On the Inside Track in Venture Capital

By William Santiago, The New York Times

01/15/03 - From her desk at Mayfield, a venture capital firm in Menlo Park, Calif., Julie Hanna Farris founded her first company in June. But she did so from within one of the most coveted yet loosely defined relationships possible with those who put up the money Ñ as an entrepreneur in residence.

Such entrepreneurs, or E.I.R.'s, have a great arrangement. They base themselves inside a venture capital firm for six months to a year, review all the deals coming into the firm, gain a big-picture perspective of industry trends, brainstorm with the firm's partners about possible companies to create and tap into their expertise in writing business plans. All of this comes with no previous obligation to let the firm have a stake in the start-up, even though the firm is paying the entrepreneur a stipend of about $10,000 a month. Often, though, the firm agrees to invest.

The concept came into fashion about 15 years ago in Silicon Valley. But even now, in a climate where business is wary of start-ups, many venture capitalists say the idea is as relevant and effective as ever in generating investment opportunities.

"Close to 30 to 50 percent of our projects start this way," said Mark Saul, a general partner at Foundation Capital in Menlo Park. Since he joined Foundation in 1999, he said, all three first-round start-up investments he has made have resulted from E.I.R. programs.

Even so, Mr. Saul cautioned, starting an E.I.R. project must be done just right. "It requires a lot of general-partner involvement," he said. "When E.I.R.'s are left to their own devices, then you shouldn't expect anything more than a random outcome."

Grant Heidrich, general partner at Mayfield, says the key is to collaborate closely with the entrepreneur in writing a business plan. The results are "less risky than responding to a nicely packaged-up deal that walks in off the street with a bright shiny team of smiling faces," he said. But he cautioned that "you couldn't invest your entire fund with this strategy. It's enormously labor-intensive."

The flow of expertise, of course, is a two-way street. The entrepreneur or executive in residence is often asked to evaluate investment opportunities and to advise on improving the performance of companies in the firm's portfolio. Ultimately, E.I.R.'s help firms generate deals in-house.

"That's highly attractive for a venture fund, the ability to create opportunity versus waiting for opportunity to come to me," said Joanna Rees Gallanter, founder of Venture Strategy Partners in San Francisco.

MOREOVER, if the E.I.R. develops an idea for a company into a viable investment during the residency, the firm usually gets in on the ground floor. "We don't ask them to give us first dibs; it just happens that way," said Irwin Federman, general partner at U.S. Venture Partners in Menlo Park.

Venture capitalists began using E.I.R.'s as strategic partners in the mid-1980's as a result of two trends, one technological and the other financial, according to Andy Rachleff, who was a general partner at Merrill, Pickard, Anderson & Eyre in Menlo Park at the time. (He went on to start his own firm, Benchmark Capital, also in Menlo Park, in 1995.)

First, computers suddenly made it possible to design prototypes of products, making it unnecessary to finance the building of a physical mock-up for market testing, he said. As a result, the emphasis in this early financing period shifted to identifying exceptional entrepreneurs. The process turned into "figuring out where you wanted to create a product and then having the confidence that the person could create it - as opposed to spending time creating a prototype and then showing it to a bunch of customers to figure out if that's the right product," Mr. Rachleff said.

Second, as the amount of money managed by venture capital firms soared, small investments, say, $200,000 for a 30 percent stake in a start-up no longer made much sense.

"By 1986, if we invested $100,000 and made 40 times our money on that, it would have no impact on the performance of a $100 million fund, because it would only be worth $4 million," he said. "What we really wanted was to make a $2- or $3-million investment and make 20 times our money, which could really move the needle."

E.I.R. programs now vary widely in expectations, duration, research responsibilities, the degree of collaboration with partners and, of course, success. But the relationship appears to always be nonbinding: neither side is committed to entering into an investment deal with the other.

"Basically, it's: `O.K., here's a desk. Here's a phone. Here's a stipend. Think. Do,' " said Danny Shader, chief executive of Good Technology, a mobile communications company in Sunnyvale, Calif. He joined the company after two tours of duty as an E.I.R, both joint residencies with Benchmark and with Kleiner Perkins Caufield & Byers. Mr. Shader was named chief of Good Technology by the two firms, which finance it. "But they get to know you, while you are looking for the great idea, which mitigates the people risk for them," he said, "so you have a better chance of getting funded if you are an E.I.R. than not."