It's 4:30 p.m., and the Christmas party at the Mayfield Fund is in full swing. But not everyone in the offices of this Sand Hill Road investment firm is sipping chardonnay and toasting another profitable year. Back in the wood-paneled conference room, a couple of venture capitalists are trying to keep a deal alive.
The mood is tense. For nearly three months, the two VCs -- Geoff Yang and Yogen Dalal -- have been haggling with the three entrepreneurs across the table, working on a deal that would launch the "Internet-in-a-box."
But first the entrepreneurs need $4 million.
Yang, MBA '85, and Dalal, MS '73, PhD '77, are seriously interested, but they won't make a deal until the three partners agree to give them about 40 percent of the company's equity.
The partners -- Jim Li, Gordon Ritter and Canh Le -- believe their little device will spawn a billion-dollar enterprise, a fabulous company the size of networking giant Cisco Systems. Why should they hand over almost half of their company?
So here they are. Everyone in the room knows that if they don't have a handshake by the end of this meeting, the deal is dead.
As the Christmas revelers down the hall refill their glasses, the trio's lawyer, Josh Pickus, nervously pulls his clients out of the conference room. He's been with them through every step of this deal, and he's worried they're on the verge of saying something that will detonate the talks.
"Guys, if you want to do this, then work within their confines," he tells them. "If not, then let's go."
Will Li, Ritter and Le walk? Pickus isn't sure.
Scenes like this play out every day in Silicon Valley, where last year startups raised $2.6 billion in 949 separate deals backed by venture capitalists. The Mayfield Fund has an elite address at the center of the action: 3000 Sand Hill Road. This stretch of Menlo Park asphalt is becoming as emblematic of 21st-century commerce as Wall Street was of 20th-century business. More than half the nation's 600 VC firms are in Silicon Valley. And Sand Hill Road, just east of Interstate 280, is their magnificent mile.
The financiers are drawn here by cutting-edge technology, much of it incubated just a mile away at Stanford. Professors and students working out of Margaret Jacks Hall, former site of the computer science department, hatched Valley giants Cisco, Silicon Graphics and Sun Microsystems (SUN, as in Stanford University Network). More recently, young graduates used venture capital to launch Internet darlings Yahoo! and Excite. Nowhere else will you find university-supported entrepreneurism so richly fed by nearby industry and capital.
The VC firms -- loaded with Stanford alums themselves -- have become arbiters of the technological future. From the genetically engineered cancer drug that may one day save your life to the Web site you visit to buy the latest best-seller, the venture capitalists decide which business ideas will survive.
This is the story of just one deal in the land of VCs. It starts two months before the Christmas party, in October 1995, when Li, Ritter and Le launch their search for backing from two of the Valley's most respected venture capitalists.
Just before 9 on this bright fall morning, Li and Ritter, overdressed and nervous, are searching for a place to park their Honda Accord among the gleaming BMWs and Mercedeses. The two men are hoping that this morning's meetings with two "gold standard" VCs will separate them from the hordes of would-be entrepreneurs. As Ritter parks, he repeats mantralike to himself, "Venture capitalists need smart entrepreneurs with great ideas like us as much as we need them." Li gently strokes the laptop in which his Powerpoint presentation resides.
They're anxious but confident. After all, both are veterans of a Wall Street investment bank. They're convinced that their years in finance have prepared them to go up against the VCs. At 9, they're due at Institutional Venture Partners (IVP) to meet with Geoff Yang, one of the season's hottest VCs. Yogen Dalal of the Mayfield Fund, just a few doors down Sand Hill Road, is scheduled for 11 a.m.
For the two sweaty-palm guys, this day -- October 24, 1995 -- could transform their lives. But for the VCs, the appointment is just one more pitch crammed into a 17-hour workday. Yang has been on the run since 7 a.m. Before the day is over he will hear pitches from two other cash-hungry entrepreneurs and interview a potential CEO for his newest investment -- a promising but still shaky Internet search engine start-up called Excite. Typical of hyperactive VCs, Yang, 38, is a blur. The schmoozing never stops. Even in his BMW 535, his telephone headset is a permanent body part.
He knows this Internet-in-a-box thing may be just one more half-baked idea. Then again, maybe it's another Cisco or Netscape. Separating the winners and losers is a standard part of the hunt on Sand Hill Road each day. In a valley addicted to high stakes, VCs are the daredevils who thrive on finding and betting on the long shots.
But their bets are highly calculated. After all, they're gambling with their own stash and with money from private endowments, pension funds, insurers and universities like Stanford. Traditionally cautious corporate America has been investing millions, lured by returns as high as 50 percent. While only about 7 percent of Stanford's $4.2 billion endowment is invested with VCs, it's the endowment's most lucrative investment, reaping an average annual return of 38 percent over the last five years.
Before backers will hand over these millions to start-ups desperate for cash, each deal must pass a three-stage test. VCs must: 1) believe in the product, market and entrepreneurs; 2) do the homework to determine if the product and team hold up under scrutiny; and 3) negotiate the deal.
At this moment, the Internet-in-a-box deal is at stage one.
Ritter and Li are making their pitch just three months after Netscape's initial public offering ignited the Internet start-up frenzy. "I'm looking at the massive growth of the Internet and trying to figure out how to get a piece of the Internet business," recalls Yang of his mindset on the morning of October 24. That's why he's agreed to meet with these two entrepreneurs.
The guys claim their invention, a toaster-sized gadget soon to be named the InterJet, has the potential to open the Internet to almost any small business. In these early web days, no one is really sure small businesses will even want to use the net. But the guys boast that their device, for the moment just a crude prototype, will tap into a growing small-business market that they estimate will soon be worth $200 million.
Ritter and Li have done their homework on the VCs. Both Yang and Dalal are Internet-hungry. They've made their names and wealth in computer networking, software and communications start-ups. "Yang is a strategist who knows where the next wave will come from," Ritter says. "He loves to ride that wave." Dalal is more the techie who will be lured by the product.
The mere fact that Ritter and Li have landed appointments with VC big fish is remarkable. They've made it through the first of many filters. By Yang's count, entrepreneurs e-mail, phone and fax him more than 1,000 ideas a year. He meets with about 300 entrepreneurs and only gives funding to three or four start-ups.
As usual, Yang is late, eating up 15 minutes of Ritter and Li's precious hour. They spend the time checking out Yang's office, eyeballing the collection of trophy-like mementos of initial public offerings for some of the Valley's hot companies, including MMC Networks and Applied Digital Access.
Yang gambled $1.5 million on MMC -- a stake that eventually would be worth about $80 million, a 53-fold return. On Sand Hill Road, unless your investment multiplies at least 10 times within about five years, it's considered subpar.
So how do you decide to place a $4 million bet on unknown entrepreneurs? Pretty much the way you'd size up a race horse. You do your research -- checking out history and pedigree -- and then you watch how they run the track.
Ritter and Li are on the track from the moment Yang rushes into his office. He spends more time sizing up the two men than he does studying their vague business plan. He's watching how they handle themselves, if they answer questions directly. "I'm looking for drive, determination and a basic skill set," he later says of the play-by-play he was doing in his head. "I'm looking for that sparkle in the guys' eyes that shows they've really thought about the idea and are really smart."
Ritter and Li are touting the virtues of their all-in-one box: Plug your small company's computer network in one end, then plug a telephone cord into the other end and your system is connected to your Internet service provider. Presto, you can web surf, get e-mail, even create web pages secure behind a fire wall. "He's talking about doing it all for $2,000 to $3,000," says Yang, who recently oversaw the installation of a similar system at IVP -- for $50,000. "I'm thinking, 'This is a great idea!' "
But their backgrounds worry him. "These guys weren't out of industrial or university labs. They were from Wall Street," he says. The staid world of investment banking is not where Yang expects to find Internet-hip entrepreneurs.
Ritter, Li and third partner Canh Le's entrepreneurial passion was sparked while working at First Boston in New York. Ritter helped create and market institutional securities, Le was a bond trader and Li was the techie who programmed financial software. In 1990, bitten by the Silicon Valley start-up virus, they quit their lucrative jobs and headed west to found Tribe Computer Works, which they bootstrapped with their own $100,000. Tribe built networking hardware for small businesses and the education market. Their Internet-in-a-box grew out of Tribe, and now they want to spin it off into a new company, Whistle Communications.
Yang is intrigued enough to promote the Whistle boys to stage two. As Li folds up his laptop, Yang promises to start "due diligence" on the viability of the product and the founders. He'll check out Tribe's performance, call their references and run the idea by potential customers like MCI. If the idea still looks good, Yang will be back in touch.
An hour later, just down Sand Hill Road, the pitch is replayed at Mayfield for Yogen Dalal. Pickus, the lawyer advising the Whistle founders, describes Dalal, 47, as a "vibes-oriented investor" who is hot for an Internet deal. He set up the meeting because he believes that Dalal will plug into the founders' "energy." (Pickus also laid the groundwork with Yang.) Pickus knows Dalal well. In the inbred world of Sand Hill Road, everything for the needy entrepreneur is at hand. Pickus's venture capital law practice, for instance, is just downstairs from Mayfield.
In fact, one of the smartest moves an ambitious entrepreneur can make is hiring a well-respected, connected VC attorney. In the saga of the Whistle deal, Pickus plays a dual role: One moment he's like fictional sports agent Jerry Maguire, cheerleading for his boys, and the next he's Henry Kissinger, keeping the deal alive with shuttle diplomacy.
Pickus's matchmaking is on target. Dalal immediately connects with Ritter and Li. Mayfield recruited Dalal in 1990 for his shrewd entrepreneurial instincts and engineering skill. At Stanford, his PhD in electrical engineering was supervised by Vinton Cerf, considered by many the father of the Internet. After a stint at Xerox's Palo Alto Research Center, he went on to found two Valley success stories, Claris Corp. and Metaphor Computer Systems.
As he schmoozes with the Whistle guys, Dalal's gut tells him that they have the energy to "walk through very heavy water to produce something." But it's not just his money at stake. His partners must be convinced.
A week after that first Mayfield meeting, several BMWs pull into Tribe's parking lot in a nondescript East Bay office complex. Out pop Dalal and five of his nine partners. They are conducting a field inspection, an honor Dalal bestows on only about 30 of the 150 or so deals he scrutinizes each year.
Tribe's grungy, no-frills operation is an immediate hit with the ever-thrifty partners. They grill the founders about the product and its still-unproven small business market. They even suggest a new look to head off possible confusion among potential buyers.
By mid-November, both Dalal and Yang have wrapped up most of their due diligence. Their conclusions are similar: The founders have reps as hardworking and innovative. The product is promising. But to have a real shot, the start-up will need more experienced managers.
That's when the incestuous world of venture capital really kicks in: Dalal picks up the phone and calls his rival Geoff Yang. "I understand you're looking at this deal," he says. "What are your concerns?" It turns out they both feel $4 million is way more than one VC should gamble on the hope that small businesses will flock to the Internet. But if they split the risk -- $2 million each -- well, that's much more palatable. They map out the terms: They'll offer $4 million in return for about a 40 percent stake in the company (20 percent for each VC). And the founders must agree to bring in a new CEO within six months to oversee them, with a block of stock set aside for the CEO. That means less stock for all the founders.
"There's definitely a mafia of certain firms," concedes Yang, who's comfortable with this everyday form of cooperation among the top VCs. "In any deal, you never know what can go wrong," he says. "We know what we can expect from each other."
On November 15, Yang phones Ritter with the joint-VC offer. Ritter, who is acting as the partners' lead negotiator, is stunned. He didn't count on two supposed competitors joining forces behind the scenes. He had hoped to play them off against each other. "There's not as much competition on Sand Hill Road as you think," Ritter observes bitterly. His options? Go with a second-tier VC, raise the money from "angels" -- private investors he knows back East -- or haggle with the VCs, knowing he has little ammunition.
By early December, the deal has reached stage three: negotiating. Things get a little ugly.
"We had some knock-down, drag-out times," recalls Ritter of the tense talks. The deal almost blows up several times between November 15 and December 15.
The Whistle partners have agreed to a new management team, but there is still a struggle over ownership. They can't see why Yang and Dalal should get such a large stake -- 40 percent -- of their sweat. But the protracted negotiations are even more about pride, control and trust.
Ritter is dismayed that the VCs are haggling over the company's worth. He insists his company's value should be pegged at around $20 million (which would make the VCs' $4 million investment worth only a total of 20 percent). But the VCs refuse to budge. Ritter's conclusion: "They're trying to screw us."
December 8: With the talks stalemated, Pickus urges the founders to whet the VCs' interest by doing a demo of Whistle's improved version of the InterJet and then "get down to negotiations."
The demos go well, but the money men are noncommittal since Ritter is still pushing his $20 million valuation. "We came pretty close to saying, 'Guys, may The Force be with you," Dalal says. 'Go do it on your own.' "
Instead, Dalal picks up the phone and calls Jim Li to try to jumpstart the talks. The way Li remembers it, Dalal suggested he consider parting ways with Le and Ritter, since Li is the technical visionary. "It struck me as an underhanded negotiating tactic," says Li, who immediately told Le and Ritter about the call. Ritter is livid, accusing Dalal in a subsequent call of trying to bust up the trio. Dalal insists his motives are pure and later points out that his tactic worked: "They came back to us as a unified front."
On December 21 -- the day of the Mayfield Christmas party -- Ritter, Li and Le stride into the Mayfield conference room for their showdown with the VCs. They are indeed unified -- in their conviction that they are swimming with sharks. This is why Pickus pulls his agitated clients into the hallway and gives them a sobering reality check: The deal is dead if they keep offering the VCs only a total of 20 percent of the company. "What I'm trying to do at this point is to prevent a nuclear war, because there clearly is an attraction," Pickus recalls.
They agree to return to the table. But instead of talking about valuation, they discuss their fears. Dalal recalls the conversation: " 'What's the problem? ' we asked, and they said, 'We don't trust you. Maybe you'll fire us and take back all the stock you've given us.' "
It's past 5 p.m. and the lights are going out at Mayfield as the staffers head home. In the conference room, Yang warns that he has to leave in a few minutes to catch a flight.
In a last-ditch attempt to clinch the deal, Dalal and Yang start proposing ways to protect the founders' equity. "Put yourself in our shoes," Yang and Dalal say. They pose this question to the Whistle partners: "How would you feel if one of you isn't performing and that person has a lot of stock and can just walk away?" As he watches the three founders, Dalal sees "a lightbulb go on."
Seizing the moment, the VCs suggest the founders invest some of their own money to raise their stake. It's the face-saver needed to make the deal work.
In those final minutes at Mayfield, the Whistle guys agree to give Yang and Dalal a 37 percent stake -- about 17 percent each, with a chunk set aside for the CEO and other senior managers. As Ritter walks out of Mayfield, he tells himself, "It cost us something. But we have a deal with two of the best VCs on the planet."
It's been two years, and Ritter now realizes that his original negotiating position was "unrealistic." But he still is somewhat bitter about the VCs' tactics. "They have it down to a system," he says. "They know what emotions to play on, how to play team members against each other."
In spite of his anger, Ritter admits that the VCs have proven their worth. Thanks to their connections, Whistle used a top Silicon Valley headhunter to recruit a seasoned executive team, including CEO John Hamm, the former vice president of Adaptec Inc., and Doug Brent, who was the V.P. of product development at Taligent Inc.
A year ago, Whistle started shipping the InterJet. The reviews have been good, but most small businesses have still never heard of the product. "I really believe there's a market. But how do I get to the customer?" Yang asks. They're trying a multi-prong attack -- working with Internet service providers, courting the contractors hired by businesses to install networking gear and running a clever ad campaign.
Yang and Dalal have hung with Whistle through three rounds of financing and still are waiting for a return on their investment. They're willing to give the InterJet another 18 months to catch on. There's no guarantee it will. The floor of the Valley is pockmarked with grandiose dreams that bombed. Over their careers, Yang and Dalal have lost all of the money they've invested in a company only twice. But even if they take a small profit, the deal is considered a loser. And if VCs lose once too often, they'll find themselves cut off from their firm's future investment funds.
It all comes down to something called "The Burn Rate."
Entrepreneurs like Ritter get a lesson in it while waiting in the IVP reception area. Hanging on the wall is a 4-foot blowup of a $1,000 bill, the edges charred and black. A printed card next to the blowup explains that the burn rate is the speed -- expressed in thousands of dollars -- at which the investor's capital is used up as a company heads toward profitability. "As such," the sign reads, "it becomes the critical barometer by which a 'start-up' company's progress is measured."
Here in the capital of venture capital, where the Burn Rate is king, Yang and Dalal are watching closely. If their millions start smoldering before Whistle sets the world on fire, it's time for the Sand Hill Road VCs to move on to the next great idea.
Tia O'Brien is a frequent contributor to Stanford.
