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Marcy Swenson
Executive Coach
at
Startup Happiness
22:00

How the physics of funding and business affects your job as an engineering manager.

About 20 years ago. At that time I was the VP of engineering at critical path. It was one of the darlings of the.com boom. And I had a team of about 40 engineers working for me. And in the course of a couple months, I was given two mysterious. The first project was to integrate our service, which was a hosted email service with AOL.

And it just seemed like utter nonsense. We were actually integrating with a subsidiary of AOL, so it was like a lot of late nights talking to a foreign team for an integration that just really didn't make any sense to me. And I kept asking the business development team like, well, what is this actually going to get us, like, why are we doing this crazy integration?

Like, we're not going to use all the features. They're not going to have a great login. And I was super focused on the customer experience and why this was going to be great for these customers in our company. And I didn't come to know till quite a bit later that the goal of integrating. Was to get AOL on our slides for the next funding round.

So that VCs would be impressed and go, whoa, you have AOL as a customer. Yeah. And so that was one mystery. The second mystery was I had to do a similarly mysterious integration with. You know, E-Trade is a trading platform. Like why would you need email with your trading platform? That is ridiculous.

Until I found out that E-Trade was one of the strategic investors in our next round of funding. So had I known those things, they would have been incredibly valuable. And what I recognized from my recent experience actually doing some investing is that the mechanics of how venture capital investing works are somewhat mysterious.

Various seldom revealed by the leadership at accompany, or at least not fully revealed. But incredibly impactful in the things that you're asked to do as an engineering leader. And so the impact of VC will trickle down to some of the projects you'll be asked to do. If you work at a venture backed startup.

And that's something that I totally didn't understand. The first chunk of my career was being a VPE at several different companies and a co-founder for 18 years. The next part of my career, which I'm still doing today is as an executive coach. So for the last 13 years, I've worked with founders from these companies and many more working on leadership effectiveness, and I've got this incredible window into what CEOs are worried.

And then I started learning even more about this earlier this year. When I started a tiny seed stage investment fund with two friends. And so these three different experiences have kind of colored my understanding of how VC impacts engineering. And this is knowledge that I wanted to pass along in a way that would really help you because it's not really spoken about.

It actually feels now, like there's kind of two layers of things going on at a venture backed startup. The first layer is, you know, the obvious, like building of a product and a service and selling it to customers and trying to amass users. But the second thing that's going on behind the scenes is your CEO is trying to raise money the whole time.

And your CEO is going to get money in little chunks. Right? First they're going to get our friends and family round. They use that to build something initial and they go on and raise more and more rounds of funding. They're generally not talking about it or they're at least they're not talking about the details of it.

And so it's something that will impact you all the time as an engineer. But you might not hear about it. So here's what we're going to talk about. I'll give you some understanding of venture capital and how it works and kind of what the levers are that drive a lot of decisions. And then we'll talk about two specific questions that I'd like you to think about for your particular company, if it's venture backed.

And then we'll end with let's see you covered some of this So VCs are actually entrepreneurs as well. They are raising fund and getting other people to invest in their company and then figuring out how they'll invest in companies to make money. And there's a very specific business model that they use that I didn't really understand until I started doing it.

Venture capital is a very risky asset. And so if you're a wealthy family, or if you're an institution you're investing a whole bunch of your money in bonds and stocks and, you know, things that you know are going to make a steady return over time. Venture capital is in the riskier side of that.

And at worst, it needs to return 12% year over year to actually be kind of investible by the people who do it. And so venture funds run generally over 10 years. So when a venture capitalist says to a potential investor, I'm in a return 12% of your money year over year and invested over 10 years.

If you look at the math behind me, the 12% annual return to the power of 10, the fund length means that they have to return about three X of the money that was invested for people to consider them to be a successful fund and by successful fund. I mean, if you're a venture. You're going to have to go raise a new fund every say three to seven years, which means you'll have to go back to your old investors and say, Hey, look at all the great things that we're doing.

Don't you want to put money in our next fund. And so you've actually got to show great returns. The folks that you're, that are going to be investing in you or people like university endowments, pension funds, insurance companies, banks family offices, which is kind of a code word for wealthy people. And so the startup, these people are fussy about making a good return.

They want to know that they're investing their money with folks that are going to bring in lots of. So if this there's a hundred million dollar fund, let's say I'm a VC. I go out and I raise a hundred million dollars. I get to deploy that over 10 years. That means for the first, like several years, I'm looking for different companies.

I'm investing in each company, I'm saving some back to even invest in them further. And that means that fund has to return at least $300 million in the course of the fund to be considered good. And you need to be considered good to raise more money from your LPs or limited partners. So all the universities, endowments, wealthy people, et cetera, et cetera, et cetera.

So that's the very basics of how venture capital works. That means for every dollar as a venture capitalist, I invest I need to return at least $3 to the folks invested it under my, I dunno, struggling for a word. Here are the likely outcomes that happen when you invest in startups, right?

50% of the things that you invest in as a venture capitalist will either be dead within 10 years or become zombies. And by dead, I mean the company actually closes its doors and doesn't function anymore and doesn't return it. By a zombie, I mean, a company that may actually continue to run successfully and serve customers, make money, employ people, but isn't actually ever going to return money to any of the investors.

So the original investors, aren't going to get money back the founders, aren't going to get money back or at least their stock, isn't going to be worth something. And that's 50% of the fund. So 50% of the fund totally wiped out investor gets zero. About 45% of the companies that venture capitalists invest in are acquired.

So that means another company buys them all the investors are returned some multiple of their money. And now guess what you're now a part of this new company and a very small percentage. Very small percentage in that IPO category. So if you're working for a venture backed startup, there's a really good chance that if you are, have an exit you will be acquired.

And so given that 50% of the companies actually fail the other 50% of the companies have to return that 300 million to make the VC successful and actually make the fund to make. Another way to look at the VC fund returns is about 50% are in that blue bottom piece. You know, those are the companies that die or zombies and return like less than one, a one time, their value 35% will have like a kind of small exit.

You know, it's an exit that like the investors will get their money back. Maybe the founders will make a little bit of money, but like, no, one's knocking it out of the park. The orange wedge, some of them will have a higher value acquisition. And then that tiny little red pie wedge 5% of the companies that they invest in are going to make three X or more.

And so what VCs are doing is pressuring all the CEOs in their particular portfolio to hurry and return my money money because they're trying to push everyone into that red pie, which, and a certain amount are just going to die and be taken off the table. Everyone else they're hustling to get them to try and make more money so that the fund is success.

So VC's basic job. In addition to the Smith is they go out and raise money from those universities and high net worth individuals, the investing companies, they push their CEOs to grow or exit. Sometimes they do that by being on their board. The board will be primarily made up of venture capitalists.

Although there'll be some independence, maybe some other people and they'll also just push them by. So even if they're not on their board, they'll be making phone calls and how are you doing? You're going to do this more. You're going to go faster because they need to pay their investors back at least three X, and then they'll repeat the entire cycle.

So they have incredible pressure to create returns within a short timeframe because they want to demonstrate quality so they can raise other funds. I'm clear on the job of a VC at least at a high level. So then let's go on to the CEO. This the three pieces of a CEO job are from a blog post by a Fred Wilson at union square ventures, one of the top venture capitalists and according to the blog posts, there's really three things that a CEO does.

And this comes up a lot in my coaching practice. So I actually agree with them. The first is to set the vision and strategy for them. And communicate it to all the key stakeholders. The second is to recruit, hire and retain the very best talent. And then the third is to make sure that there's almost enough cash in the bank.

And so making sure there's enough cash in the bank really means making sure that you can make your next fund raising right. At least until you've got the escape velocity of you make enough money to sustain your company and grow in whatever way you need to. And so that red thing is what we're going to be kind of talking about throughout the rest of the time.

These are the typical investment stages. Each of them kind of has their own milestones Jones that they need to adhere to. So for the angel or friends and family round, it's really, you're funding a team in an idea. You don't have to show a lot of technology and it's a new engineering manager.

It's unlikely, you'll end up at a company like that. At the seed stage, you're really proving out that you've got some initial product market fit and you can make some money at the, a round. What you're showing is that. If investors put more capital in the company, the company's going to grow even more quickly.

And so the investors want to see, boy, if we just dumped some money into this, it's going to go pull like crazy. For the B round, they want to see that you're going to move into another vertical or another area and basically increase your entire market size. So all these are things that your CEO needs to be paying attention to behind the scenes so that she, or he can go out and raise cash.

When you next need to grow. And then finally you'd move on to potentially IPO or acquisition, but your CEO should always be working towards your next funding milestone. If you're a venture backed. That means CEOs are under crazy pressure to grow. They'll be under pressure from their board to grow by three or four times a year, because again, the majority of companies won't return any money.

So the rest have to grow even faster. There'll be under pressure to accumulate marquee customers so they can put on their board deck like, whoa, look, we, we lended AOL. Isn't that? Cool. There'll be pushed to partner with other companies that their current VCs have backed. You know, so the VC will say like, Hey, so-and-so's in our portfolio, don't you think you could integrate with their thing.

And then you guys could both get more users. And the CEO doesn't really want to say the board is making me, but in, and that's not really true with the CEO would be saying, is we really need to raise the next funding. And we want to get all the existing investors on the board to say, hell yes, you're doing great.

We'll throw more money in. And we want to get even more investors to get excited about it and jump on the bed and wagon and fund our next round of growth. So a great question to ask yourself as a new leader in engineering is like what's required for a company's next fundraise because your job, the entire engineering teams.

Is to build the things that will get your company to your next funding round. And those are usually features that will capture revenue, attractor retain customers, but it also means doing things like ignoring technical debt, unless it creates significant churn. So here's some questions that you might be asking if you're at a venture Baxter.

Why is my CEO asking for more and faster revenue and more users? Well, your CEO is not just an asshole. They're trying to raise the next round of funding so that there are no layoffs. You don't have to shut your doors. And so you can actually grow your revenue, your customer base and your work. Why is my CEO asking me to ignore technical debt and hack together features like crazy.

This is making me nuts. Your CEO is doing that because they need to prove that those new features can be built, attract more customers onto your platform. And again, prove that your product has traction. You might be in a features race with another company. She, or he could have promised investors that they'd reached certain milestones or land certain partnerships by the next funding round.

So again, they're getting squeezed in this way. That's not necessarily apparent when you're the engineering manager. Don't where are we doing this stupid integration. Another question you might ask is why is my CEO asking me to cut costs while building more features that's not possible? And it's so that they can show increasingly.

They want to show that the cost of acquiring customers is going down while the lifetime value of a customer is going up. And the overall costs of the company are going down. Another one that I find humorous, like why is my CEO asking me to make it social? Venture capitalists are subject to trends, just like anything.

And so being able to go out into the fundraising committee and go, Ooh, look at our new social angle on our product might mean you attract a VC. That's really making a lot of investments in social media and that otherwise would overlook it. So following current trends sometimes makes the company more interesting.

And finally, why am I spending cycles on integration with this super lame partner? I explained a little bit about this earlier, but a lot of times you'll be asked to do integrations where there's like $0 in revenue. There might be very few users, but what your CEO and your executive team is working towards is getting logos on stuff.

Getting help with fundraising and also attracting some potential strategic investors. And those strategic investors can become potential acquirers. And if you remember back a few slides, we said 45% of companies exit through acquisition. That's not a bad thing to work on. A great question to ask and answer is how do I explain all this to my team?

One of the best ways to do that is actually to understand how venture capital works. So being able to understand we're heading towards this next round of fundraising, we have to show these compelling features, partnerships, et cetera is really gonna make a big difference. The only way that I've been able to effectively explain this to my teams is to talk to them about the facts back, that we're not building software as art we're building as a business.

And our business has to make its next round of funding to continue. So this is kind of an unfortunate side effect. We're not working at a giant company that can take forever to build a thing. We're actually running a race where we're constantly trying to get to the next funding round. And you've kind of play along with that.

To actually be successful at a startup. So the next question you might ask is how will your company exit the investors want to make their money back? So again, they're pushing your CEO to like go faster, go faster, grow, grow, grow, and they don't care if your company dies. If the alternative is it's going to return very little.

So they're sitting behind your CEO, go, go, go, go, go, go faster, faster. And that's, what's driving your board and your executive. If you look back at the different possible exits, they're trying to push you towards that acquisition or. A great question. That's queued for some of these acquisitions, is, does partner XYZ has strategic value.

Strategic value is a kind of a code word for, is there a reason that we're partnering with this person other than revenue and users? And you can further ask a little bit more about like, okay, why would that be valuable? Sometimes you won't hear a complete answer. An incomplete answer could mean that someone's sandbagging you, but it also could mean, yeah.

If a potential acquirer or strategic partner that the person you're talking to is just not allowed to talk about. And as your company gets closer to a potential acquisition it might be that multiple companies are looking at you. It might be that there's a single company. That's looking at you, but understanding what those signs look like can be really valuable as an engineer.

So diligence, when someone's looking to acquire your company, looks like this. It looks like a partner coming in and having lots of meetings with key staff members. It means senior staff members are out of office a lot. They might be traveling to the partners office to talk. It means absurd requests for technical documentation that you've never in your life had to write for the company.

They were like, who would use this? This doesn't make any sense, like Nope, need full documentation on everything. Get cracking on that. Forget about the features. It often looks like a hiring freeze and it looks like no decisions are getting made because the books are getting frozen while potential acquire looks at like, okay, what are, what's your cost of acquiring customers?

What's your run rate, et cetera, et cetera. So no decisions are getting made. It isn't a sure sign that there's an acquisition, but that's a good hint. Because the biggest clue for an acquisition is actually. I want to end with a warning though. This insert insider information is both powerful and dangerous.

So it's great to understand how venture capital works. It's great to understand what your CEO or executive team, what pressure they might be under. But it is not necessarily something that you can say in town hall, like, okay, Hey, I saw someone from partner XYZ here are we getting acquired? And the reason is leaks about an acquisition can actually literally scuttle it.

And so it's not the kind of thing that you can come out and say, even though that sounds ridiculous. But your senior executive team is actually under legal obligation not to leak a potential acquisition. So they won't be able to answer your questions with anything, but as sort of like VIG strategic partnership kind of thing you can however, ask subtle questions in private.

And the kind of question you could ask is, is this something I should prioritize over my other work, right? And so if you can go to somebody who's in the know about whether this partnership is actually going to go anywhere or not, that's a great way to discern. Is this a partnership I should put a lot of time and energy in and further you could ask the question, tell me the level at which this partnership is most important.

Are we trying to just kind of like stamp the logo on our next slide deck or. You know, to the press that we're partnered with this person and kind of any integration is going to be fine, or is this something that we're actually trying to use to make revenue? Is this something that we're actually going to do a much deeper integration with?

So asking those specific questions about like, what will make this partnership valuable will make you a more valuable engineering. So hopefully I've given you a taste of what it's like to be a venture capitalist. I'm a CEO and you understand a little bit more kind of the influences that they're under and what they might be asking you to do.

And maybe you're less likely to argue with things that don't make sense at face value and ask some good questions. Really my goal was to give you the information to be. To allow you to create more business value and be valued more by your team so that your company can be wildly successful.

That's what I got.

About Calibrate—

Founded in 2015, Calibrate is a yearly conference for new engineering managers hosted by seasoned engineering managers. The experience level of the speakers ranges from newcomers all the way through senior engineering leaders with over twenty years of experience in the field. Each speaker is greatly concerned about the craft of engineering management. Organized and hosted by Sharethrough, it was conducted yearly in September, from 2015-2019 in San Francisco, California.