There was a thought provoking article in the Wall Street Journal small business report yesterday. Hopefully the link stays up for a while here.

It was on the topic of becoming an entrepreneur and the things you should consider in the process of making that decision. It made me think about a lot of the issues I went through as I did my several startups and having most recently started my own venture capital firm after seeing a clear lack of innovation in the space.

But more importantly, it created a framework for doing so and I find myself meeting with more and more people in Silicon Valley that are hatching great new ideas and getting ready to take the plunge to start their own business. Let me give you my two cents on the various questions the article poses:

1) Are you willing and able to bear great financial risk?

You should be prepared to go without pay or way below what you are used to making for quite a long time. My first startup in Africa doing wireless telecom, I went without a paycheck for nearly two years. It was tough, especially with all the debt I racked up in business school, and I had to make radical changes to the way I lived (basically packing up life into a suitcase) but I still fondly recall that venture as being one of the most challenging business I ever started. I would advise being sure you have savings for at least 6 months without income or have a very supportive spouse who can carry you through it. I recently heard Peter Thiel of Paypal on a panel talking about how he believed there was a positive correlation between how low a CEO/founder’s pay was and the success of the venture – low pay sets a threshold for capping other employees’ compensation which in turn keeps burn low and increases chances of success – a mantra we at Nueva Ventures strongly believe in. My second startup relied on just $80K of angel capital and in the first year we took almost no pay. Within 18 months we had ramped to $10M in sales and delivered a fantastic return for our investors.

Also be thinking of ways to drastically cut back on your personal cost structure. The more flexibility you have, the longer you can keep a buffer. When your resources are exhausted, before starting to finance the business on credit card debt, be sure you see #3 below! I racked up some serious credit card debt financing a few payrolls, something I don’t think I’d be comfortable ever doing again given more wisdom, or at least limiting it to what I could afford to lose. It was a serious issue with my wife too!

2) Are you willing to sacrifice your lifestyle for potentially many years?

Relates closely to #1 for costs but keep in mind starting a new business is going to put you on the path of some really hard work. As a small business owner, the buck stops with you and you are going to be thinking about all aspects of your business 24 hours a day 7 days a week. It’s going to be a real challenge to maintain a personal/work life balance. And just when you think things are going great, some random thing can happen throwing all into disarray. Be prepared for huge highs and lows.

3) Is your significant other on board?

Absolutely a must and probably one of the MOST important things you need to do. It’s extremely lonely being a founder and there are few people you can turn to when things are really rough. Your spouse needs to understand the risks and rewards and be part of your decision making process because this decision is going to impact the whole family – economically and emotionally.

4) Do you like all aspects of running a business?

When you start a company, whether it is venture funded or angel funded, you have to wear many hats, but most importantly you are chief salesperson. You will be selling to customers, to convince people to sign up to your vision and join you, suppliers and landlord to believe in you and extend you credit etc. Ultimately you have to get things done and use your resourcefulness and creativity to their greatest abilities. A lot of it can be unpleasant work – dealing with accounting, angry customers or suppliers, inconvenient travel etc. A lot of it can be great – closing your financing, launching your product, experiencing customers buying it and delivering returns that can change lives!

5) Are you comfortable making decisions on the fly with no playbook?

You will find yourself making decisions constantly with very little guidance. Surround yourself with the best people that you can, be generous on incentives to motivate them to join you and take risk, confide in your advisors and investors, try to join a mentor group like YPO or find others who have started businesses, even outside of your space as they can still have very relevant advice and experience you can benefit from.

6) What’s your track record of executing your ideas?

Given the vast number of decisions you will be making, you have to be comfortable managing and executing across multiple dimensions, keeping track of all that you have to do, being organized and disciplined. How well did your lemonade stand do as a kid?

7) How persuasive and well-spoken are you?

Howard Stevenson my professor of entrepreneurship at HBS defined entrepreneurship as “the pursuit of opportunity beyond the resources that you currently control”. That has stuck with me all these years since I graduated. When all you have is a vision and your talents, you have to convince investors to believe in your vision, people to join you, customers to buy your product…and when things are tough, possibly laying people off and keeping morale up for the remaining team, or getting your suppliers or debtors to cut you slack while you restructure. Given the times we’ve been through the last few months, I’ve found myself helping my portfolio CEOs do a whole lot of the latter, quite unpleasant but necessary and requiring the same skills.

8) Do you have a concept you are passionate about?

If not, don’t bother…it’s so much work that you have to be fired up about your idea as does your spouse and a host of others. I would invest significant time to get feedback on your idea before taking the plunge – talk to some potential customers, check whether someone else has tried this before, get some insight into what the key drivers of success are going to be. My entrepreneurial field study at business school was about starting a new business in the computer space. I spent a whole lot of time talking to potential customers, culminating in finding a person who had previously tried what I was going to do and failed miserably – resulting in my shooting it before investing years getting it off the ground. Time is really all you have – are you going to devote the next 5-10 years on this idea or are you better off doing something else. How will you feel if at the end of 10 years your venture fails?

9) Are you a self-starter?

In the face of discouragement, you have to find inspiration and energy to keep going. I’m convinced it’s a key factor – you have to able to react constantly and decisively to correct course.

10) Do you have a business partner?

Maybe not necessary at the beginning but it sure helps to weather the ups and downs to have someone else as closely involved and experiencing all you are going through to relate. The next closest thing is your spouse or perhaps an experienced friend you might convince to invest in you and be your mentor.

I have to say what keeps me going is having often tasted failure and learned from it, I’ve also tasted success and know just how great that feels. I love being able to be in control of my own destiny, feeling challenged like nothing else – whether things are going well or not – and inventing something new that customers appreciate and buy. And of course there can be the financial rewards and good feelings knowing you are creating jobs in this bleak economy!

I liked Guy Kawasaki’s post on his blog How to Change the World about how to find a job using LinkedIn. I keep referring to it in many conversations I’m having with friends who have lost their jobs and trying to pick up the pieces.

I personally use LinkedIn a lot for networking and opening doors. I think you get out of it what you put in – make the effort to do a detailed profile so people can search and find you, keep it up to date and link up with others. I find myself using Linked-in a lot more than Facebook for my professional work. When I finally made the commitment to really use it a year or so ago , I used the LinkedIn tools to upload my contact database and scan my e-mails for contacts which provided the fastest way to get going and link with others.

http://blog.guykawasaki.com/2009/02/10-ways-to-use.html

Another good resource to use is the quarterly publication of venture funded companies put out by VentureOne and the San Jose Mercury News. This one lists all the startups in the Bay Area that got funding in Q4, how much, what sector they are in and which VCs did the round. These startups secured funding so are likely hiring but may not be listing job openings so you might use Linked-in to connect with a VC that funded them or an executive in the company in your area of expertise.

http://www.mercurynews.com/vcsurvey

The Q4 fundings are here:

http://www.bayareanewsgroup.com/multimedia/mn/biz/specialreport/vcchart_q42008.htm

I recently attended a book launch session by Spencer Ante, an editor at Businessweek who is the author of a new book entitled Creative Capital and presents the story of Georges “General” Doriot and the birth of venture capital. Doriot is considered the father of VC, founding and running the first successful venture capital firm, American Research and Development which went on to finance and nurture over a hundred startups. Many of the founders of the most successful venture firms, such as Bill Elfers of Greylock, Eugene Kleiner of Kleiner Perkins and Don Valentine of Sequoia, trace their roots to Doriot.

It was quite fascinating to me to hear Spencer talk of the history and strategies followed some 50 years ago. How the industry was formed on investing tiny amounts of capital, intensely nurturing those startups and bringing the right mix of talent in to scale the business up, and the returns brought about by investing early at low valuations and high corresponding multiples at exit.

One of the questions asked of Spencer was how the General would see today’s VC industry as compared to that of when he started. He commented that there has not been much innovation in venture capital in the past two decades. Many in the industry have enjoyed “sitting on their laurels” while returns to LPs have declined. The sheer size funds have grown to and number of firms seems too large to be able to deploy all their capital across the best startups. With the exit markets the way they are, too many billion dollar sized exits are needed to make these funds return capital. That’s not going to happen anytime soon.

At the end, he expressed that if he were going into VC today, he would be aiming to raise a micro-cap venture fund, investing $500K sized amounts at the earliest stage, injecting the right mix of DNA to help it be successful and being flexible in today’s exit market- exactly what my vision was for Nueva Ventures when I started it 5 years ago.

As a serial entrepreneur, I experienced firsthand in raising capital the large disconnect between the amount of capital standard VC wants to invest and what is really needed to prove out certain business models while maintaining flexibility in today’s exit market. I felt the VC industry had not scaled well and a new model – or perhaps more of a return to the way the industry started out – was necessary to overcome the challenges of today’s market conditions.

So what is a micro-cap fund and how are we different?

I’d say there are a few things that destinctly characterize a micro-cap fund and why as an entrepreneur you’d want to consider taking money from one versus standard VC:

1) A micro-cap fund makes $250k-$1M sized investments in a startup. They offer a far more efficient fundraising path than pooling angel capital and they are usually managed by full time partners whose job it is to work with their entrepreneurs much as General Doriot did in mentoring his companies. Standard VC has effectively abandoned this sized investing because the economics of their fund sizes and demands on time are such that it cannot work for them.

As an entrepreneur, I would say your job is to eliminate risk as efficiently as possible. If you eliminate risk with less capital, you can conserve more upside. Today’s cost of technology, outsourcing options and distribution channels offer a more efficient path to prove out a business model before ramping it. Why not take the least amount necessary, albeit maintaining a prudent amount of runway, to prove out the business and then be in a great position to raise larger ramp capital at a better valuation once that milestone is achieved? Such a path also preserves your exit options. If you take $10M from a standard VC, it might be hard to convince them later to sell the business for $50M (making them say a 2x return on investment) while you may really think that is the right strategic move to make at the time. A micro-cap fund could make a 10x return on such an exit and would be more inclined to seriously consider it.

Furthermore, taking more capital than you need can actually decrease your chances of success. It encourages hiring more people and building large overhead, raising your burn to such a level that makes it hard to rapidly change course if things are not working as planned (and they won’t!). It can make you over develop your product and lengthen time to launch iterations since you feel obliged to get it all right before launch, avoiding getting critical market feedback early and often.

2) Micro-cap funds can make smaller sized investments because of the way they are structured. They typically have $10-25M of capital under management per partner, compared with $50M for standard VC. While the focus in both cases is on homerun potential startups, the micro-cap fund gets in earlier and has higher return multiple potential. The ones who make the most money are usually the first ones in – e.g., Andy Bechtolsheim’s legendary $100K seed funding in Google worth $1B at exit. The exit economics and lower fund sizes are such that doing smaller investments earlier can move the needle on a micro-cap fund’s overall return.

Now come the economics of the fund: why would a fund manager choose to manage $50M versus $10-20M? It comes down to fees – it is more lucrative to be guaranteed to earn a 2.5% management fee on $50M than on $10M, especially if you are not delivering ROI and earning a carried interest which kicks in only after returning all of the original capital of the fund! It’s also a lot nicer to have a fancy pants office with an army of administrative and analyst support staff, and the perks – attending fancy conferences, travel, etc.

Making a small fund work means deliberate and frugal choices about how to run the fund – just like the entrepreneurs we back. I don’t have an administrative assistant and book meetings myself (I find this more efficient actually), I use a lot of low cost technology to support a highly streamlined operation, I do the accounting myself as a former CFO and I do the detailed diligence myself while once in a while consulting with experts in my network who are happy to help out for free. I really don’t need much of an office because most of my time is spent up and down the valley meeting with entrepreneurs and our portfolio companies at their offices – I get to see firsthand how they operate and if they are up to bootstrapping. I know that I have a greater part of my compensation directly tied to delivering return to my investors, totally aligned with their incentives, and can live with that and look forward to a decent carried interest return eventually if I do my job well and luck is also on my side.

Many VCs forget that ROI for a venture fund results when there is a large numerator and as small a denominator as possible. That means getting into a startup very early on in its formative stage at a low valuation, backing entrepreneurs who can prove out the business model with less capital and being able to make returns on what may amount to lower exit values than has been traditionally the case. An entrepreneur should not be bragging about how much venture capital they raised. It just makes it that much harder to generate ROI.

3) Most micro-cap funds practice the same sort of “hands on” value add as a standard VC. While there are many best of class angels who do the same, often it’s hard to get that same professional attention and help as you go through the trials and tribulations of starting and managing a new business. In our case, we want to be part of your Board, we’re dedicated to being there when times are tough and choices unclear, we help you find talent and resources.

The one key difference is that an early stage investor, closer to seed financing, is going to face a higher rate of failure. We take that into account in terms of how we can allocate our time efficiently across a portfolio and the expected rate of attrition freeing up time. A micro-cap fund has to do more investments, we think 2x as many as a standard VC, because of expected attrition. This has to be carefully managed such that at the end of the day we follow industry norms about how many companies we can be involved with. Standard industry rule of thumb is no more than 8 board seats per manager. Sometimes I feel that even 8 may be too many given the intensity of involvement at the early stage of the start-up’s life. Working back from that number, translating it into how many investments each manager can therefore make and how much capital that means is needed is the way we calibrate our fund size.

This gets us to a key issue – why the VC industry has not scaled well. I believe that the fee driven approach to raising ever larger funds has moved most if not all standard VC up to doing later stage investing or to encouraging putting far too much capital in at the early stage, a “capital deployment strategy” per say rather than a prudence strategy of de-risking a business. This has created the gap that exists today in raising capital between $500K – $2M. Too big for most angels and too small for standard VC.

I’ve been in the entrepreneur shoes and I’ve been tempted quite a few times and have taken the larger capital offered by the “capital deployment strategy” – the rationale being if I’m going to be diluted only a little more, why not take the larger capital amount. My experience has been that taking that larger amount resulted in ramping our burn, making us far less able to iterate and change our strategy and product quickly, and put us on a path to having to exit at a huge number. My most successful startups (both from experience as an entrepreneur and investor) have been those that took the least amount of capital and focused on proving out the business model first.