Taking a Venture Capital Perspective

Describe the characteristics of a good venture capitalist (VC) and you’re likely to find yourself describing the characteristics of a good CIO. VCs and CIOs must make efficient use of finite resources to achieve an acceptable return on investment. VCs and CIOs must have technical and market (or business) expertise. VCs and CIOs have networks of experts inside and outside their organizations to solicit advice on their proposed investments.

CIOs know they have areas of technical strength and vulnerabilities. You, as the CIO, need to make strategic decisions as to how best to achieve your mission. Within that strategy, you need to define what kinds of activities should be evaluated for the expenditure of your finite resources.

This tracks pretty closely with the operating environment of the venture capitalist. Could the similarities be extended? I think so. Let’s examine the interplay of the venture capitalist (who’s looking for the next big thing), the entrepreneur (who’s trying to attract VC funding and get his product or service to the mass market) and the CIO (who’s looking for strategic technology at the right price).

The Venture Capitalist

The VC has a number of resources that he wants to provide prudently to a select number of portfolio companies that have, in his opinion, the greatest opportunity to provide a superior return on the investment of those resources. The most obvious asset is that capital that the VC manages, but there are others: domain expertise within a certain technology and/or market; a network of people upon whom he can draw to evaluate opportunities and to assist the ones that receive investment; credibility and reputation that the portfolio company will bask in until it’s able to establish its own, independently; and his time, among others.

The typical VC plots a strategy for the fund and then implements it. Among the elements included in this strategy will be a fairly strict definition of what a potential portfolio company should look like to even be considered for investment evaluation. The factors will include technology area, size and growth rate of the market to be addressed, business model, barriers to entry, proprietary elements, stage of the company, quality, experience and completeness of its management team, current customers and prospects, location and so on.

Contrary to popular belief, the venture capitalist is not a swashbuckler swinging from the lanterns, but a prudent investment professional with a process that permits him to weed out inappropriate candidates.

A high profile venture capitalist in Silicon Valley may receive 10,000 business plans in a year (it went as high as 25,000 during the peak of the dotcom bubble). On average, 80 percent of those plans are rejected by the third paragraph of the executive summary. They don’t fit the VC’s investment profile. Another 10 percent are eliminated after a review of the plan and the founders’ backgrounds. Preliminary due diligence and interaction with the companies reduces the pool to 5 percent that may be invited in to meet the partners. 3 percent receive serious due diligence. 1-2 percent are offered terms sheets. 0.5 percent – 1.5 percent receive investments.

At the time a deal is closed, the venture capitalist believes that the deal is likely to achieve a liquidity event that will yield a superior ROI, and that could “make the fund” [provide a return on investment that would be sufficient to make the investors into the VC fund happy, even if every other deal cratered] if the moons align correctly.

At the same time, the VC knows that his success will ultimately be a portfolio game. Some companies are likely to fail. Others are the “living dead,” staying in business and covering payroll, but never providing an exit opportunity. A percentage will provide VC-type returns, and a small subset, maybe 1 out of 20, will hit the ball out of the park.

The Entrepreneur

Let’s take a brief look at a typical entrepreneur who wants to attract that VC’s investment. The VC is making decisions based upon risk vs. reward. The entrepreneur needs to evaluate his risk, as perceived by the investor. What are some of the things that the entrepreneur can do to lower that perceived risk?

• Have a customer that provides independent verification of the value of the entrepreneur’s offering (product or service);
• Squeeze $10 of value out of every $1 spent, being creative and tenacious in avoiding unnecessary expenses and extremely prudent those expenses that can’t be avoided;
• Being creative in securing that limited financing that permits the entrepreneur to make enough progress that the VC would even consider taking a look; and
• Create a viable and attractive exit strategy for the VC.

The more perceived risk he can wring out of his company, the more likely it is that a VC will look at the deal, and the terms of the deal are likely to be more attractive to the entrepreneur.

The CIO Opportunity

It is my belief that a CIO can exploit significant opportunities by applying the VC process to your new IT consideration, screening, evaluation and adoption process.

I remember in my corporate days, it used to be said, “no one ever got fired for buying Big Blue.” I’m sure many of you are thinking, no one ever got fired for NOT buying a product from an unproven, wild-eyed entrepreneur.

While I am sure you are the exception that proves the rule, many CIOs with whom I am familiar, are focused on implementing corporate IT initiatives, avoiding mistakes, and correcting those that have happened, regardless of source. This CIO is often removed from the day-to-day activities of his troops. This often creates a culture that is risk averse and implicitly puts a premium on avoiding problems, not seizing opportunities.

If the preceding were close to describing your peers in your competitors, think about the opportunities that are available to you to outflank them.

Now, I will admit a bias for the entrepreneur, but see if you agree with any, or all, of the following:

• IT is a strategic asset of my company that needs to be exploited
• Innovation is a source of competitive advantage
• Entrepreneurs are a primary source of true, “change the world” innovation

If any of these strikes a responsive chord, let’s look at the implications if you were to extend this perspective to your operation.

The CIO as Venture Capitalist

In labs and garages, revolutionary technologies are being developed that have the potential to materially change the way you do business. If you were the one to find and exploit such technologies, your company could have an unassailable competitive advantage.

Is that a reasonable expectation? I think so. Those technologies do exist. You must find them and embrace them, while your competitors continue to repel them in their risk-averse cultures.

CIOs have tremendous power relative to many, if not all, of these nascent enterprises.

• They need a customer.
• They need cash, the amount of which is enormous from the entrepreneur’s perspective and is likely to be modest to you.
• They would like to maximize the deployment of their dear resources by working on customer-defined features, instead of reading a crystal ball and hoping they guess right.
• They would like all of this to happen as quickly as possible.

YOU can satisfy all those needs. If you create a culture that pursues, the ROI on your asset deployment can be extraordinary. Like the VC, you will have to kiss a lot of frogs to find a prince, but if you know that going in, you won’t be deterred by the ones that don’t work out, but excited by the ones that do. Like the VC, you can control your downside and only take prudent risks. By virtue of your willingness to satisfy these immediate and critical needs, you can structure your contracts to meet your specific needs and on terms that provide meaningful benefits.

This strategy closely parallels that of Adams Capital Management (www.acm.com) with over $700 million under management, founded by Tepper School of Business at Carnegie Mellon alumna, Joel Adams. Their investment strategy is to seek proprietary technologies that exploit market discontinuities. Another cornerstone is Portfolio Company Navigation, a critical element of which is to secure a corporate partner. Sound familiar?

What’s the downside? Your team is on the leading edge of potentially applicable technologies. If a project doesn’t work, you’ve learned that well in advance of your competition, and you’ve just screened a number of highly intelligent and motivated engineers to whom you can extend job offers.

Such an enlightened approach, in my humble opinion, would spread like wildfire within the entrepreneurial and venture capital communities. Your access to relevant technologies would increase geometrically. Almost daily, I am exposed to jaw-dropping technology across the campus at Carnegie Mellon University. Much of it remains within the laboratories or is licensed by our Innovation Transfer Office. The hurdles to launching enterprises often appear insurmountable, particularly customer attraction. For some of these latent entrepreneurs, you can significantly lower those barriers while creating win-win relationships.

In past articles of this publication, there have been discussions of the CIO assuming his rightful place in corporate management and the possibility that CIO is on the path to the CEO’s office. The forward-looking CIO will achieve such recognition and success.

Frank Demmler is Associate Teaching Professor of Entrepreneurship at the Donald H. Jones Center for Entrepreneurship at the Tepper School of Business at Carnegie Mellon University. Previously he was president & CEO of the Future Fund, general partner of the Pittsburgh Seed Fund, co-founder & investment advisor to the Western Pennsylvania Adventure Capital Fund, as well as vice president, venture development, for The Enterprise Corporation of Pittsburgh.