeptical about a lot of the open source business models."
"I usually have a theory about what I'm looking at but then I always invest in something else," says Sands. His current interested include online marketing, wireless models that don't involve carriers and enterprise infrastructure.
Thygesen is on the lookout for substantial horizontal niches and also companies that are new and disruptive to incumbents in the enterprise software space. "Supply chain, for example. Nobody has done it right."
Enterprise Technology
As the enterprise software sector matures, it is important to watch advancements in adjacent markets for signs of what's to come. "This is a cycle where more innovation is happening outside of the traditional enterprise technology," says Sands. "Consumer technology is outpacing enterprise with wireless, broadband and so on."
"There is an insane amount of innovation ahead of us," says Jadallah. "It won't be in the same areas we saw in the past."
Maryann Jones Thompson is editor of SandHill.com. Read more insight from Software 2005 at the post-conference site .
The software startups that received $5.2 billion in venture backing during 2004 might beg to differ. Software continues to receive more venture dollars than any other sector in the U.S. And as new technologies and new business models continue to appear, most venture capitalists continue to see new financial opportunities in software startups.
At Software 2005, three veteran industry investors took the stage to discuss what software venture capitalists are looking for today.
* Sam Jadallah, general partner, Mohr Davidow Ventures
* Greg Sands, managing director, Sutter Hill Ventures
* Allan Thygesen, managing director, The Carlyle Group
Dan Dorosin, partner at law firm Fenwick & West, moderated the panel and succeeded in focusing on the issues that matter most to startups looking for capital. Here are some of the venture capitalists' thoughts about today's criteria for investment in new software companies.
Management Team
All panelists agree: a startup's executives are still the most important determinant of whether VCs will invest in the company. "The no. 1 thing we look for is confidence in the management team," says Sutter Hill's Sands. He says there are still deals getting done with "two people and 20 PowerPoint slides" but those are the exception. Today, he looks for companies who are intellectually honest about what a startup has - and what it doesn't - in terms of key executives. "We want people to tell us, 'Here are the gaps on the team and here's when we're going to go hire them."
Market Size
Another factor that kills many deals is a relatively small potential market. "Sometimes a company's focus is so narrow and so vertical, that it doesn't make for a good venture opportunity," says The Carlyle Group's Thygesen. It isn't that it won't be a good opportunity for the founders. But Thygesen says that if a software startup won't earn $100 million in revenue during its lifetime (or possibly less for companies with non-license models), it may be difficult for it to become a viable independent company, and therefore, not a good venture investment.
Economic Sensibility
Startups need to be as focused on today's economic constraints as any other business. "There is a seismic shift going on in the software business," says Jadallah of Mohr Davidow. "That means there are very few dollars available for software spending. Customers are going to write small checks and you have to have a sales and marketing model to match to that."
Company Mission
Software startups need to be razor sharp about their mission and focus. "Be really crisp about what your company is trying to do," says Sands. "Some people come in and say 'Here are 3 things we'll do.' I say 'Pick one.'"
Fund Affinity
Resources are as scarce at venture firms as they are elsewhere in today's economy. Therefore, investments must be large enough to impact the performance of a particular fund. "One metric to look for is whether your deal supports a post-seed round that is 1/100th of the fund's size, plus a couple of additional rounds," says Thygesen. If not, it probably doesn't warrant taking up the time of a senior partner. "We sometimes pass up deals because we can't put enough money at them."
"We do about a deal-and-a-half per partner per year. We might do 3. We might do zero," adds Jadallah. "I want to make sure that the opportunity is worth my time - am I passionate about it?"
Firm Affinity
Each venture firm has different cultures, fund sizes and interests and it pays to know who does what. "You need to know your investor," says Sands. His firm might invest in a startup with only $50 million in potential revenues, depending on the deal.
Business Models
Open source and software-as-a-service are exciting but startups need to explain how they'll succeed long-term with relatively low revenue in the short term. "Subscription model software companies can potentially consume a lot of cash along the way," says Sands. "So figuring out how to make money earlier and being creative about how to do that is incredibly important."
Personal Connections
It is still all about who you know. "Having a sponsored introduction is a great 'in.' An introduction from another entrepreneur, CEO, angel, or sponsor can help a lot," says Jadallah. Entrepreneurs should also use these sponsors to help prepare for the meeting with the venture capitalist. "You only have one hour to hook me. Last year, 200 companies came in to meet with me - not counting the ones that didn't get in the door - and I did one investment. The odds are tough."
Thygesen says his firm reviewed 4,500 business plans - not all of them in in-person meetings - and completed 12 financings. "I personally don't look at a deal if it isn't a referral." But as you move from series to series, the story and the hook, changes. Thygesen says just because his firm did not invest early does not mean he wouldn't invest at a later stage, after a first beta product or customer exists and referencability is less critical.
Financing Plan
Startup founders should not be afraid to set forth their plans for how the company will progress. "Pencil it all out. Explain your model for series A, B, and C investors and show a rational model for how you and your investors will make money," says Sands who cautions against including an assumption of "irrational exuberance" in the financial markets.
Risk Assessment
Venture is a risky business. Sands advises startup founders to acknowledge that fact - and plan for it. "Identify your risk reduction milestones. Show where you are now and how long it will take to knock down that first risk. Then it'll take 18 months to knock down the second risk, and so on."
Sector Trends
"My focus is largely around infrastructure. Also individuals and how people work, how technology lights people up," says Jadallah. "I've been spending some time on the open source space but I'm very skeptical about a lot of the open source business models."
"I usually have a theory about what I'm looking at but then I always invest in something else," says Sands. His current interested include online marketing, wireless models that don't involve carriers and enterprise infrastructure.
Thygesen is on the lookout for substantial horizontal niches and also companies that are new and disruptive to incumbents in the enterprise software space. "Supply chain, for example. Nobody has done it right."
Enterprise Technology
As the enterprise software sector matures, it is important to watch advancements in adjacent markets for signs of what's to come. "This is a cycle where more innovation is happening outside of the traditional enterprise technology," says Sands. "Consumer technology is outpacing enterprise with wireless, broadband and so on."
"There is an insane amount of innovation ahead of us," says Jadallah. "It won't be in the same areas we saw in the past."
Maryann Jones Thompson is editor of SandHill.com. Read more insight from Software 2005 at the post-conference site .
