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10/17/2005

Datapower: VC Lessons

IBM announced today that it was acquiring Datapower.  I’ve written another post on why I think this announcement is significant from an industry perspective, but given that I was an investor in Datapower, I thought I would also write a post about some of the venture capital aspects of the deal.

I invested in Datapower in early 2002 when the company had 6 employees and was based in a mouse infested former auto-body shop located between two housing projects.  Datapower was founded by Eugene Kuznetsov, a brilliant MIT engineer, who saw the promise and the challenges of XML messaging early on.

Like all venture deals, I learned a lot from my Datapower experience, but here are a few of the most important things I learned:

  1. Local presence matters.  I live and work on the west coast.   Datapower is in Boston.  When I first wanted to invest in Datapower my partners’ first reaction was “it’s too far away, you need a local partner”.  They were right.  I spent the next few months trying to find just the right partner.  Luckily Jeff Fagnan, who was then at Seed Capital (a fund I knew well) had already been looking at the space and quickly decided that he would like to join us in the investment.  Jeff proved to be an invaluable co-investor and ultimately got stuck with much of the day to day investment management chores that I could not effectively do.   It was an important lesson for me on the critical importance of having high quality local co-investors if you do a deal “out of market”.  Incidentally, Jeff left Seed early this year to become a partner at Altas and his first investment at Altas just happened to be in Datapower.  I suspect everyone at Atlas is happy with the IRR on that investment!
  2. Sometimes VCs should keep their mouths shut.  Just after Datapower had launched its first product, a performance oriented appliance, Eugene lobbied for the company to accelerate the launch a second security oriented product that had been planned for a quarter or two in the future.  At the time, I remember cautioning Eugene on the potential distractions and costs of having two immature products in the market at the same time.  Eugene lobbied hard to take the risk and thankfully he won the day.  I say thankfully because not only did the company land a $300K order that quarter for the security product, but it was able to establish significant mindshare in the security space well ahead of its competitors.  To this day the security space continues to have the most robust market demand and competitors that failed to quickly launch a security product suffered in the market.  The lesson for me in this was that VCs have to be careful not to micro-manage product development in a rapidly emerging market because demand can move very quickly and in unexpected ways.
  3. Shotgun Weddings Don’t Work.  Early on in the company’s life we were trying to recruit another local investor into the deal.  That investor had an entrepreneur-in-residence (EIR) that helped them with due diligence and really liked the deal.  The new investor made recruiting an interim Chairman/CEO a condition of their investment and there was an implicit understanding that they would feel most comfortable with their own EIR taking that role.  The existing team was not 100% comfortable with the EIR but felt pressured to take him on in order to secure the funding.  As it turned out, the EIR was the wrong person for the job and tension started to develop between the existing team and the EIR to the point where it became a major distraction for the company.  Ultimately, the board ended up hiring a new CEO who turned out to be a much better fit, but we almost blew it by not taking action earlier.  The lesson for me as an investor is that you should never insist on making a company hire a specific person a condition of investing as that dramatically raises the potential for conflict.  You are much better off investing in advance and helping the company recruit someone great that everyone is 100% confident in.
  4. VCs can indeed be very unethical.   Prior to raising his first significant round of venture financing, Eugene had raised a seed round from a few individuals and a couple of investment funds, one of whom was a reasonably well known VC fund.  The partner at this fund had a strategy of sprinkling small seed investments around the Boston-area and then trying to lead the first institutional rounds of any company that looked particularly promising.  In Datapower’s case, this partner invested a few hundred thousand dollars.  He also introduced Eugene to a technology executive affiliated with the fund that was currently in-between jobs and encouraged Eugene to involve the executive closely in the formulation of Datapower’s technology and market strategy.    Everything was ok until Eugene decided to raise his Series A financing.  At that point the VC fund submitted what was clearly a low-ball term sheet and pushed very hard to close it.   When Eugene objected to the terms and announced that he would try to generate some alternative offers to see if this was in fact “market” he found that he couldn’t get any traction with other Boston based VCs most of whom would either not meet with Eugene at all or who told him that they would not do the deal without also including the original VC (at the terms they had proposed).   Now I don’t know if the original VC had an active campaign to try and discourage other investors from doing the deal, but they obviously knew that new investors would not want to do the deal without them (if the original investors don’t invest that is typically a big warning flag that something is wrong) and used that leverage to try and get a better deal.   While to this day I use this situation as a classic example of why entrepreneurs shouldn’t have a VC in their seed round, if that was all there was too it there wouldn’t be much to write about.  However after Eugene rejected their term sheet and instead ultimately accepted mine, the VC in question went ahead and not only invested in a competitor, but installed the same executive that they had installed at Datapower at their new investment.  Within months, this competitor began spouting very similar marketing messages and appeared to be executing against a carbon copy of Datapower’s product and market roadmap.  This brazenly unethical behavior by the VC fund was absolutely stunning and so egregious that it almost was a caricature of what you expect an “evil VC” to do.  To add insult to injury, when the Series A investors in Datapower approached this fund, politely pointed out the rather obvious conflicts, and requested that the fund sell its shares back to the company or to other investors, the fund refused.  Luckily Eugene got the last laugh though.  The competitor the original VC fund invested in was recently sold in a transaction that reportedly didn’t even return capital handing many of its investors a substantial loss on their investment.  In contrast, Eugene is now a very deservedly wealthy man and all of his investors made a handsome return on their investments.  I guess good guys do sometimes win.

One last piece of trivia: I closed two investments on January 14, 2002.  (It’s highly unusual for a VC to close two investments the same day.)   The first was in a company called Cyanea and the second was in Datapower.  Both companies ended up being bought by IBM; Cyanea last summer and Datapower today.  While Cyanea generated a higher IRR, the difference in cash-on-cash return multiples between the two deals was less than 10%.  I have got to close two deals on the same day more often!

October 17, 2005 in Middleware, Software, Venture Capital | Permalink

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The thoughts and opinions on this blog are mine and mine alone and not affiliated in any way with Inductive Capital LP, San Andreas Capital LLC, or any other company I am involved with. Nothing written in this blog should be considered investment, tax, legal,financial or any other kind of advice. These writings, misinformed as they may be, are just my personal opinions.