I decided last week that the next post in this series should be about Franklin “Pitch” Johnson, Jr. who has been a venture capitalist since 1962. It is a good follow up to my previous post on Georges Doriot and posts I have written on Arthur Rock and Don Valentine. These people and a few other innovators created the venture capital industry. Johnson is a founding partner of the venture capital firm Asset Management, which has made more than 250 investments during its more than 40 years of operation. The firm’s investments include Amgen, Applied Bio Systems, Applied Micro Circuits, Sierra Semiconductor, Tandem Computer, Teradyne and Verity. Johnson developed and taught a well-known course in entrepreneurship and venture capital at Stanford from 1979-1990.
- “This is a big argument between me and my good friend Don Valentine, a founding partner of Sequoia Capital. The first thing you look for in an entrepreneur is a sense of integrity, honesty, openness, and decency. Once you think you have found a decent person, the second thing is: Do they have a clear vision of the marketplace they want to serve? Don believes that you need decent people, but the marketplace comes first, because you can’t change that, but you can change the people.” One way to look at venture capital investing is as a three stool with three legs: people, markets and innovation. All three legs are required for success, but different venture capitalists put different emphasis on different legs of the stool at different times. This is especially true in the very early stages of a business. Johnson believes that the “people” leg of the stool is more critical than Valentine, who was famously involved in replacing the founders at Cisco. I prefer Johnson’s approach since replacing people in any business, including a startup, is not only unpleasant but often not successful. Johnson seeks teams composed of people who not only have desirable qualities like integrity, honesty, openness and decency but also a clear vision about an attractive market. Johnson’s preference to invest in firms that do not need a management change is more like the approach of Warren Buffett and Charlie Munger who won’t buy a business if it does not come with management with the necessary skills and integrity.
- [Don Valentine and I] both ask: Do they have a differentiated ability? Is their product workable? Do they have enough of a different idea that they will be free of certain kinds of competition? Will the business operate with good margins?” Both Johnson and Valentine agree that if a business performs the same activities as its competitors it won’t have significant barriers to entry. I am not aware of any successful venture capitalist who does not believe a moat is required to generate a sustainable profit. The key strategy questions that every business should ask related to moats include: (1) what will the businesses will do differently than its competitors? (2) what sustainable advantage can the business create versus competitors and (3) is that differentiation sustainable in the face of competition? These strategy questions are quite different than matters relating to what Professor Michael Porter “operational effectiveness.” Without a moat, competition among suppliers will inevitably cause increases in supply, which will cause price to drop to a point where there is no long term industry profit greater than the cost of capital. When Buffett says “microeconomics is business,” this is what he means. Too much supply is bad for profits. It is that simple.
- “You’re trying to find people with good ideas and the ability to make those ideas into companies. Lots of people think we’re investing in technologies. That is not really a correct statement. We’re backing people who can take technologies and serve markets, thereby serving people and building great companies.” “You concentrate on building a good company, which means getting the right people, having great products, marketing them well, having a good organization, and getting adequate financing in the thing to make it happen. And those are the immediate objectives, because if you don’t achieve those things, the rest of it doesn’t count.” As stated above, the three legs of the stool in venture capital are: people, markets and innovation. The process of taking innovation and turning it into value is the essence of a business model. Johnson has identified the key steps in that process and the objective, which is to build a scalable business that delivers unique sustainable customer value. Venture capitalist Mike Maples, Jr. describes a business model as “the way that a business converts innovation into economic value.” The innovations that underlie the business are absolutely necessary, but not sufficient. Johnson is saying that his early focus in evaluating a startup is more focused on making sure the right people and team are in place.
- “We look for zeal. We look for guys who give a damn—and women—that want to make things happen. You can be as bright technically, you can understand marketing, you can do all the intellectual part of it right. But if you don’t yourself feel it and stimulate in your employees this same winning team feeling, you’re much less likely to succeed.” “If you don’t feel excitement, you’d better find another business.” “Entrepreneurs, the men and women that start companies, are quite competitive. They’re athletic in that sense of the word. Some have been athletes, some haven’t, but they have that drive to succeed, this unwillingness to fail, that’s characteristic. The venture capitalists—the good ones—the best ones, share this enthusiasm, this zeal that they have. So they sense that you’re as zealous as they are to succeed.” The best entrepreneurs don’t quit when inevitable problems arise during the process of turning an idea into a successful business. These people are often referred to as missionaries. In other words, the ideal founders have a burning desire to create the business that is not just driven by money. The importance of perseverance is part of what Ben Horowitz writes about in The Hard Thing About Hard Things. Johnson is saying that entrepreneurs should look for the same missionary qualities in their investors and advisors.
- “Running out of cash gets your attention [as an entrepreneur]. The sight of the gallows clears your mind. [The mistake I often see entrepreneurs making is] running out of money. Often they plan to grow faster than reality will permit. They are too optimistic.” One of the risk levels that you have to think about is will you be able to get enough money together to make this thing succeed? Companies can get a great idea with great leadership. If they don’t have enough money they can’t develop their products.” You can be forgiven for a lot of things in business, except running out of cash. Many accounting problems can eventually be overcome as long as the business has access to cash, which is the oxygen of business. Even bankruptcy can sometimes be survived if the business has enough cash. How much cash to raise and how much cash to burn are questions that involve judgment in the face of risk, uncertainty and ignorance. There is no magic formula that can be used to answer cash management questions, but having enough cash for nine months of operations is a common standard. If you don’t have that much cash on hand it is a good rule of thumb to be working toward raising more funds. At only six months of cash remaining it should be a major priority. At three months of cash remaining, the CEO and the CFO should be thinking about raising more cash first and foremost.
- “[Entrepreneurs] treasure and love independence. They love their feeling of being self-reliant, or a group bring self-reliant. They know that if they work hard and are right, in the end they’ll make some good money, which is certainly a primary aim. But they also can live with uncertainty, they can live with risk—they can sleep. I know people that can’t be in little companies—it just makes them too nervous. And they’re not good or bad people, they’re just people. So you have to be able to sleep when you have no idea what’s going to happen to you. Venture capitalists all learn how to sleep when things are going to hell.” “We knew that if you’re going to attract good people, whether they’re scientists or down the line, you want to have a plan so that everybody feels like an owner, and that if you had an option and the company succeeded greatly, then people were incentivized by that.” Johnson is describing a few of the qualities that a venture capitalist looks for in a founder.Getting the balance right so the startup has the best opportunity is not simple. Making everyone involved feel like an owner of the business is central to success. It takes a special person to be an entrepreneur and is not something everyone is suited for. For example, as Daniel Kahneman has written, “For most people, the fear of losing $100 is more intense than the hope of gaining $150. [Tversky and I] concluded from many such observations that ‘losses loom larger than gains’ and that people are loss averse.” Kahneman also points out:
“It is costly to be risk averse for gains and risk seeking for losses.” “Many unfortunate human situations unfold [. . .] where people who face bad options take desperate gambles, accepting a high probability of making things worse in exchange for a small hope of avoiding a large loss. The thought of accepting the large sure loss is too painful, and the hope of complete relief is too enticing, to make the sensible decision that it is time to cut one’s losses.” “When action is needed, optimism, even of the mildly delusional variety, may be a good thing.” “The optimistic risk taking of entrepreneurs surely contributes to the economic dynamism of a capitalistic society, even if most risk takers end up disappointed.”
- “There are three ways in which venture capitalists [are involved with a business.] “I always think of it as capital, consulting, and commitment.” “The first one, they provide money to give the company some capital to operate with. [The second], they provide advice and help, and on a frequent basis, weekly in young companies very often, certainly not less than monthly. The balance is between advising the management and trying to run the company yourself. “If you get the management too dependent on you, or you’re too assertive and they get too resistant, you’ve got to get this balance of discussion of keeping things open so that people will ask you stuff sometimes. But the worst thing you want to hear is have a guy come to a board meeting and he says, ‘I have three courses of action. Which one does the board want to take.’ That’s really bad news when a guy does that. What you want a guy or woman to come in and say is ‘Here’s where I want to go.” If you don’t like it then you can argue about that, but you don’t want them dependent on you for operating decisions.” Johnson believes that capital is only one element that an venture capitalist should provide. Venture capital is fundamentally a service business. Success in the venture business requires hustle, wisdom, judgment and hard work. If all a founder needs is capital then they are quite lucky indeed. Johnson is also saying that board’s primary role should be as advisors to management, not running the business. Someone like Johnson has seen many different boards and knows how important a good board is in terms of increasing the probability of success.
- “This is true of any venture: you don’t think about losing money, you think about what an investment can do, especially startup venture capital in some strange area. So you use your hunches, you use what you read, you use your sense of the practicality of the science, where the science is workable. You bring all that together on kind of a judgment call. I was trying to tell my class when I taught it—you can’t calculate all this. You should run the numbers— you have to run the numbers, but in the end you’ve got to have a sense of balance of the likelihood of success and what you need to do yourself to make things succeed. And the venture capitalist can play a substantial role in success by selecting the right people, encouraging them, getting them incentivized, and then helping the companies devise strategy. That’s an important venture capital function.” Venture capital is all about judgment. The way to get better judgment is to pay attention to your mistakes and the mistakes of others (and conversely the successes). Good judgment comes from experience, which often comes from bad judgment. A venture capitalist never has all the data and an investing decision simply can’t be made based on a formula. A really smart venture capitalist said to me once that success in the “picking” part of venture capital mostly about pattern recognition. The more businesses you see in your career, the better you can get at spotting the patterns that can lead to success.
- “[Georges Doriot, my Harvard Business School professor] said: ‘Remember there’s a great tape recorder going all the time,’ which is fairly true. So what he was saying is, ‘Behave yourself, because if you’re going to cut corners, you can’t.’” “When we were first starting our firm, a lawyer, Ed Huddleson, said to Bill [Draper]and me: ‘We can write all the investment agreements you want but if you have to bring them out of the drawer, something has gone wrong. Invest in people you can believe in, and you will never need to take the papers out of the drawer.'” One simple approach that can help guide personal and company behavior is to imagine that everything you do in life will appear on the cover of The New York Times. Would you be proud of what you have done? In interviews Johnson talks about how the venture capital industry he wants to work in is a place where handshakes matter and where people are good for their word. Of course, it can take years to build a reputation and just minutes to destroy it. Someone who takes any pride in how much time they spend in court litigating with other people and businesses is an idiot.
- “The whole portfolio isn’t so risky, but any one deal is risky.” “George Quist said it best—a friend of mine who was a founder of Hambrecht and Quist. He said that venture capitalists sleep like babies—they sleep for an hour and they cry for an hour! But I sleep fine. I’ve had nights when I’ve been happier than other nights, when I was worried about something, but I really have been able to get off to sleep and get a night’s sleep almost always.” “We all have had a series of things we could have done differently, but it’s a batting average, you know? And my batting average is good. I’m not the greatest slugger in the business, but I’ve got a good solid batting average for a long time. But involvement would be the cornerstone of what I believe venture capital is. Involvement and help to the companies.” When Johnson says “the whole portfolio isn’t so risky” this is what he means: In an essay in which he discusses the nature of risk, Warren Buffett advises: “If significant risk exists in a single transaction, overall risk should be reduced by making that purchase one of many mutually-independent commitments. Thus, you may consciously purchase a risky investment – one that indeed has a significant possibility of causing loss or injury – if you believe that your gain, weighted for probabilities, considerably exceeds your loss, comparably weighted, and if you can commit to a number of similar, but unrelated opportunities. Most venture capitalists employ this strategy. Should you choose to pursue this course, you should adopt the outlook of the casino that owns a roulette wheel, which will want to see lots of action because it is favored by probabilities, but will refuse to accept a single, huge bet.” Founders by contrast have made a single huge bet. Chris Dixon has been both a founder and a venture capitalist so he has empathy for both venture capitalists and founders on this set of issues. He says: “VCs have a portfolio, and they want to have big wins. They’d rather have a few more lottery tickets.. while for the entrepreneurs, it’s their whole life, and let’s say you raised five million bucks, and you have a fifty million dollar offer, and the entrepreneurs are like, ‘Look, I make whatever millions of dollars. I’ll be able to start another company.’ And the VCs are like, ‘Wait! We invested billions of dollars.’ That is usually where tension comes.”
- “People forget San Francisco and Silicon Valley have their roots in pioneering. Failure is not unthinkable here. You can try again. In some places in Europe, however, it is a disgrace to fail and you have to retreat from business life.” “I think the most important single reason is the presence of two, now three, great research universities in the area—Stanford, Cal, and UCSF. But also, the presence of other important educational institutions that provide a great flow of engineers and people that aren’t scientists, although two produce engineers.” You simply can’t have a business like venture capital which is based on buying mispriced optionality and not have lots of failure. The failures are the price you pay to discover payoffs from optionality. Mistakes are inevitable. If there is a culture in a company, city or region that penalizes failure, there will not be successful venture capital industry or startups. Johnson is also saying that in order to create a successful innovative climate any region also needs a critical mass of supporting services and resources. That means, most importantly, at least one major research university. I discussed that in more detail in my post this week on economic development.
- “My class [at Harvard Business School] was ’52. I don’t remember people talking about venture capital at all when I was in school. The term didn’t come up. I learned later that the term had been invented by Elton Mayo [a professor of Industrial Management at Harvard], in the early forties, middle forties.” “There were very few venture firms when Bill [Draper] and I got started in ’62. We had an informal group that met monthly for dinner. There were twelve of us and it was called the Western Association of Small Business Investment Companies, which itself was the forerunner of the Western Association of Venture Capitalists.” “The idea of angels—I’d never even heard of angels ‘til about twenty years ago [the late 1980s]. And that’s recent times.” “The word [angels] wasn’t used. Because we were all small, we were doing brand new startups a lot of the time, but not always. We did startups and we did deals that were already underway. The idea of angels only took place much later, when individuals were backing companies to get them going. Probably not fair, but I always think of angels as putting money in and seeing what happens.” Pitch Johnson was in a good position to know who invented the term “venture capital.” It could be that Mayo was the originator. Some history buffs trace the term to Schumpeter who wrote an article in 1943 in which he uses the term “venture capital.” Another account http://www.startup-book.com/2012/03/31/prophet-of-innovation-joseph-schumpeter-and-creative-destruction/ makes a case that Schumpeter did not invent the term and that its origins are obscure. In any event, I agree with Johnson that the word “Angel” should be reserved for use in describing amateur early stage investors. Professional seed stage venture capital investors belong in another category.
Bio publications and papers http://www.gsb.stanford.edu/faculty-research/faculty/franklin-pitch-johnson
National Venture Capital Association Venture Capital Oral History Project http://digitalassets.lib.berkeley.edu/roho/ucb/text/dennis_johnson_donated.pdf
IESE Interview https://www.youtube.com/watch?v=o6oLLj1Zz2k
TiEcon interview https://www.youtube.com/watch?v=9VmeF9LeqSU