Many Are Called But Few Are Believed

Many Are Called But Few Are Believed

Experienced Venture Capitalists trust nothing and nobody

Place a sales manager, chief financial officer, or company president in a conference room, and within 30 minutes, one of them will say to potential investors, "These are conservative projections." The clichÈ always accompanies a colorful slide showing columns marching up the steps to fiscal paradise. Some time ago, after an entrepreneur led us through another one of these artfully choreographed presentations, one of my partners at Sequoia Capital, Don Valentine, said, "We'll finance the first CEO who tells us his projections are wildly optimistic."

Pardon the brutal cynicism, but an experienced investor trusts nothing and nobody at first glance. Think about all the fast-growing public companies that have enjoyed their moment in the sun only to fall from grace into a sump of incriminating litigation. Almost all these companies had the patina of veracity. They shipped products, reported growing revenues and profits, were audited by the best accounting firms, had the most expensive legal counsel that money could buy, listed Fortune 500 companies among their customers, had reputable private-market investors, were floated on the public markets by high-caliber investment banks, and were operated by executives who had personal histories that appeared credible. These are all the characteristics of such headline cases as MiniScribe, Kurzweil, Informix, MediaVision, and Cendant. It's only later, after you read about the falsifications of inventory, the wrongful recognition of revenue, or an executive pleading guilty to cooking the books, that you stop and think that there is a place for litigators like Bill Lerach.

And yet, a public-market investor has it a lot easier than those of us investing in private companies. When people like us invest in a company, nothing about it is real. A thicket of claims, predictions, and projections always surrounds a new investment and makes the kernel of truth almost impossible to discern. The company might not even have a legal incarnation; it probably does not have an office or a product; the principals will not have business cards. The company amounts to little more than a figment of someone's imagination. When we summon up the conviction to invest, we do so based on our belief of what someday might come true. If a pattern of future success were glaringly obvious, it would be too late to make a great venture capital investment.

Self-serving financial forecasts are perhaps the least meaningful indicator that venture capitalists use to make investment decisions. But they serve to highlight the essence of our business: How do you winnow out fantasy from reality, deception from truth? So much hot air rises from small companies in Silicon Valley that it must be a major contributor to global warming. A founder is barely considered the real article unless he is called a visionary. A CEO is not authentic unless he is dubbed world-class. A company no longer seeks to conquer a market, it has to take over the planet.

Part of the reason we are skeptical about any claim or promise is because of the disappointments we have endured. (We sometimes mordantly tell people that the only projection that ever comes true or will be exceeded is operating expenses.) But our skepticism helps prepare us for what needs to happen after we make an investment. If we do our work properly before investing, we will rarely be confronted by a surprise later on. So a startup can always expect to be barraged by us with a battery of questions and doubts that are really designed to arm us for the future.

We question whether market projections make any sense. We are dubious about whether any product can be developed on schedule and for the cost promised. If a company is shipping a product, we will talk to customers to gauge their satisfaction. We try to ferret out the real agenda of company founders. We doubt the claims and rÈsumÈs of job seekers. We can be certain that the power of competitors is underestimated. We wonder whether a letter of intent is worth more than the deadweight of its boilerplate. We've seen contracts broken, and price lists and rate cards whose numbers are just decorative. We doubt the technologist who claims to have bulletproof patent protection. We assume that, whatever its projections, to reach profitability a company will need to raise four times as much money as it projects. Why are we so distrustful? Probably because the venture capital business amounts to the occasional triumph of hope over a large collection of disappointments and setbacks.

Look at some of the market opportunities that have been predicted and have either failed to materialize or, more frequently, only developed years after they were supposed to do so. Computers with handwriting recognition. Network computers. Interactive broadband. Multiplayer games. Artificial intelligence. Object-oriented databases. The paperless office. Gallium arsenide-based semiconductors. All these products were forecast by some of the smartest people in the electronics industry for 10 to 20 years before they ever saw the light of day. (Some never have.)

We operate in a world where only one out of 10 predicted markets ever comes to fruition. Should we doubt the veracity of smart people who appear to believe what they are saying? Should we consider them liars when their high-octane pitches turn out to have the propulsion power of toothpaste? We often embark on a wild-goose chase to investigate whether a proposed product will attract customers. The prospective customers will almost always tell us that if the product were available today, they would order it in large quantities. The confusing aspect of this quest is that demand for a hypothetical product is usually infinite! It's only after the product is introduced and customers are asked to sign a purchase order, dispatch a wire transfer, or write a check that the real answer is known.

Although markets are difficult to predict, they are far easier to measure than people. We are rarely wildly off in our assessment of a market. Nor are we prone to being duped by the predictions of a product schedule. But we can always be fooled by individuals. We've been deceived by sugarcoated references intended to cover up the shortcomings of people who have played key roles at public companies. We've encountered our share of people who have had a fondness for the bottle or illegal substances, a lust for too many creatures of the opposite (or same) sex, or a corrosive distrust of anyone over (or under) the age of 30. We know programmers who have buried expletives and allusions to graphic sexual acts in their code. We've encountered CEOs who have put their relatives and friends on the payroll. Then there are the rogues whose only purpose in life seems to be to justify the existence of plaintiffs' lawyers.

Does this mean that investors would be wise to avoid taking the plunge at all? Does it mean we believe the world is full of nothing but congenital miscreants? No. You should interpret this quest for the truth as a journey designed to avoid ugly and costly surprises. For the venture capital business revolves around developing enough faith to support the impossible goals of improbable characters. We do this whenever we make a new investment. The most rewarding aspect of our business is to be partners with the people who are what they appear to be, mean what they say, and will do what they promise. In recent years we've been fortunate enough to do this with individuals such as Gaurav Garg, the founder of Redback Networks, Simon Cao, a cofounder of Avanex, Michael Marks, CEO of Flextronics, Larry Page and Sergey Brin, founders of Google, and David Filo and Jerry Yang, the cofounders of Yahoo. It is people like these who allow us to defeat the odds and participate in a company that does become great, where the good guys do finish first, and where appearance and reality collide.

Venture capitalist Michael Moritz is a partner at Sequoia Capital in Menlo Park, California. Sequoia Capital has provided the startup financing and helped organize companies that now account for roughly 20% of the value of the Nasdaq stock exchange. Before joining Sequoia in 1986, he was an award-winning correspondent for Time magazine. Moritz's interview, "The Curse of the Unexpected," appeared in Forbes ASAP's Big Issue II.