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John V. Balen
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Today
I ask John Balen, General Partner with Canaan, to share his
perspectives and thoughts on venture investing and
entrepreneurship. John has been involved with venture
capital for more than 18 years. I'm delighted to be able to
bring to you, in this issue, some of his tremendous
experience in the field.
As you may know,
Canaan Partners is one of the premier venture capital
firms in the country, with $2B in investment capital under
management and a strong focus on early stage investing. I
started working with Canaan over twelve years ago, and while
they have certainly grown significantly, I think that the
firm’s approachability and strong spirit have remained
unchanged. I look forward to the next twelve years.
Anthony: John, can you give
us an overview of Canaan's investment focus, size of funds
under management, and number of portfolio companies?
John: Our current fund, Canaan
Equity III, is a $700M fund that was started in 2001. We’re
getting into the second half of that fund’s 4 year
investment cycle and have invested in 34 companies so far.
The focus of our fund is roughly 70%-80% in information
technology and 20%-30% in healthcare. Those percentages vary
depending on the period. We concentrate on early stage
opportunities – Seed, Series A and Series B. But we like to
balance the mix with later stage opportunities in areas
where we haven’t made some bets in earlier stage companies
for whatever reason (market too crowded or idea too early).
This enables us to have a diversified and well-balanced
portfolio. We are actively involved in and sit on the board
of all our portfolio companies.
Anthony: How many companies
did Canaan invest in since January 2004, and how would you
characterize your investing pace?
John: We’ve invested in 11
companies to date. We try to be as discerning as we can
about our pace as we invest the fund over a 4-year cycle. In
our business, you do some deals in some quarters, and none
in others. It goes in fits and starts, but over the
investment cycle time frame, it averages out quite well.
We even made investments in 2001 when the funding
environment was really tight. Because we have a healthcare
focus, we had several deals in that area. We also funded a
number of IT deals in those times when money was extremely
scarce. These deals involved some very good entrepreneurs
who were starting out their next venture and who understood
the long-term nature of this process. As a result, we
achieved good diversification of the fund over time, which
we think is essential.
Anthony: Why has Canaan
remained very active in early stage investing after the
bubble burst when many other VCs have shied away from this
segment?
John: We thought it was
important to be on the ground floor of new opportunities
when early stage companies got started. Frankly, our deal
flow was showing us a number of really good companies. As
people pulled back during the downturn, in reaction to the
marketplace, we found good entrepreneurs undaunted by the
prevailing macro effects. They discussed their idea first
with a selective group of strong VC firms. The objective of
those entrepreneurs was to 1) get a validation of their
idea, and 2) determine whether these venture firms would
fund them from start to finish as they built their
syndicate. Because we’ve been around for so long and our
network is so vast, we had the opportunity to work with
entrepreneurs who had built companies in the past, who had
very strong industry knowledge and who wanted to build
towards that next thing. So innovation never stops,
regardless of the economic climate. In fact, people talk
about how the best companies are built in some of the
toughest times. That’s because tough times tend to bring out
those types of entrepreneurs.
Anthony: What are your main
sources of deal flow?
John: Our deal flow originates
primarily from our relationships and our network. Our
investment professionals continually work all the
relationships we have from the portfolio companies we’ve
built through the years. Canaan has been around as an
independent firm since 1987. We started before that in the
early 80’s as part of GE. With that comes a wide network of
relationships. We also build new ones working with different
networks from universities, foundations, and entrepreneurial
syndicates. Existing contacts as well as new ones have all
proven to be good sources of deal flow.
Anthony: Would you consider
investing in companies founded by first time entrepreneurs?
If so, how should they approach you?
John: We certainly would. The
important ingredients in a company are a great market
opportunity, a differentiating technology, and obviously
good people to execute the plan. For first time
entrepreneurs, it is imperative they surround themselves
with good people, including venture partners, to help them
build their company. So we generally look at the members of
the team, and see who else we can surround them with so they
can succeed.
As to how they should approach us, we tell people that
cold calling or just sending an unsolicited business plan
won’t get you noticed by our firm. The best way to connect
with any venture firm is by referral. Entrepreneurs should
network with someone who has relationships with venture
firms. The person who has helped them flesh out their ideas
may feel comfortable enough referring them to a venture
firm. So it’s almost a first stage litmus test for that
entrepreneur. We receive thousands of business plans. You
naturally pay attention to those that are referred by
someone you know.
Anthony: How important a
role are angels currently playing in supporting the growth
of seed and early stage ventures?
John: I think angels have
always been around this area. They became more vibrant
during the boom, when money was plentiful and the excitement
of entrepreneurship was in a euphoric state. Today, they
have pulled in their reins somewhat because they are more
cognizant of the risk side of venture investing. This
situation is not unlike what it was prior to the boom.
Nonetheless, there is still some capital available from
angels. If an entrepreneurial team has some prior experience
with start-ups, they’ll either find financing themselves, or
they’ll find a small group of people to get the company
going. This is where some of the angel investing takes
place. However, we’ve also found that some good start-ups
will go directly to a venture firm. There are a number of
venture firms, like us, that will invest in a start-up from
the seed stage if they know the team. A lot of press gets
written about how money is tight now and how venture firms
will never do seed investing. Actually they always have.
People just haven’t always noticed it. The seed deals that
have been done by venture firms happen to be those where the
team has been pulled together quite well. Many venture firms
have Executives in Residence (EIR) programs, which help
develop seed opportunities.
Anthony: What's hot and
what's not in VC investing today?
John: Security has a lot of
buzz. Our viewpoint is to be very judicious. This can be a
very lucrative space, but can also be very difficult for the
customer to adopt because of its complexity. The Mobile
space has had some false starts, but there are more
investors interested in it as communications capabilities
become available. Other hot areas are Linux/open source,
analytics and grid computing.
The communication space has gone through a big downturn.
We’re starting to see some activity in the wireless space
and some infrastructure applications that investors are
funding. WiMAX is one example. However, this is all
happening with a great deal of caution.
Nanotechnology has enjoyed a fair amount of buzz too. Our
viewpoint is that nanotechnology is an enabling technology.
It will evidence itself through a number of different
products or systems that could end up in the medical and
information technology spaces. This is somewhat similar to
the laser, which was an enabling technology. There wasn’t a
single laser company per se, but there were companies that
used that technology to build a variety of medical,
communication and information technology products.
Nanotechnology will appear in many different areas, but what
we’re looking for is its manifestation in a particular
product or service that has a competitive advantage over its
peers.
There are many opportunities in the medical space as the
big pharmaceutical companies experience difficulty
developing new products. Medical devices are also rich with
opportunities on a selective basis.
What’s not in vogue: Storage was a big area for a while.
Right now it seems to have been overdone, which is causing
some pullback. Also, the large enterprise software
applications space is extremely difficult right now.
Investors are starting to pay closer attention to more
efficient application sets. With the advent of companies
like Salesforce.com going public, people are waking up to
the next generation of ASPs that were built from the ground
up.
Anthony: What criteria do
you use to tell a winner from a loser during the
pre-investment screening process?
John: That’s a million dollar
question. I wish I knew the exact answer. Frankly, every
opportunity we consider has a different DNA. We typically
look at the market opportunity, the technology you need to
bring to bear to take advantage of it, the people involved
to capitalize on it, and the amount of capital necessary to
penetrate the market. When entrepreneurs pass the litmus
test on all those categories, they have a venture that is
fundable. There’s never any one criteria. It’s easier to
point to deals we didn’t invest in. Often, the market is not
ready to be exploited, the technology is not as discernable
as the entrepreneur would like to believe, or investors
don’t have confidence that the team can carry the company
far enough to be successful. The market issue is certainly a
key one.
Anthony: How do you use the
financial plan in your assessment of an investment
candidate?
John: There are different ways
of looking at the financial plans of companies depending on
their stage of development. In very early stage start-ups,
we use the financial plan to get a sense of the cost of
reaching certain milestones. How cognizant is the
entrepreneur and his/her team of the milestones necessary to
drive success so you can secure more capital? As the company
matures, the financial plan is used to assess capital
efficiency: is the company adding the right headcount at the
right time or is it overspending? In today’s game, since
money is no longer as plentiful as it used to be,
entrepreneurs have to sharpen their pencils and use capital
efficiently. We tell entrepreneurs that it’s always best to
get good financial planning up-front. If you can afford it,
bring in people who know how to do it, so you start with the
right system early on. Experienced entrepreneurs tend to be
better at it. Those with less experience need more help.
Anthony: Can you describe
your valuation methodology?
John: At Canaan, we are
interested in companies that will first and foremost be
strong as independent companies, have a breakout value at a
public offering, and have legs beyond the IPO. If they get
acquired along the way, that’s fine so long as the valuation
is strong. But we avoid “feature” companies, which are
typically acquisition candidates and have compressed
valuations, except for some rare cases.
In today’s market, discounting outliers like Google with
high numbers, the norm for pre-money valuation at IPO is in
the $100M-$150M range, depending on the space. Using that as
a baseline, we work our model by analyzing:
- How big an opportunity can the company have?
- What kind of revenue stream will it create in 3 to 5
years if it’s an early stage company?
- Will the space remain attractive in the marketplace?
- What could the company be valued at in the public
markets?
- How much total capital will it take to fund the
company through financial independence?
- Will the company be able to achieve adequate
performance to attract subsequent financing rounds?
- How does the company compare with its peers?
The important thing is not to let valuations get ahead of
the company’s progress. It’s a very painful process working
backwards to reset your capital structure. Try to be as
pragmatic as you can in valuing a company so that growth and
achievement can be rewarded but not at the expense of
hurting the company’s progress as it moves forward. Keep in
mind that expectations about valuation can change in the
public markets as well as in the private markets at any
point in time.
I should bring up a couple of other points that impact
valuation. Historically, when you considered the slew of
companies that were funded by venture firms, out of ten
companies, 1 or 2 generated 10X+ return, another 3 to 5
returned some multiple on your money, and the remainder
returned your money or lost capital. During the boom time,
that whole risk curve shifted in favor of a larger
percentage of companies producing higher returns. However,
we are now back to those types of metrics, which are taken
into account in the valuation exercise. Also, round to round
markups of 3X and 4X were customary during the boom. Now 2X
markups are great, which is more consistent with the
pre-boom era. Finally, we like to have at least 15%
ownership in our portfolio companies. We’re averaging
somewhere close to 18% to 20%, with some deals reaching 30%
to over 50%.
Anthony: How long do you
typically keep a company in your portfolio? And what is your
preferred exit strategy?
John: Typically, a start-up
company needs 4 to 6 years to reach fruition. It all depends
on what stage you invest in. At Canaan, we’re not momentum
investors. We aim to invest in companies that build value
over time. When you invest in a later stage company, you
obviously try to shorten the time to liquidity, but then
you’re paying a higher valuation. So it’s a balancing act.
Anthony: Do you have any pet
peeves when it comes to start-up entrepreneurs?
John: Entrepreneurs who do not
do their homework. Even to this day, we sometimes find
serial entrepreneurs who forget to do the hard work of
analyzing the market and checking out the competition. You
must ask yourself all the hard questions, so you’ll be
prepared for the difficult questions the venture
capitalists, and for that matter, your customers, will ask
you. That’s the litmus test that all companies must face:
will the customer buy the product and embrace it? While you
may never have all the answers, you need to be prepared for
the marathon so you’re not caught in midstream.
Also, entrepreneurs who are not realistic about
expectations. You need to be realistic without being too
conservative, as conservatism stifles innovation. Also have
strong communications skills and give people feedback.
Finally, we are turned off by entrepreneurs who play
different firms against each other. Competition is great,
but deception is not. We are experienced enough to detect
those signs even when people try to cover them up. We will
not play those games. I find the way people act during the
time of funding says a lot about how they will act later.
This is like a marriage, and the interactions we have in the
course of the funding transaction are very telling signs of
the way people will react when you’re working with them on a
difficult situation within the board, or during some
transition in the company. We like for everyone to be as
honest and as straightforward as possible.
Anthony: Do you have any
thoughts on bootstrapping?
John: Do your homework before
you start turning the lights on in a place, or hiring some
people, because all of a sudden, that will start the drain
of capital. The best way to bootstrap is to first do your
homework while employed. Do as much work you can at night
with your potential team before you step off. At some point
you will have to make the move. If you don’t have your own
capital, talk to one of us. There are always people we know
who might be able to help. If your idea is better fleshed
out than you think, you may be able to get funding.
Anthony: What advice would
you give today's entrepreneurs?
John: My advice has been
partly conveyed in the question about pet peeves. In
essence, do your homework and manage your expectations. In
addition, you should surround yourself with good people and
hire talent that is smarter than you. The good thing about
being in Silicon Valley is that there is a broad network of
experienced professionals who still like the business and
are willing to help out at different levels, and you can
capture that.
Avoid taking too much money too early. Too much money can
create bad habits and is expensive at an early stage. And
pick venture firms whose investment cycle coincides with
your funding plan horizon, so they have funds available for
your subsequent financings. You don’t want to be their last
deal. Look for those who’ll provide staying power.
Finally, don’t embark on this road unless you are willing
to walk down a 3 to 6 year path. And it won’t be over then,
since the IPO is not the end of the journey. It’s just a
financing event from which you hope to build a very
successful company. So you have to really love the vision of
what the company is going to achieve. Think long term. Good
counsel is available and willing to help, and capital is
available. The key is getting people who are willing to dig
in and do the hard work to create value.
Bio
John Balen joined Canaan Partners in 1995, and serves as
General Partner in the firm's Menlo Park, California office.
He is primarily focused on investments in information
technology companies.
Prior to joining Canaan, John served as a Managing
Director of Horsley Bridge Partners, a multi-billion dollar
private equity investment firm headquartered in San
Francisco, California. During his nine-year tenure at
Horsley Bridge Partners, he was responsible for a wide
spectrum of investments in high technology companies,
venture capital partnerships and buyout partnerships.
Earlier in his career, he was a sales applications engineer
at Codenoll Technology Corporation, a fiber communications
start-up, and an engineer at Digital Equipment Corporation.
John received a BS in electrical engineering and an MBA from
Cornell University. He currently serves on the boards of
Command Audio, Commerce One, Dexterra, Echopass, Everdream,
ID Analytics, Istante Software, and Silicon Optix. He
previously served on the boards of Rightpoint, which was
acquired by E.piphany, and Intraware.
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