The Web Startup Success Guide (Part 3): Early-stage Venture Funding

By Guest Author Bob Walsh

[In this next excerpt from “The Web Startup Success Guide”, which will be published on July 22, Bob turns to early-stage funding in an interview with Rebecca Lynn, a principal at Morgenthaler Ventures. With over $2.5 billion invested in 300-plus companies over the years, Morgenthaler Ventures is one of the oldest VC firms in Silicon Valley, focusing on life sciences and IT. Here’s what Rebecca, who focuses on early-stage investments in mobile, Internet services, digital media and financial services, had to say.]

Bob: What do you look for in early-stage venture funding in the areas that you follow?

Rebecca: I think it’s pretty core. There are a number of areas, but there are two core things. One is a truly disruptive technology or business model. The second is they have to address a very large market. Those are really, I think, always the two key contributors to what we look for when we’re looking at early stage. Team is also a big factor. Market is a big factor and all of that.

But the vein that runs through everything are those two issues. Is it truly disruptive? And does it address a big market?

Bob: How often do you find what you are looking for in the course of a year?

Rebecca: It’s funny, it goes in clusters. We will look at 100 or so deals where nothing is sort of what we were looking for. And then, it’s funny; we will find two in a row. It seems to go that way to be honest. It’s really a funny kind of business, but you just have to keep hunting and keep looking and be optimistic.

Bob: You’re one of the people who would act as a gatekeeper, I would say. If they can’t get past you, the odds that Morgenthaler Ventures, which is a 40-year-old VC firm, is going to consider them are pretty slim. What do you down-check people for?

Rebecca: What do we sort of count against people?

Bob: Yeah. What are the signs that these people are not going to make it for you.

Rebecca: There are a few things. One thing is, venture capital funding is not for everybody. Oftentimes you’re better off just creating a really profitable business without creating the funding. When I say that, the reason is, when we look at a business idea, a lot of times we will see some great business ideas and we’re like, “Yeah. These people are going to make money doing this.” But it is not going to be enough for us to justify a venture investment.

We see so many ideas that we’re like, “Yeah, we could see these people making a couple million dollars a year and being profitable,” but we can’t see them becoming a $100-million-a-year company. I think that’s the number one thing that we see. It’s hard to sort good businesses. For us to back a company there has to be some way that we could envision—some low probability, perhaps—that the stars are lining up and it could be a billion-dollar company.

We know the likelihood of its being that big is small, but there has to be sort of a path that we believe it can get there. And then if it can’t, then that is just not something that we can invest in as a VC business. I tell entrepreneurs that all the time, that VC is not the only path for a lot of people. Oftentimes you can bootstrap companies, you can get angel investment. You could do things like that. But venture capital money is for capital-intensive businesses.

Bob: A small point that a lot of people seem to forget in this game is that really you have to be a startup that needs significant amounts of capital and have that possibility of returning a really significant value to the people who have the capital.

Rebecca: Yeah, absolutely. Like I said, I see a lot of good businesses day in and day out that are solid businesses. They’re going to make somebody a pretty decent return. But the problem is, if somebody has a good idea and they come in and we write them a check for $3 million or $5 million, and the next day Google comes by the office and goes, “Oh, let’s pay you $10 million for that,” then the answer is no. I think a lot of entrepreneurs don’t realize that they have to basically be in it for the bigger payout.

Bob: Now, if Google were to come by and you’ve written the check for $3 million, and they say, “We’re prepared to pay $100 million,” then . .

Rebecca: Oh, it would be done.

Bob: Then it’s break out the champagne.

Rebecca: Yeah, we’d be done. Exactly. We have been around for a very long time. I think one of the reasons we have been around for so long is that we are known as very friendly to entrepreneurs. We are very collaborative with them. We have a lot of entrepreneurs who have come back to us several times. And we have those honest conversations with people. We lay that out for them. We are like, “OK. If you take this money and there are . . . ” We want to make sure our goals are on the same page, and that’s what creates our success. I think that’s really important for people.

Bob: Can a startup still get funded if it has no actual revenue but a great technology and the potential to reach a market of the size you are looking for? Has the bar gone up?

Rebecca: I do think the bar has gone up in a lot of ways. Especially right now, since the funding situation is a lot tougher, companies have to have a way to support themselves and, if not support themselves, then have a way to sort of “make it through the desert,” which is what you have people talk about on the low burn right now. Our portfolio companies have been pretty successful at doing that. Will a technology-only company still get funded? We funded a semiconductor company, believe it or not, in 2004 after the crash. It is going to be a while before they’re profitable. But we believe in the technology and we think it’s truly disruptive.

So, yes, it’s still possible, but I think the bar is higher on a number of fronts. I just think there’s more expected. And I think when you look at true consumer software plays, that bar is higher, for a few reasons. And one is, of course, the economy and just the tightness overall of credit and things. But the second reason is it’s fundamentally cheaper by a lot, significantly cheaper, to start a company now, an Internet company especially. You’ve got the cloud computing resources at Amazon. You don’t have to go buy your own servers right now, which was a huge expense for startups in the past. You’ve got all kinds of Open Source available to you. Ten years ago, when I was with NextCard, everything was from scratch, absolutely everything. And now that’s not as much the case. There are all kinds of tools, and then you have platforms like the iPhone and Facebook that significantly help with marketing distribution, so the payment for the initial marketing fund is oftentimes not as great.

So I actually think it takes less money and I think when you look at the online space, expecting that somebody is scrappy enough to at least get a product and a prototype going is not unrealistic at all.

Bob: So the bar is raised. Are there more or less or maybe the same number of companies coming your way? In other words, on one hand the need for the type of capital that a firm like Morgenthaler can provide, in general, seems to be less. A lot of platforms have gotten pretty mature. No one’s expecting a new Google to happen on Windows. Are you guys finding the opportunities drying up, or are they actually starting to cascade more than in the past?

Rebecca: No, I actually think it’s been a pretty steady state, to be honest. To answer the question, I think we’ve seen a lot of very interesting opportunities lately. There’s this weird phenomenon happening right now where people who have been successful entrepreneurs in the past, maybe checked out for a few years. They were kind of “on the beach,” is how we talk about it. And now, all of a sudden, they’re coming back. They’re like, “Wow, I can hire engineering talent again. I couldn’t hire it in here to save my life a year ago.” And now that there’s talent available and they can hire people, and their resources have become less expensive. We’re seeing a lot of those people resurface. And they are starting to kick around what they want to do next. And so that’s been really fun to see how that’s evolved.

Bob: Would you say that perhaps a drop in personal worth might have something to do with that too?

Rebecca: Yeah, I know, probably, actually. Probably they are saying, they’re probably like, “Hmm, maybe I’m not quite as done as I thought I was.”

Bob: Yeah.

Rebecca: And it’s kind of motivated them to come back and sort of try another shot at things.

Bob: For those people who are going out there and they’re looking to raise their first round of capital—they may not be going to Morgenthaler or they may be going to a real early-seed- or angel-type investor—what advice would you have for them in general?

Rebecca: In terms of presentation or what?

Bob: Mistakes not to make. Maybe insights that they should really have clear in their mind before they go off and look for venture capital or significant angel capital.

Rebecca: Yeah, it’s hard to say, because a lot of times different venture firms are different, to be honest. And some things that might work well with us I wouldn’t suggest people do with other firms. For example, with us it’s a good idea to come in really early, have a cup of coffee with us, talk to us about it in a casual way, so then we get a chance to know the entrepreneur over the next few months and see what they’re delivering and see how they track. And so I think it’s good for the entrepreneur to come in. One of the recommendations that came from a panel discussion I was on last night was “Don’t bring your entire team in.” Really, just the one or two people, the key people in the venture, are pretty much all you want to bring in on your first pitch. I come from a product background and product development background, and it amazes me how many times I see a technology and no real market assessment as yet. So that, to me, is very important. I want to know that they’ve gone out, have talked to the consumer, have the tested the faults to see if this is going to be something that people want. And I think that’s very important for people to do before they come in.

And other than that, I think people need to be confident and be honest about what they’re doing and how they got there. Every entrepreneur is a little different, and I think I would encourage . . . It’s hard to give general blanket advice in terms of what to do and what not to do when you come in. The other thing, too, that is a huge mistake is coming in with a 35-page deck. They should pretty much be able to say things in 10, maybe 15 slides, tops. And be prepared for lots of questions. I’ve sat through pitches before where the first half hour was telling me about the market segments. That should have taken two to five minutes maybe, tops. So I think getting right at what’s the need, what’s their value proposition, and how they’re the best at it, and let us ask questions.

This segment is part 3 in the series : The Web Startup Success Guide
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