Engineer's View of Venture Capitalists
Nick Tredennick, with Brion Shimamoto,Dynamic
encountered venture capitalists (VCs) in 1987. Despite a bad
start, I caught the start-up bug. In the years since, I have
worked with more than 30 start-ups as founder, advisor, engineer,
executive, and board member. It's a lot more than that if
you count all the times I've tried to help "nerd" friends
(engineers) connect with the "rich guys" (VCs). Naturally,
I've formed opinions along the way. Many books and articles
eulogize VCs. But here I want to present an engineer's view
of VCs. It may sound like I'm maligning VCs. That's not my
intent. And I'm not trying to change human nature. VCs know
how to deal with engineers, but engineers don't know how to
deal with VCs. VCs take advantage of this situation to maximize
the return for the venture fund's investors. Engineers are
engineers are trained problem-solvers--I want to harness that
power. Engineers, armed with better information about how
VCs operate, can work for more equitable solutions. I'm not
offering detailed solutions--that would be a book. Rather,
this is a wake-up call for engineers.
experience with VCs was as an engineer starting a microprocessor-design
company; VCs were the gods of money. The other founders and
I told the VCs what we thought we could do and how long it
would take. We believed it; they believed it; we were all
naive. I had designed two microprocessors, had written a textbook
on the topic, and had taught at a well-known university. They
thought I knew what I was talking about. We landed money from
premiere firms on Sand Hill Road in Palo Alto, Calif. We told
them a year; it took something like seven years and it took
major changes in strategy to get there.
the CEO; I hired and managed the engineering teams that eventually
reached the goal. I wasn't there for the finish. I had a run-in
with the other founders, including the CEO, over how to manage
engineers. It was micromanagement versus laissez faire. (Their
attitude: "Turn your back on them and they'll sit on their
hands." My attitude: "Turn these particular engineers loose
and they'll work themselves to physical ruin.") We were in
danger of losing good engineers to morale problems. I suggested
to the board that firing all of the founders, including me,
might solve the problem. A new team might manage more consistently.
member from our largest VC firm invited me to his house in
Woodside for a chat about the morale problems. Acres, opulence,
wealth. We sat in leather chairs on a black marble floor.
Behind him, through the glass wall, I saw major excavation
and construction work going on up the hillside. "It's too
bad someone is building a resort hotel so close to your house,"
I said. "That's my new house," he said. "This one will be
torn down when that one's finished."
about the situation at the start-up. I outlined my concerns.
I handed him a list of names. "Here's contact information
for some of the project engineers. The first four will tell
you what I have told you. The fifth will say the following
things...." To his credit, he interviewed the engineers. Also
to his credit, he called to tell me the result. "Everything
you said is as you said it was." I felt relief. I had struggled
with a deteriorating situation for a year and a half.
on the problem; we agreed on the circumstances--a solution
was on the way. They told me: "We think you should resign."
I left; the problems didn't.
to venture capitalists
connects wealthy investors to nerds. There are few alternatives.
You can self-fund by consulting and by setting aside money
for your venture. That doesn't work. You could go to friends
and family, but that risks friendships. You could find "angel"
investors, but that only delays going to VCs.
community is a closed one. It caters to a restricted audience.
In fact, you don't get to meet a VC unless you have a personal
introduction. Don't send them your business plan unless the
VC has personally requested it.
don't sign nondisclosure agreements.
them protection if they like your ideas, but they want to
fund someone else to do them. At least two of my friends have
had their ideas stolen and funded separately. One case was
blatant theft--sections of the original business plan were
crudely copied and taped into the VC-sponsored plan. My friend
sued and won a moral victory and a little money. The start-up
based on the stolen idea went public and made lots of money
for that start-up's VCs. Most entrepreneurs don't have the
time, the means, or the proof to sue. In the second case,
venture firm D sent its expert several times for additional
"due diligence" regarding the possible investment. My friend
got funding elsewhere, but D funded its expert with the same
industry is driven by fads, just as the fashion and toy industries
are. The industry is periodically swept by programming language
fads: Forth, C++, Java, and so on. It's swept by design fads
such as RISC, VLIW, and network processors. It's even swept
by technical business fads such as the dot-coms. No area is
immune. If one big-name VC firm funds reconfigurable electronic
blanket weavers, the others follow. VCs either all fund something
or none of them will. If you ride the crest of a fad, you've
a good chance of getting funded. If you have an idea that's
too new and too different, you will struggle for funding.
they aren't engineers--even the ones with engineering degrees.
An engineering degree is a starting point. If you design and
build things, you can become an engineer; if you work on your
career, you can become an executive or a venture capitalist.
VCs in Silicon Valley are as technically sophisticated as
VCs come. As you get geographically farther from technical-industry
concentration, investors become more finance-oriented and
all people, they dismiss what they don't understand, your
novel ideas, and they focus on what they know, usually irrelevant
marketing terms or growth predictions.
aren't very good.
will send at least one "expert" to evaluate your ideas. Don't
expect the expert to understand what you are doing. Suppose
your idea implements a cell phone. The VC will send an expert
who may know all there is to know about how cell phones have
been built for the last 10 years. As long as your idea doesn't
take you far from traditional implementations, the expert
will understand it. If you step too far from tradition--say,
with a novel approach using programmable logic devices instead
of digital signal processors--the expert will not understand
or appreciate your approach.
I worked with had an innovative idea for a firewall: build
it with programmable logic and it works at wire speed. Wire
speed meant no buffering, no data storage, and therefore no
need for a microprocessor or for an IP (Internet Protocol)
address. Simple installation, simple management, but so different
that experts--even those from programmable logic companies--didn't
understand it. To them, proposing a firewall without a microprocessor
and an IP address was like proposing a car without an engine.
No funding. Back to work at a big company. Worse for them;
worse for us. The industry loses. Progress is delayed.
don't take risks.
a reputation as the gun-slinging risk-takers of the electronics
frontier. They're not. VCs collect money from rich people
to build their investment funds. Answering to their investors
contributes to a sheep mentality. It must be a good idea if
a top-tier fund invested in a similar business. VCs like to
invest in pedigrees, not in ideas. They are looking for a
team or an idea that has made money. Just as Hollywood would
rather make a sequel than produce an original movie, VCs look
for a formula that has brought success. They're not building
long-lasting businesses; they're looking to make many times
the original investment after a few years.
VCs build a venture fund, they charge the fund's investors
a management fee and a "carry." The carry, which is typically
20 to 30 percent, is the percent of the investors' profit
that goes directly to the VC. The VC, who gets a healthy chunk
of any venture-fund profits, may have no money in the fund.
Even a small venture fund will be invested across a dozen
or so companies, spreading risk. Also, the VC, as a board
member, will collect stock options from each start-up the
fund invests in.
investors take some risk, though their risk is spread across
the fund's investments. The real risk-takers are the entrepreneurial
engineers who invest time and brain power in a single start-up.
funds are big.
If your idea needs a lot of money, say $100 million, then
you have a better chance of getting money than an idea that
promises the same rate of return for $1 million. The VCs running
a $1 billion fund don't have the time to manage one thousand
$1 million investments. It won't even be possible to manage
two hundred $5 million investments. It's better to have fewer,
bigger investments. In such an environment, if you need only
$5 million, your idea will struggle for funding.
in "bake-offs" that are the VC's version of price fixing.
They discuss among themselves funding and "pricing" for candidate
start-ups. Pricing sets the number of shares and the value
of a share, and is typically expressed in a "term sheet" from
the VC to the start-up. VCs optimize locally. It wouldn't
do for several of them to fund, say, six companies in an industry
wedge. Limiting the options to two or three limits competition
and makes the success of the few more likely. The downside:
limiting competition stifles innovation and slows progress.
As in nature, competitive environments foster healthier organisms.
Innovation is the beneficial gene mutation to the current
a recent talk by a VC luminary, who gloated over the state
of the venture industry, after money for technology start-ups
was scarce. Here's my summary of the VC's view:
ago there was too much money available, so there was too much
competition to fund good ideas. Valuations for pre-IPO (initial
public offering) start-ups were too high. Start-ups could
get term sheets from several venture firms and select the
most favorable. Too many ideas were getting funded. With too
many rivals, markets might never develop. The current market
is much better. Valuations are reasonable and, with few rivals
in each sector, new markets will develop--as they might not
have with many rivals."
is nonsense. Look, for example, at hard disks and floppy disks.
In the hard-disk business, there have been as many as 41 rivals
fighting for market share. Only three major manufacturers
competed in floppy disks. The hard disk has improved much
faster technically; the floppy disk is stagnant by comparison.
I'm not talking about market size or market opportunity (the
hard-disk business versus the floppy-disk business); I'm talking
about rates of innovation.
don't say no.
VC is interested, you can expect a call and, eventually, a
check. If the VC is not interested, you won't get an answer.
Saying "no" encourages you to look elsewhere--that's not good
for the VC, who prefers to have you hanging around rather
than going elsewhere for funding. Fads change; the herd turns;
your proposal may look better next year. In addition, the
VC may want more due diligence from you--to add your ideas
to a different start-up's plan.
think you have few alternatives, they will string you along:
the deal, but it'll take time to bring the other partners
more time to get expert opinions."
definitely going to fund you, but we're closing a $500 million
fund, and that's taking all our time."
call you Monday."
your alternatives are gone, they negotiate their terms.
version of a pet is the "executive in residence." Many venture
firms keep a cache of start-up executives on staff at $10
000 to $20 000 per month (a princely sum to an engineer, but
just enough to keep people in these circles out of the soup
kitchens). Start-up executives, loitering for an opportunity,
may collect these fees from more than one venture
firm, since the position entails no more than casual advising.
These executives have "experience" in start-ups. When you
show your start-up to the VCs, they will grill you about the
"experience" of your executive team. It won't be good enough,
but not to worry, the VC supplies the necessary talent. You
get a CEO. The CEO replaces your friends with cronies.
pets are like Hollywood's superstars. Just like Julia Roberts
and Tom Cruise, the superstar CEOs command big bucks and big
percentages (of equity)--driving up the cost of the start-up--but
are "worth it" because they give investors and VCs a sense
idea, your work, their company.
CEO gets 10 percent of the company. VC-placed board members
get 1 percent each. Your entire technical team gets as much
as 15 percent. Venture firms get the rest. Subsequent funding
rounds lower ("dilute") the amount owned by the technical
team. Venture firms control the board seats. The VC on your
board sits on 11 other boards. Board members visit once a
month or once a quarter, listen to the start-up's executives,
make demands, offer suggestions, and collect personal stock
options greater than all of the company's engineers hold,
with the possible exceptions of the chief technology officer
and the vice president of engineering. The VC's executives
control the company. You and the rest of the engineers do
take advantage...to maximize the return for the venture fund's
investors. Engineers are getting short-changed.
I know got a good valuation a year ago. Over the year, it
grew rapidly, developed its product, met or exceeded its milestones,
and spent its money according to plan. When it was time to
get money again, the funding environment had changed. Last
year's main investor wouldn't "price" the shares or "lead"
the new funding round. The "price" declares the number of
shares and the valuation of the company. Think of the company
as a pie. It is a certain size (valuation) and it is cut into
a number of slices (shares). An investor "leads" by offering
a specific price for shares for a large percentage of the
next round. Other investors follow at the same price. Even
though the company's engineers had executed flawlessly, the
round came in at less than a third of last year's valuation.
part of closing this "down" round, the last year's investors
renegotiated the previous round, effectively saying, "Since
this round is lower, we must have overpaid in the last round.
We want more equity for the last investment." If there had
been fraud by the entrepreneurs instead of flawless execution,
renegotiating the previous round might have been reasonable.
Imagine the opposite scenario: "In light of market developments,
it's obvious that your idea is worth much more than we thought,
so we're returning half the equity we took for last year's
funding." It's so ridiculously improbable that you can't read
it without laughing out loud. That we accept the converse
highlights the entrepreneur's weak position.
know money and they don't care about the technology; the entrepreneurs
know technology and they need money. Money knowledge applies
across all the start-ups; the technical knowledge is unique
to each. The VCs don't care about any single technology because
they spread their investments across the opportunities. Knowing
money isn't the same as knowing value. A year ago, VCs were
lining up to give money to Internet dog-food companies; this
year, they wouldn't back an inventor with a working Star Trek
financial; it's not technical or personal. To the VC, the
engineer and the ideas are commodities. The venture firm squeezes
the technical team because it can. VCs believe that they are
exercising their responsibility to maximize return for themselves
and for the fund's investors.
the engineers' share of the pie is counterproductive, however:
they become demoralized; productivity suffers; eventually,
they leave. Engineers are not commodities. Replacing a chip
designer one year into a complex design delays the project
six months while the replacement engineer learns and then
redesigns the work-in-progress.
appreciate that the electronics revolution is built on the
backs and brains of engineers, not of executives. Moore's
law and engineering talent drive the electronics revolution.
Tremendous market pull for its products builds momentum. The
pull is so great that the revolution is indifferent to the
talents and decisions of its executives (legendary blundering
causes only ripples), but it depends on the talent and the
work of its engineers. The engineers are the creators of wealth;
the VCs are the beneficiaries.
building the future deserve a fair equity share in the value
they create; today they don't get one. For them to get their
share, wealthy engineers must fund start-ups. And they don't
have to be Bill Gates to do so. "Qualified investors" can
participate in pre-IPO funding. This means your net worth
(exclusive of your home) must be at least a million dollars
or you must meet minimum annual income requirements. These
days, the millionaire's club isn't all that exclusive. Many
engineers are qualified investors.
are a qualified investor, participate in start-ups as an "angel"
investor. An angel investor participates in early or "seed"
funding rounds. Don't do it with more money than you can afford
to lose, however, because it is risky. To change the situation
I'm describing, start-ups need your money and they need your
advice. More money and more start-ups bring faster progress
and create more wealth. Creating wealth isn't only about money;
it's about quality of life and it's about raising the standard
of living for everyone (but that's another essay).
should band together to form venture funds. Start-ups need
more angel funding and they need better-organized angel funding.
I'd like to see a dozen or so $100 million venture funds run
by nerds. These nerd-based venture firms would work at the
seed round and at the next funding round (called the A round).
They provide initial funding and advice and they, with the
benefit of professional financial advice, represent their
start-ups in future funding negotiations with traditional
a third suggestion. I'd like to see an engineer-run start-up
whose goal is to raise $100 million in a public offering.
The money becomes a fund for sponsoring start-ups. It's a
public venture firm and it sells shares to raise money. Investing
in start-ups wouldn't be exclusively for rich people; anyone
who could buy stock could be investing in start-ups. Ideally,
the public VC firm would be managed and run by nerds with
empathy for nerds in the start-ups.
to publicly thank more than a dozen people for help on this
essay, but they all said "NO!" None can afford to have the
VCs find out that they contributed.