The Masters of Private Equity and Venture Capital

The
MASTERS of
PRIVATE
EQUITY
and
VENTURE
CAPITAL
MANAGEMENT LESSONS from the
Pioneers of PRIVATE INVESTING
ROBERTA. FINKEL
President, Prism Capital
.ith DAVID GREISIN6 c^fb„siness Correspondent,Chicago Tribune

USD $34.95
The Masters ofPrivate Equity andVenture

Capital is a gathering of concise, en
gaging, and eye-opening profiles that grant
you a virtual audience with ten of today's pri
vateequityandventurecapitalgiants.Through
their exclusive stories, told in their own words,
these wealth-creation experts share timely
advice and the wisdom of their experience.
Each chapter in The Masters ofPrivate Equity

and Venture Capital is dedicated to a different
topic, as explored by a different expert. The
profiles arise out of extensive discussions with
the ten, arranged and conducted by Robert
Finkel,an experienced fund manager and ven
ture capitalexpert, and David Greising, a long
time business journalist. For each "Master," a
thumbnail biography that kicks off" each chap
ter highlights their most important deals,
favorite accomplishments, biggest mistakes,
assets under their management,and other vital
facts. Chapters conclude with useful takeaway
points that encapsulate keylessons from:
•John A. Canning,Jr. (Madison Dearborn

Partners)—who describes how the current
economic crisis is putting an emphasis back
on financial fundamentals, is refocusing
investors on operating performance, and is
marking an end to the leverage-fueled
megadeals
•Jeffery Walker (JPMorgan Partners/

Chase Capital Partners)—who details the
importance of proper capital structures for
businesses and how to apply the rigors of
private investment into philanthropy and
social entrepreneurism
(continued onbackflap)
The
MASTERS
PRIVATE
EQUITY
and
VENTURE
CAPITAL
Management Lessons from the Pioneers
ROBERT A. FINKEL
with DAVID GREISING
Mc
Grat/u
Hill
New York • Chicago • San Francisco • Lisbon • London

Madrid • Mexico City • Milan • New Delhi • San Juan
Seoul • Singapore • Sydney • Toronto
heMcGraw-Hill Companies
Copyright © 2010 by RobertFinkel and David Greising. All rights reserved. Printed inthe United
States of America. Except as permitted under the United States Copyright Actof 1976, no part
of this publication may be reproduced ordistributed inany form orby any means, or stored in a
database or retrieval system, without prior written permission of the publisher.
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ISBN 978-0-07-162460-2
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This book is printed on acid-free paper.

For Matt and Allison, may you never stop learning.
RA.F.
For Wes, Greta, and Claire, who make it all worth while.
D.G.
CONTENTS
ACKNOWLEDGMENTS ix
INTRODUCTION.
Robert A. Finkel
Prism Capital
PART I: PRIVATE EQUITY
1 METHOD OVER MAGIC: THE DRIVERS

BEHIND PRIVATE-EQUITY PERFORMANCE 17
Steven N. Kaplan
University of Chicago Booth School of Business
2 Operating Profits: using an Operating

perspective to achieve success 31
Joseph L. Rice III
Clayton, Dubilier & Rice
3 Skin in the Game: investing

in service businesses 47
F. Warren Hellman
Hellman &c Friedman LLC
© v ®
vi • Contents
4 The Partnership paradigm: working with

Management to Build Toward Success 73
Carl D. Thoma
Thoma Bravo, LLC and predecessor firms Golder
Thoma & Co.; Golder Thoma Cressey Rauner, LLC;
and Thoma Cressey Bravo, Inc.
5 beyond the balance sheet:

Applying Private-Equity Techniques
to Not-for-profit Work 95
Jeffrey Walker
JPMorgan Partners/Chase Capital Partners
6 the inside game: managing a firm through

Change after Change 117
John A. Canning, Jr.
Madison Dearborn Partners
PART II: VENTURE CAPITAL
7 The Entrepreneur and

the Venture Capitalist 141
Garth Saloner
Graduate School of Business, Stanford University
8 Pioneer Investing: taking venture

Capital from Silicon valley to
Bangalore and Beyond 151
William H. Draper III
Draper Richards L.P.
9 Change for the Better: Managing for profit

as Markets and Technology Change 173
C. Richard Kramlich
New Enterprise Associates
CONTENTS • Vii
10 Beyond the ivory tower:

Taking laboratory research to market 195
Steven Lazarus
ARCH Venture Partners
11 FOSTERING INNOVATION: PEOPLE, PRACTICES,

AND PRODUCTS MAKE NEW MARKETS 221
Franklin "Pitch" Johnson, Jr.
Asset Management Company
12 RISK, THEN REWARD: MANAGING VENTURE

INVESTMENT IN RUSSIA 243
Patricia M. Cloherty
Delta Private Equity Partners, LLC
APPENDICES: TOOLS OF THE TRADE
1 checklist for evaluating investment

Opportunities 271
2 Guidelines for Transforming research

into Commerce 273
Steven Lazarus
3 WHAT WE WANT IN A CEO 277

Joseph L. Rice III
4 Portfolio Company valuation template 279

5 "WATERFALL ANALYSIS": THE STRESS TEST

FOR POTENTIAL PORTFOLIO COMPANY 283
viii o Contents
6 MANAGING DIRECTOR SELECTION CRITERIA 289

7 PERFORMANCE METRICS FOR MILLENNIUM

VILLAGES 293
Jeffrey Walker
8 "CARLISMS": KEY PRACTICES FOR PRIVATE-EQUITY

INVESTORS 297
Carl D. Thoma
INDEX 301
ACKNOWLEDGMENTS
Ineed to acknowledge a group ofpeople who made it possible for me

to put this project together:
First, thank you to the wonderful people whose life work is herein
profiled; each interview was a master class for me. I wish to thank
the Illinois Venture Capital Association for the opportunity to create
mentoring panels that were the inspiration for the book. Also, my
professional mentor, Art DelVesco, and the good partners at Wind
Point Partners, for teaching me the ropes with a loose tie.
Joan Shapiro, a guiding hand in my very fortunate life, introduced
me to David Greising. Leslie Pratch thoughtfully aided in our quest to
reach the masters. Emily Thornton of BusinessWeek was kind enough
to introduce me to McGraw-Hill. And to our editor at McGraw-Hill,
Leah Spiro, thank you for your steadfast commitment to doing this
right and on time. I am grateful to each of you.
To my loyal Partners at Prism, thank you for your patience as
I traveled to conduct interviews. To my top-notch assistant, Lauren
Belcher, for transcribing so long and so well and to the passionately
focused Renata Johns, for your skillful research, well-crafted editing,
and attention to detail, I thank you.
Through this process I have gained a friend in David Greising. Thank
you, David, for being a terrific collaborator, writer, and interviewer.
David artfully and faithfully incorporated the voice of the professional
masters who very generously agreed to participate. When looking for
a writer for the project, a friend of a friend, Terri Savage, advised me
whatI knew in my heart butwas good to hear again: "If you gave John
Canning a referral for a plumber, you would make damn sure it was a
good one, right?" For me and this book, David Greising is the Harry
Tuttle of writers (in the movie Brazil, Robert DeNiro plays the heroic
and good-natured craftsman who always appears when you need him).
To my lovely and supportive wife Linda, for being my life's partner, and
to my parents, who taught me that persistence is everything, thank you.
—Robert Finkel
• ix o
X • ACKNOWLEDGMENTS
It isone thing to come up with a good idea andquite another to exert

the energy, resources, persistence, and creativity to bring the idea to
life. I would like to thank Robert Finkel, first, for conceiving the notion
that in these times ofchallenge and trial there ought to be a book about
the core values ofthe private-equity and venture capital industries. The
good humor, patience, and trust Robert embodied as we worked tobring
his idea tofruition helped make this a mission, not just a piece ofwork.
When Robert set out tofind awriter toshare the work with him, Joan
Shapiro steered him tomy friend and former colleague R.C. Longworth,
who directed him to me. For that, Ithank both Joan and, especially, Dick,
whose wisdom and grace have meant so much tome over the years.
I wish to thank my editors at the Chicago Tribune, editor-in-chief
Gerould Kern and managing editor Jane Hirt, for their support ofthis
work and their recognition that newspaper reporters grow professionally
through projects outside the newsroom. My friend Jim Kirk, business
editor at the time, gave an early green light, and his successor Mike
Lev was generous in his encouragement andflexibility. Tim Jones and
Jim Miller provided what is sorely needed during a project such asthis:
friendship and fresh-ground coffee.
This book renewed a working relationship and friendship with Leah
Spiro, our editor and a former colleague from BusinessWeek. Leah's
advice, judgment, and trust in us proved invaluable. I wish tothank Joel
Weisman for offering astute counsel during negotiations and unflagging
encouragement in all respects. Rafe Sagalyn represented us wellin talks
with McGraw-Hill.
Renata Johns provided invaluable research assistance and tracked
countless details, and Lauren Belcher's transcriptions and other work
were timely, accurate, and good humored. Numerous aides-de-camp
to our pioneers provided important assistance on short notice and
contributed mightily to our work.
Finally, ofcourse, comes family. My wife, Cindy, kept us happy and
healthy and upto date on obligations, while handling the demands and
transitions at her own job, and still had time to help me work through
the latest challenges with the book. Wes, Greta, and Claire provided
welcome relief from the pressures ofwork and book, and our dog, Nopi,
was always readyfor a walk when Cindy and I needed one most.
—David Greising
INTRODUCTION
Robert A. Finkel
Prism Capital
During dinner when I was young, the conversation frequently

turned to business, a topic that often prompted my father both
to entertain and teach with an almost vaudevillian impersonation of a
Harvard GraduateSchool of Business professor named Georges Doriot.
In a voice that combined Peter Sellers' Inspector Clouseau with Colo
nel Klink from the "Hogan's Heroes" television show, Dad doled out
Doriot's truisms like so many Danish cookies from a blue tin on the
countertop nearby.
I didn't know it then, butProfessor Doriot widely was considered the
founding father ofventure capital and private-equity investing—even in
the days before venture capital built Silicon Valley and private equity
reinvigorated thousands of companies. When he formed American
Researchand Development in 1946, Doriot
did more than raise a pool of money that
would go on to fund Digital Equipment
and other start-ups. He created a way of
thinking and operating in business: pooling
investors' money and deepening its impact
byputting discipline, accountability, anda
sense of purposeto work on its behalf. By
harnessing the capital and commitments
needed to support innovation, Doriot was
introducing a new chapter to the history
of capitalism. Doriot as sketched during class
The Doriot bon mots that my dad tossed by the author's father, Stanley
across the dinner table no longer survive. Finkel, MBA '39.
1 •
2 • THE MASTERS OF PRIVATE EQUITY AND VENTURE CAPITAL
But, as I reviewed Doriot's writings recently, I found a passage that

captures the essence of his thinking and shows why his voice rang so
powerfully, not just among Harvard Business School graduates but also
among a new industry of private investors:
The study ofa company is not the study ofa dead body. It is not
similar to an autopsy. It is the study ofthings and relationships.
They are very much alive and constantly changing. It is the study
ofsomething very much alive which falls or breaks up unless con
stantly pushed ahead or improved. It isthe study ofmen and men's
work, of their hopes and aspirations. The study of the tools and
methods they selected and built. It is the study ofconceptions and
creations—imagination—hopes and disillusions.
What Prof. Doriot described, in his misleadingly simple phrase as "the

study ofa company," is really the essence ofwhat private investment is
all about. Companies are hardly cadavers. Rather, they are complex,
living networks of people, capital, products, and markets. Likewise, pri
vate investment isnot a simple transaction of buyer meets seller. It is the
beginning ofa relationship—one that requires nurturing, discipline, shar
ing, and accountability. If the relationship works, the rewards are rich.
If it does not, the company suffers and, eventually, so does the private-
investment firm, because itshares responsibility for the failure, especially
in the eyes ofthe investors who support the fund and expect success.
IfDoriot's surviving teachings are quotations from a founding father
of private investment, then the lessons contained in this book are the
embodiment of his ideas by the modern masters of what is now a full-
fledged trade. Just as Doriot was a mentor to hundreds of would-be
businesspeople in the mid-20th century, so these present-day practi
tioners can be mentors to people today who strive for achievement as
managers, investors, or students of business.
A Growth in Scale
The people who share their experiences in this book are leaders of an
industry that has built a track record that merits attention. Even in the
face of economic uncertainty and rising public scrutiny, private-equity
INTRODUCTION • 3
and venture capital investment has continued to grow in scale and im

pact. As recently as 2000, large private-equity deals, those valued at
over $1 billion, totaled only $28 billion worldwide. In 2006, that num
ber reached $502 billion, and in2007 private-equity firms puttogether
some $501 billion of such large deals—in just the first half of the year
alone. Between 2000 and 2007, a record 2,173 venture capital funds
raised approximately $272 billion. In 2008, the pace ofprivate-equity
investment slowed, as the availability ofcredit dried up and many firms
started realizing they had significantly overpaid in many of the large
deals of the prior two years. As with other industries, private equity
and venture capital go through times ofexpansion and contraction, at
which point the winners survive and the losers find other work.
There is general agreement, among private investors, economists,
and others, that the period from 2006 to 2007 was one of excess in
which some in the private-equity industry lost their way. That, too,
is another purpose of this book. The professionals profiled here, both
the private-equity and the venture capital investors, had built records
ofsuccess long before many oftheir peers paid toomuch money intoo
many deals during the latter years of this decade. They earned their
money and built their records of success through patient and intelligent
investing and a surprising knack for strategy and management that
has contributed greatly to their success. While even these high-caliber
investors were not immune from mistakes during the difficult phase
beginning in 2006, we are inclined to consider those errors against the
backdrop of the successful careers that preceded them, as well as the
adjustments these masters have made since credit dried up, making
transactions more difficult to close.
As the size ofprivate-equity and venture capital funds has grown, so
has their impact on the economy, particularly on the companies where
the funds invest their money. As private investment has matured and
become a style of investment and management in its own right, it has
had agrowing impact on how companies are run, who leads them, what
strategies they pursue, and how their assets are maximized. Along with
the investment capital they contribute, private-equity and venture capi
tal investors also bring resources ofexperience and insight to the table.
The private-investment professionals who have contributed agreat deal,
both in capital and in strategic expertise, clearly have much to share with
4 * THE MASTERS OF PRIVATE EQUITY AND VENTURE CAPITAL
people who want to understand how businesses succeed or fail. Choosing

to absorb what these successes or failures teach is akin to adopting men
tors for our own careers. In all aspects of life, including in our careers, we
are best off ifwe seek advice from the best brain trust we can find. The
selection of amentor is one of the most important decisions aperson can
make. It literally can be the first step in directing our own destiny. Our
parents influence us profoundly, but not by our choice. Our mentors, on
the other hand, we choose. Their ideas, their habits, their ethics, their
successes, their failures—we embrace the best of these winning qualities
because we want to emulate the people who embody them.
The voices that populate this book are the very best mentors
of an important part of our capitalist system: private investment.
(We will use the term to represent both private equity and venture
capital.) Individually and as a group, these pioneers of the trade have
built tremendous track records and helped to turn the private-equity
and venture capital businesses into major forces in our economy.
Admittedly, some private-investment professionals have paid too
much for companies they acquired, and others fairly can be accused
of using too much leverage and managing for short-term profit. But
the vast majority of private-equity investors have breathed new life
into countless companies that otherwise might have floundered in an
increasingly competitive global economy, starved for capital, orclosed
down altogether. The venture capitalists, meanwhile, have helped
make Silicon Valley a mecca of capitalism and helped entrepreneurs
everywhere realize their dreams and build new industries.
Fundamental Principals
Why do the lessons of private-equity professionals and venture capital
ists belong together? Because the guidance they share applies to all of
those participating in private enterprise, and their insights are useful
to anyone interested in learning more about the art of management.
Although they invest in different parts of the life cycle of business,
their role in the economy is much the same. Venture capitalists support
start-up and early-stage companies. Private-equity investors finance or
purchase more mature companies, middle-aged even, and give them
new leases on life. What they share is what they do: inject capital,
INTRODUCTION • 5
provide counsel and governance, devise and implement stock and com
pensation systems, help with strategy and tactics, and, in most cases,
prepare their companies for private or public sale.
Both venture capitalists and private-equity professionals invest pri
marily with money they raise in the form of investment partnerships.
With those funds in hand, they use the same disciplines: assessing hun
dreds of business plans orbuyout opportunities, weighing the arguments
for and against investing in companies, and peering into the hearts and
minds of the entrepreneurs or business people who need their backing.
When the risks are large, they often invest in syndicates, spreading the
risk—and the potential reward—among several firms. They charge fees
for managing their limited partners' capital and participate in their in
vestors' profits when they successfully exit their investments.
When venture capital and private-equity funds go to raise money,
they typically turn to pension funds, endowments, and wealthy fami
lies. There they compete against other so-called "alternative assets":
hedge funds, real estate, and ahost of commodities. These are distinc
tions with a huge difference. Even hedge funds, which seem similar to
private investment to many outsiders, bear little resemblance to private-
equity or venture investments.
The typical hedge fund manager spends much of the day paying rapt
attention to multiple plasma screens, closely monitoring the ups and
downs of the equity and derivatives markets. They trade actively, often
relying on rocket-scientist types, "quants," who run exotic financial
models. For at least a decade, the hedge fund model succeeded exceed
ingly well. Amuscular bull market in stocks and easy credit helped fuel
the growth of hedge funds, making them anearly $2 trillion business.
While the alternative asset pie grew as a whole, the hedge fund indus
try took an outsized share of that growth, and in some senses it posed
a competitive threat to private investment. Hedge funds competed for
deals, recruited the same junior talent, and sought backing from the
same limited partners. The financial troubles that began in 2007 intro
duced new troubles that many hedge funds were ill-equipped to handle.
The reverses in performance that resulted have caused havoc in the
hedge fund community. In January of 2008, well before the financial
markets broke down in late 2008, three-quarters ofall hedge funds re
ported losses, in large part due to the tightening of the easy credit that
funded much of their trading. The losses intensified after the collapse
ofthe Lehman Bros, investment firm in September of 2008, further
exposing the vulnerability ofhedge funds to the collapse ofcredit and
extreme market volatility.
Patient Capital
The conditions that have assailed hedge funds—tight credit, tough
stock markets, and economic uncertainty—have created challenges for
private-equity and venture funds, too. Yet, the approach ofthese funds
has proven out over amuch longer period of time, through numerous
investment cycles. Except for asmall number of high-profile mishaps,
private-investment funds have relied on their experience and savvy—
and their more patient investment mindset—to succeed in the face of a
credit crunch and unprecedented economic stress. Akey component of
their resilience is due in large part to the fact that their successes have
been built on their ability to promote sound management practices in
their portfolio companies, not just the latest investment fad or the mo
mentum of fast moving markets.
Hedge fund managers rely on their ability to time markets and gauge
changes in stock prices and the related derivatives markets to create com
petitive advantage. Private-investment professionals use similar analytical
skills, but to different effect. They use them to confirm hypotheses and as
sessments about how acompany might perform over along time frame. In
fact, many of the major sources of competitive advantage for the private-
investment asset class are qualitative in nature: picking the right companies,
mentoring their managements, measuring their performance, and driving
them toward success. Structuring deals requires the conceptual skills ofa
master negotiator, the sleuthing skills ofaprivate detective, and the steely
stomach ofarisk manager. Moving from deal to asuccessful long-term
investment requires patience, ahuman touch, strategic insight, and, ulti
mately, akeen assessment of acompany's market value and potential.
There are many styles of both venture capital and private-equity
investment. Some such investors try to get in at the earliest possible
stage, when risks and potential rewards are both extreme. Others prefer
more mature companies. Some move in and out, buying the distressed
INTRODUCTION • 7
shells of outmoded companies, stripping out what is valuable, and then

eventually turning over the streamlined company to new ownership.
Some focus on specific sectors. Some buy and hold, almost as if they
are investing on behalf of their grandchildren.
There is plenty to learn from each of these investment methods, but
this book is focused on the mainstream of success, the professionals
who on behalf of others in primarily private companies stay in their
investments for roughly five years. It is this group that represents the
core ofthe business and its most profound contribution to the capitalist
economy. This is the group that has the greatest impact on how com
panies are managed. They stay with their investments long enough to
have alasting effect, but also exit them speedily enough to move on and
spread their capital elsewhere, in effect pollinating the economy with
new energy and new ideas.
Hallmarks of Success
Regardless of technique or investment preference, all private investors
must be expert at selecting, nurturing, and assessing their CEOs and
other company management. It is company management that makes
the key decisions of setting strategy and budget, allocating capital, man
aging inventory, and recruiting, hiring, and firing employees. Whether
providing helpful guidance or actively coaching, the private investor
still remains onthe sidelines. The better the company performance, the
more passive the investor can afford to be.
The best private investors are walking sources of wisdom based
on broader experiences than most of the managers with whom they
work. They frequently do not have the industry knowledge orpossess
the operating talent needed to run their portfolio companies, but they
do have what few corporate CEOs can hope to have: knowledge
about patterns of success based on data points acquired from
up-close experience in dozens of companies and several industries.
The veteran venture or private-equity investor likely has sat on as
many as 30 boards—both successes and failures—and learned to
navigate through the many potential minefields that a manager must
traverse to create value in a private company. They also often draw
on informal networks of advisors, people who can add additional

operating and global perspective.
Ultimately, all ofthe attributes must add up to bottom-line returns.
Those who do succeed tend to share certain traits. They are those who,
while motivated by a desire for wealth, also value other aspects of the
trade. They enjoy coaching the entrepreneurs they choose to work with,
supporting innovation, encouraging enthusiasm, establishing good gov
ernance practices, and promoting an adherence to bottom-line disci
pline. This requires extensive investment, not just of money but also of
time and attention. Not only are the successful practitioners rewarded
handsomely for their efforts, but the marketplace also corrects for those
who do not behave this way. Private-investment managers who do not
deliver results will not attract or retain investment capital. This is avery
difficult business and, despite the casual caricatures of some business
press, it is no place for quick-hit artists.
In other words, the successful private investors are people who value
the sort of holistic approach to business that Doriot preached. They fig
ure out how to ask the right questions in the right order. They value
intellectual honesty and let the facts speak for themselves. They do not let
emotions cloud their decisions. Their ability to be self-critical, reflective,
and adaptive is the lifeblood of their livelihoods. They see companies not
as mere numbers on a balance sheet but as living entities that need sup
port andencouragement to survive. Sometimes, thedecisions aredifficult.
Other times, they are inspired. Not all companies can make it, and some
times it falls to theprivate-investment professional to decide whether the
company can survive: are the challenges temporary or final?
Both Failures and Success

Most people do not dwell on their mistakes. They prefer to think and
talk mainly about their greatest triumphs. However, the most success
ful few in any profession constantly examine and improve on their past
performances, both winners and losers. They know what worked, what
did not, and howto improve the nexttime around. Such isthe case with
the best private-equity and venture capital investors. The super success
ful, the masters of the business, succeed in large part because of their
ability to learn from both their triumphs and disasters. They remain
INTRODUCTION • 9
students oftheir own histories and humble about what thefuture could
bring—remarkable success or devastating failure.
There are two ways to benchmark: from success and from failure.
This book will use both. Uncommon success is rarer than failure. It is
remarkably difficult to achieve. That's why itis important to learn from
the successes profiled here, especially ifwe can distill from them what
made the difference and what made their decisions right. We fail to
learn from our many mistakes at our peril, sothemissed opportunities
shared by these pioneers of the profession are important lessons, too.
Taken together, these lessons offer powerful insights into the science
and art of managing toward success.
Like any industry where ittakes many years oflistening and learning
to come up to speed, private investment has evolved as a classic master-
apprentice business. It takes a long time to learn enough that one can
responsibly invest someone else's money. Ithelps to experience the life
cycles of many different companies in a variety ofeconomic environ
ments. Living through a failure and its consequences on people's lives is
sobering. Ifwe had all the time in the world, we could afford repeated
mistakes, but we do not have that luxury. The clock that measures
return on investment never stops ticking, not just for investors but also
for managers, their employees, and anyone who is trying to achieve.
Those who can evolve and adapt most quickly win.
What is it like to work in the business? The investment process re
quires a certain bifocal view: the need to work on long-term projects
that require great patience yet acting, when necessary, with great im
patience and urgency. Private investors have to enjoy both the process
ofinvesting and the hard work ofadding value. As the job description
entails very little instant gratification, I sometimes refer to the long-
term horizon of our business as similar to listening to a Yiddish joke:
Because the verb does not arrive until the end, you do not know until
then whether it was worth waiting for.
The patience required to create atrack record of success should weed
out the sort ofperson who likes tomeasure accomplishment from day to
day orweek toweek. Whenever advising people who are contemplating
entering the business, I try my best toapprise them ofhow long it takes
tocome up to speed and be meaningfully successful. When it does not go
well, one is fighting a multiple-front war with lenders, other stakeholders
10 • the masters of private Equity and Venture Capital
and co-investors, management, and vendors. When itdoes go well, the

satisfaction of being part of building something is real and lasting.
Gems from the Pros

The inspiration for this book arose out of a series of panels I helped
arrange as a co-founder of the Illinois Venture Capital Association.
Dubbed "VC Confidential," the series was designed topass the secrets
of our trade from elder statesmen to junior professionals in the busi
ness. The discussions were as fascinating to the senior people in our
audiences as tothe novices. Listening to the pioneers ofour profession
was like reading an inspiring book for the first time, but because we
made no record of the remarks those words were lost to history.
With this book, gems from a carefully selected group of veterans
have now been written down. In assembling this book, I have turned
to some of the most important pioneers of private investment. Some
names will be recognizable to any regular reader ofthe business press.
Others are virtual unknowns to the general public—though quietly leg
endary among investors who have placed billions of dollars at their dis
posal. What our masters have in common is that they all are founding
partners and professionals who, while having an eye for a bargain, also
know how to help create wealth where they put their money.
Few have ever memorialized their credos, missions, lessons, ortenets
to share with their own partners, much less anyone else. Now that the
private-investor business has become an industry and a major source
of jobs in this country, it is time to place this wealth of wisdom in the
public domain. This way, everyone can learn at the pens of some of
the most successful investors and advisors of our time. We have taken
an added step, in an appendix to the chapters, to elicit actual tools
of the trade from the masters: valuation spreadsheets, risk analyses,
personnel evaluations, portfolio appraisals, and other mechanisms by
which these experts practice their craft.
These are private people—not just by trade, but typically by per
sonality, too. They are more comfortable advising behind the scenes.
Although they may view themselves mainly as investors, experience
has taught them a great deal about management theory, too. They got
into the business to learn and to profit, not to teach, but they wound
INTRODUCTION • 11
up doing all three. For most, the exercise ofmemorializing these ideas
was a rare opportunity for them to proactively organize their think
ing about their methods and to share wisdom they had gathered in a
career's worth of experience.
When John Canning shares with us that managing a partnership
means having to be fair, it really means that in order to manage a
high-performing partnership one has to share the firm's economic pie,
in a sense overpaying the up and comers in order to retain and groom
them. When Joe Rice informs us that his firm views companies from
an operating perspective, it is interesting to note that his firm is one of
the very few that splits the firm's share of investment returns evenly
between deal makers and operating partners. From Jeff Walker, we
learn that measuring metrics—whether tracking revenue per employee
for an operating company or tracking the number of mosquito nets
deployed per week for an African charity—are the grist of managing
from the board level. Carl Thoma emphasizes the importance of impa
tience, and Warren Hellman shows how a private-equity investor can
bring new strategic vision thatcan improve the fortunes ofcompanies,
particularly in our post-industrial economy.
The venture capitalists in these pages educate us, as Pitch Johnson
and Bill Draper do, with intriguing stories about the origins of the
industry that tell us a great deal about the vision and risk-tolerance
required to be a successful long-term investor. Patricia Cloherty shares
how she maintains discipline andachieves success in the hurly-burly of
Russia's fast-changing economy. Dick Kramlich explains how a mega-
fund still manages to focus on the details of performance in the many
companies in its portfolio, and Steve Lazarus explores the nuances of
taking breakthrough technologies out of university laboratories and
bringing them to market.
Management Metrics
These are the lessons as the masters have learned them. I have asked
each of these teachers to focus on a different aspect of the trade,
but with a strong emphasis on how their efforts help to improve
management in the companies in their portfolios. The private-equity
pioneers have particular expertise in improving the performance of
existing companies—from corporate orphans to carve-outs to merged

entities. The venture capitalists, meanwhile, are expert at identifying
and nurturing entrepreneurial genius. This involves selecting novel
ideas that will succeed in creating new businesses in a fast-changing,
highly competitive world. It also requires an ability to help visionary
entrepreneurs become successful managers, identify the right advisors
to help buildsuccessful strategies, and decide whena business is mature
enough to seek newinfusions of capital.
Cross-pollination of ideas among the masters ofprivate equity and
venture capital can shed new understanding on the requirements for
success in the field ofprivate investment. It also is an effective way to
transmit some ofthe most piercing insights about management theory
and technique to a broad audience ofreaders. Yet, somehow, even after
exploring these ideas with the masters, I still felt the need for a frame
work in which to view and digest their information. Powerful as the
lessons are, they require context, a sense ofconnection tothe history of
private investment and the broader world of business.
To explore the unique qualities of private investment from an in
dependent perspective, we turn to academia, to two key leaders in the
growing field ofentrepreneurial studies. Steve Kaplan ofthe University
ofChicago Booth School ofBusiness explains the role that private equity
plays inthe economy and the impact itcan have onenterprises thatseek
toexpand orrefinance. Garth Saloner, the dean ofStanford University's
Graduate School ofBusiness, discusses the role that venture capital has
played in supporting invention and growing start-up enterprises, while
also sharing his insights on the inevitable tensions between entrepre
neurs and the venture investors who help them pursue their dreams.
On the surface, my career would seem to have a fairly simple ob
jective: to make money for my firm's investors, my partners, and my
self. Yet, the richest personal rewards—and the ones that make the
more commercial objectives achievable—are those I gain from activities
such as encouraging innovation, finding economic ways for companies
to operate, and mentoring business leaders to pursue their own desti
nies. As a mid-career professional, one striving to take my own firm
to a higher level, I feel a renewed passion to learn best practices and
document the experience and insights of the leading colleagues in the
realm ofprivate investment. The first step toward greatness is striving
Introduction * 13
to achieve it, and one can take that step by listening to and learning
from the greats. With this book, I amseeking to expand myowninter
est intheir accomplishments and channel it,inwritten form, into a kind
of virtual classroom, one open to public viewing.
The Social Impact of Private Capital

For the purposes of society, private investment plays a simple but es
sential role in the process of capital allocation. Private investors have
to make tough decisions about what companies and ideas to endorse.
Imagine ifthe task were not done well. Millions ofdollars would be mis-
allocated, withpotentially dire results. It happened in the late 1990s, at
the height of the dot-com bubble, when many in the private-investment
business literally flushed billions down the drain, a very unproductive
use of resources. It has happened again to some who paid too much
for companies in the private-equity buyout frenzy of 2006 and 2007.
The extremely low average returns for funds of these periods reflected
the impact of the many fund managers who fell prey to the irrational
exuberance of the times. Aftersuch periods of excess, it can take years
for private-investment managers to rebuild their credibility.
Although those in the private-equity industry are at times vilified
and at others lionized, after a period in which some lost their way—in
very high-profile ways—I feel it may be helpful to put forward this
book as a means of reconnecting with the foundational philosophies
and techniques that can help make private investment a positive force
in our economy and our society. The originals in this industry, the true
masters, were attracted to it before there was a hint of the unthinkable
success that was to come their way. Wecan both modelourselves after
their achievements and use their ideas to blaze new paths. Harkening
back to our industry roots grounds us, and can be good therapy. For
the general business reader, seeking new foundations after theeconomic
breakdown that started in late 2008, the management and investment
insights from these masters can help lead the way first to survival and
ultimately to success.
It would be naive, and inaccurate, to characterize even the most
successful private-investment partnerships as purely altruistic or com
munity oriented. What can be said is that, in the pursuit of profit, they
create opportunities and allocate capital in ways that benefit society.

They identify good managers, support them, and help elevate their
performance. They add real value. The strengths of the many who re
sponsibly and successfully practice this form of investment overshadow
the shortcomings of a few. The most successful leaders among them,
the pioneers who first showed the way, havelearned to make a mistake
only once, and to repeat their successes, again and again, ever more
quickly and on an ever-grander scale.
When an industry springs to prominence as suddenly as private in
vestment has, it helps to take a measure of the early results. Why do
they behave as they do? Who benefits? What are their core values?
Perhaps the newest generation of private-investment professionals is
attractedto the trade byheadlines boasting about instant wealth. Their
elders, though, had no such inducement. When they were starting out,
big funds were measured in the tens of millions, not in the billions,
as happens today. For them, a career in private investment promised
mainly hard work, learning the tempo of business cycles, finessing the
intricate worldof business relationships, and introducing their niche to
institutional investors.
In other words, they operated as Doriot had, according to a credo
that saw companies as living entities, one that prized innovation, in
stinctively nurtured effective managers, and valued ethical standards.
As private investors, they acted within the context of partnerships that
also lived and breathed with a culture and a soul. They recognized,
as Doriot did, that they and their portfolio companies were "some
thing very much alive which falls or breaks up unless constantly pushed
ahead or improved."
The pioneers of private investment took it upon themselves to push
ahead,and to helpcompanies improve. Society is the betterfor it. These
masters, who share their experiences in this book, embody some of the
best tenets of the profession of private investment. It is not just their
financial success we admireand respect; it is also their wealth of knowl
edge, theways in which they have acquired it, andhowthat knowledge
can help others.
PARTI
PMVATE EQUITY
METHOD OVER MAGIC:
THE DRIVERS BEHIND
PRIVATE-EQUITY
PERFORMANCE
Steven N. Kaplan
Neubauer Family Professor of Entrepreneurship and Finance
University of Chicago Booth Schoolof Business
More than two decades of research and writing have established

Steve Kaplan as a thought leader on the role of private equity in the
economy and society. Tracking the industry through economic cycles,
Kaplan identifies methods and tools that private-equity investors use to
consistently improve performance. Kaplan also debunks the notion that
private-equity investment leads tooutsized layoffs atportfolio companies,
and finds no evidence to support contentions that private-equity firms
benefit from access to privileged information when making investment
decisions.
The strong track record of private-equity firms, Kaplan finds, results
from a combination of techniques. They use equity compensation and
leverage to align management with efforts to increase efficiencies. They
make changes in firm governance that lead to better oversight and deci
sions. Finally, private-equity firms increasingly bring industry and oper
ating experience to help improve their companies.
© 17 •
The investment firms that we once called "leveraged-buyout firms"

today are called "private-equity firms," butthe rebranding has not
changed the basics of what these firms do. They use modest doses of
their own investment capital, backed by outside debt, to buy companies
and attempt to improve their performance. Proponents of leveraged
buyouts argue that private-equity firms improve the operations of the
companies they buy and create economic value by applying financial,
governance, and operational engineering to their portfolio companies.
Others argue quite the opposite. Private-equity firms, these people
say, take advantage of tax breaks and superior information but do
not create any operational value. Moreover, critics sometimes argue
that private-equity activity relies on market timing—and market
mispricing—between debt and equity markets.
I largely agree with the private-equity proponents. Overall,
private-equity firms create economic value by improving manage
ment incentives, providing better governance oversight, and, increas
ingly, providing advice on cost cuts or strategic improvements. This
sort of operational engineering—the use of management techniques
and tactics to enhance firm performance—is a thematic focus of this
book. The empirical evidence from academic research leads to the
clear conclusion that these changes lead to operating improvements
and add value, on average. That said, it also appears to be the case
that market timing matters and in some instances leads to negative
results. From time to time, in the late 1980s and most recently from
2005 to 2007, plentiful availability of very aggressive debt financ
ing allows private-equity investors to finance large public-to-private
buyouts. And the record on those transactions, particularly post-
1980s, is mixed.
The stereotype of the private-equity investor as a mercurial task
master prone to squeezing out costs, firing management, and flipping
companies is at least in part a legacy of the frenzied leveraged-buyout
boom of the 1980s. Leveraged-buyout activity mushroomed in that
decade and culminated with the $25 billion buyout of RJR Nabisco in
early 1989. Shortlythereafter, the junk bond market crashed. A number
of high-profile leveraged buyouts resulted in default and bankruptcy,
and leveraged buyouts of public companies—taking them private—
virtually disappeared by the early 1990s.
METHOD OVER MAGIC • 19
While leveraged buyouts of public companies were relatively scarce

in the 1990s and early 2000s, private-equity firms continued to buy
private companies and divisions. In the mid-2000s, public-to-private
deals reappeared when the United States led the world's rediscovery of
a second private-equity boom. Then, in 2006 and 2007, pension funds,
university endowments, and other institutional investors were among
those who committed a record amount of capital to private equity, both
in nominal terms and as a fraction of the overall stock market. Private-
equity commitments and transactions rivaled, and in some respects
overtook, the activity of the first wave in the late 1980s; however, in
2008, with the turmoil in the debt markets, private-equity transactions
declined markedly again as they had in the late 1980s.
The Rising Tide of Private Equity

We can track the ebb and flow in the popularity of private equity by
measuring the amount of capital committed to private-equity funds
over the years. Nominal dollars committed each year to U.S. private-
equity funds have increased exponentially since private equity achieved
its first bigwave of growth during the 1980s. In a quarter century, the
scale of commitments to privateequitygrew from $0.2 billion in 1980
to over $200 billion in 2007, meaning commitments that year were a
thousand times greater than the total in 1980.
Given the large increase in the market value of firms overthis period,
it is appropriate to measure committed capital as a percentage of the
total value of the U.S. stock market. The data suggest that private-
equity commitments are cyclical, tracking in part the ups and downs in
the way the investment sectors performed. Commitments increased in
the 1980s, peaked in 1988, declined in the early 1990s, and increased
through the late 1990s. They peaked in 1998, declined again in the
early 2000s, and then began climbing in 2003. By 2006 and 2007,
private-equity commitments appeared extremely high by historical
standards, exceeding 1% of the value of the U.S. stock market. Per
haps not merely by coincidence, many large private-equity buyouts oc
curred during those two years, and an inordinatenumber of those deals
seemed to run into financial trouble in fairly short order.
20 • The Masters of Private Equity and Venture Capital
One caveat to this observation is that manyof the large U.S. private-
equity firms have only recently become global in scope. Foreign invest
ments byU.S. private-equity firms were much smaller 20 years ago, so
the comparisons are not exactly apples to apples. Even so, the trends
are clear, and, if the past record is any indication, the recent poor re
sults of private-equity funds that began to be reported in 2008 seem
likely to affect investor commitments to private-equity funds, which
likely will find it difficult to raise new capital, at least until investment
returns begin to improve.
The Levers of Performance

While commitmentsto private-equity firms have ebbed and flowed over
the years, the improvement in operating results of companies boughtby
private-equity firms has been consistent across time and geographies.
Private-equity firms improvefirm performance, and maximize their in
vestment returns, by engineering changes to the financial, governance,
and operational aspects of the companies they buy. Private-equity in
vestors also appear to take advantage of market timing—and market
mispricing—between debt and equity markets, particularly when they
take publicly owned companies private.
Equity participation by management is a key tool affecting perfor
mance. Private-equity firms typically give the management teams of
portfolio companies a large equity upside through stock and options—a
practice that was unusual among public firms in the early 1980s.
Private-equity firms typically also require management to make a
meaningful investment in the company. This is designed to align man
agement with the private-equity investors to give management not
only a significant upside but a significant downside as well. Moreover,
because the companies are private, management's equity is illiquid—
that is, management cannot sell its equity or exercise its options until
the value is proved by an exit transaction. Thisilliquidity reduces man
agement's incentive to manipulate short-term performance.
To illustrate the continued importance of equity stakes, my colleague
Per Stromberg and I collected information on 43 leveraged buyoutsin the
United States from 1996 to 2004 with a median transaction value of over
$300 million. In a little more than half of these deals, the private-equity
firmwas takinga public company private. After the deals closed, manage
mentownership wassubstantial. Thechief executive officer received 5.4%
of the equity upside—both in stock and options—while the management
team as a whole got 16%. These magnitudes have not changed much
since I first studied them in the 1980s. Even though stock- and option-
based compensation has become more widely used in public firms since
the 1980s, management's ownership percentages—and management's
upside—remain greater in leveraged buyouts than in public companies.
The second key ingredient is leverage, the borrowing that is done in
connection with the transaction. Leverage creates pressure on manag
ers not to waste money, because they must make interest and principal
payments. In the United States, and in many other countries, leverage
also potentially increases firm value through the tax deductibility of
interest. On the flip side, if leverage is too high, the inflexibility of
the required payments increases the chance of costly financial distress.
This contrasts with the flexibility of payments on equity: Dividends and
the like can be reduced or eliminated as market conditions change.
Because the very inflexibility of leverage is itself a motivating factor,
private-equity firms in a sense impose discipline on their firms' manag
ers by virtue of the fact that they impose higher levels of debt on the
companies they acquire.
A third technique, what I callgovernance engineerings refers to the
greater involvement of private-equity investors in the governance of
their portfolio companies compared to the directors of public compa
nies. Private-equity portfolio company boards are smaller than com
parable public company boards and meet more frequently, around
12 formal meetingsper year and many more informal contacts. We can
infer, too, that the pressure on management increases because private-
equity firms have established a willingness to replace poorly performing
managers. Viral Acharya and Conor Kehoe report that one-third of
chief executive officers of these firms are replaced in the first 100 days,
while two-thirds are replaced at some point over a four-year period.
Financial and governance engineering were common by the late 1980s
and have remained as common features of private-equity portfolio
companies ever since.
Today, most large private-equity firms have added another type of
activity that we call operational engineering. This refers to industry and
operating expertise that they apply to add value to their investments,

and this book seeks to redress the relative lack of attention that this
particular aspect of private-equityinvestmenthas received. Indeed, most
top private-equity firms are now organized around industries. In addi
tion to hiring dealmakers withfinancial engineering skills, private-equity
firms now often hire professionals with operating backgrounds and an
industry focus. For example, Lou Gerstner, the former chief executive
officer of RJRNabisco and IBM, was affiliated withThe Carlyle Group,
while Jack Welch, the former chief executive officer of General Electric,
is affiliated with Clayton, Dubilier &c Rice. Mosttop private-equity firms
also make use of internal or external consulting groups.
Private-equity firms use their industry and operating knowledge
to identify attractive investments, to develop value creation plans for
those investments, and to implement the value creation plans. A plan
might include elements of cost-cutting opportunities and productivity
improvements, strategic changes or repositioning, and acquisition op
portunities, as well as management changes and upgrades. The oper
ating partners of these firms can enhance the implementation of such
plans by sharing their real-world experience with portfolio company
management, offering unique perspectives that aid in the execution of
plans and help to enhance results.
Impact on Cash Flow

As far back as the 1980s, when I first studied the impact of private
equity on the operating performance of companies, I found that the
operating performance of companies improved after they were pur
chased through leveraged buyouts. For U.S. public-to-private deals in
the 1980s, the ratio of operating income to sales increased by 10 to
20%, both in absolute terms and relative to industry peers. The ratio of
cash flow (operating incomelesscapital expenditures) to sales increased
by roughly 40% among public companies acquired and taken private
by private-equity firms. The ratio of capital expenditures to sales de
clined. These changes coincide with large increases in firm value, again
both in absolute terms and relative to industry peers.
Most post-1980s empirical work on private equity and leverage
buyouts has focused on buyouts in Europe, largely because of data
method over Magic <> 23
availability. Consistent with U.S. results during the 1980s, this work
finds that leveraged buyouts are associated with significant operating
and productivity improvements in the United Kingdom, in France,
and in Sweden. In a 2007 paper, the economists Douglas Cumming,
Don Siegel, and Mike Wright summarized the research in the United
States and Europe and concluded that there "is a general consensus
across different methodologies, measures, and time periods regarding a
key stylized fact: LBOs, and especially management buyouts, enhance
performance and have a salient effect on work practices."
There has been one exception to the largely uniform positive operat
ing results: more recent public-to-private deals. In a study looking at
U.S. public-to-private transactions completed from 1990 to 2006, Edie
Hotchkiss and colleagues found modest increases in operating and cash
flow margins—smaller increases, in fact, than those found in the 1980s,
both in the United States and Europe. At the same time, Hotchkiss found
highinvestor returns at the portfolio company level. Acharya and Kehoe
found similar results for public-to-private deals in the United Kingdom.
These results suggest that post-1980s public-to-private transactions may
differ from those of the 1980s and from leveraged buyouts overall.
Impact on Jobs
Critics of leveraged buyouts often argue that these transactions benefit
private-equity investors at the expense of employees, who suffer job
and wage cuts. Such reductions would be consistent—and, arguably,
expected—with the productivity and operating improvements that
private-equity firms' portfolio companies achieve. Even so, the political
implications of economicgains achieved in this manner would be more
negative. For example, the Service Employees International Union, in
a 2007 report, questioned the effects of private equity on both job
destruction and the quality of those jobs.
Whatever the reputation of private-equity firms as job cutters, the
actual employment track record at companies purchased by private-
equity firms differs from the slash-and-burn stereotype in the popular
press. When I studied U.S. public-to-private buyouts in the 1980s,
I found actual employment increases post-buyout, though they were less
than for other firms in the same industry. Steve Davis and coauthors, in
subsequent research that examined data through 2005, found similar

results: employment at leveraged-buyout firms increased, but at a slower
rate than at other firms in the same industry during the same time
period. Davis' research also found, meanwhile, that firms purchased in
leveraged buyouts also experienced smaller employment growth in the
time period prior to the buyout transaction. The relative employment
declines were concentrated in retail businesses, and there actually was
little difference in employment in the manufacturing sector. In new
establishments, employment in companies owned by private-equity
firms actually increased at a faster pace than in those controlled by
non-buyout firms.
Overall,then, the evidence suggests that employment grows at firms
that experience leveraged buyouts, but at a slower rate than at other
similar firms. These findings are not consistentwith concerns over job
destruction, but neither are they consistent with the opposite posi
tion that firms owned by private industry experience especially strong
employment growth. I view the empirical evidence on employment as
largely consistent with a view that private-equity portfolio companies
create economic value by operating more efficiently. As a group, com
paniescontrolled by private-equity firms do not cut jobs willy-nilly, but
neither are they likely to add unusually to payrolls, even as business
grows, because of their emphasis on bottom-line efficiency.
The Crystal Ball Myth

Another persistent myth about private-equity firms is the idea that these
investors as a group acquire superior information on the future per
formance of companies that may become part of their portfolios, as if,
somehow, their investment techniques are tantamount to a crystal ball
for corporate performance. While operating improvements and value
creation consistently occur after a private-equity investment, the data
do not support an argument that these investors have discovered an
ability to develop superior information on target companies prior to
making them part of their investment portfolios.
Critics of private equity often assign a sinister explanation to
the supposition that private-equity investors develop superior infor
mation. Some claim that incumbent management is a source of this
method over Magic • 25
inside information. To some extent, supporters of private equity im

plicitly agree that incumbent management has information on how
to make a firm perform better. After all, one of the justifications for
private-equity deals is that, with better incentives and closer moni
toring, managers will use their knowledge to deliver better results.
A less attractive claim, however, is that incumbent managers favor
a private-equity buyout because they intend to keep their jobs and
receive lucrative compensation under the new owners. As a result,
incumbent managers may be unwilling to fight for the highest price
for existing shareholders, a tendency that, if true, would give private-
equity investors a better deal.
Several observations suggest that it is unlikely that operating im
provements are simply a result ofprivate-equity firms taking advantage
of private information. When I studied this issue in the late 1980s,
I compared the forecasts the private-equity firms released publicly at
the timeof the leveraged buyouts with their actual performance results.
The asymmetric information story suggests that actual performance
should exceed the forecasts. In fact, actual performance after the buy
out lagged the forecasts. Moreover, when Elie Ofek studied leveraged-
buyout attempts that failed because the offer was rejected by the board
or bystockholders, even though management supported it, he found no
excess stock returns or operating improvements for these firms.
The argument that management has strong incentives to manipu
late the release of operating information is belied by the simple fact
that these managers are well aware that private-equity firms frequently
bringin newmanagement. Because incumbent managers cannot be sure
they will be in a position to receive high-powered incentives from the
new private-equity owners, they would have less incentive to distort
how information about target companies is released.
A third factor that belies the truism about private-equity investors'
supposedly greater insight into the future performance of targetfirms is
the fact that, at boom times in the boom-and-bust cycle, private-equity
firms have overpaid in their leveraged buyouts and experienced losses.
For example, the late 1980s were one such time, and it seems likely
that the recent private-equity boom will generate lower returns than
investors expected, as well. If incumbent managers provided inside
information, it clearly was not enough to help private-equity firms
26 • The Masters of Private equity and Venture Capital
avoid periods of poor returns by lowering the offering prices for their
purchases. In fact, in these periods, the private-equity investors did
the selling companies a huge favor by buying at what turned out to be
high prices.
The Negotiation Advantage

While the research does not support an argument that operating im
provements result from asymmetric access to information, there is
some evidence that strong negotiating skills help private-equity funds
to acquire firms more cheaply than other bidders. A series of studies
on post-1980s buyouts found only modest increases in firm operating
performance, yet those same companies still generate large financial
returns to private-equity funds. This suggests that private-equity firms
are able to buy low and sell high. This finding is consistent with a
notion that private-equity firms identify companies or industries that
turn out to be undervalued, as proven by subsequent valuations of the
companies in question. Even so, it is difficult to pin down exactly what
accounts for such differences. Perhaps private-equity firms are particu
larlygood negotiators. Or, perhaps target boards and management do
not get the best possible price.
The results are consistent with private-equity investors bargaining
well, target boards bargaining badly, or private-equity investors taking
advantage of market timing and perhaps market mispricing.
In the end, the empirical evidence suggests that leveraged buyouts
by private-equity firms create value, quite apart from any negotiating
advantages or the vicissitudes of marketing timing. Whatever the
reasons for their success, it appears that private-equity firms are not
particularly generous when it comes time to share the fruit of their labors
with their limited partner investors. First, because private-equity firms
often purchase firms in competitive auctions or by paying a premium
to public shareholders, sellers likely capture a meaningful amount
of value, particularly in boom periods. For example, when Kohlberg
Kravis Roberts &c Co. purchased RJR Nabisco, KKR paid a premium
to public shareholders of roughly $10 billion. After the buyout, KKR's
investors earned a low return, suggesting that KKR paid out most, if
not all, of the additional value to RJR's public shareholders.
Method over Magic • 27
Investment returns to the limited partner investors in private-equity

funds are reduced by the simple fact that limited partners pay meaning
ful fees to their general partners who operate the private-equity firms.
This implies that the return to outside investors, net of fees, will be
lower than the return on the private-equity fund's underlying invest
ments. In this, theyare no different from investors in mutual funds who
pay substantial fees but do not outperform the stock market.
When Antoinette Shoar and I studied the data in 2005, we found
that limited-partner investors in private-equity funds earn slightly less
than the Standard St Poor's 500 index, net of fees, ending with an
average ratio of 93% to 97%. On average, therefore, we did not
find the outperformance often given as a justification for investing in
private-equity funds. At the same time, however, these results imply
that the private-equity investors outperform the Standard & Poor's
500 index when their fees are added back. Those returns seem to
indicate that private-equity investors actually do add value over and
above any premium paid to selling shareholders—though the limited
partners in their funds are not necessarily beneficiaries of this higher
level of performance.
Not only do private-equity firms obtain above-market returns on
average, but the good ones have also consistently done so. Histori
cally, the performance by a private-equity firm in one fund predicts
performance by the firm in subsequent funds. In fact, their results likely
understate historical persistence because the worst performing funds
are less likely to raise a subsequent fund. In contrast, mutual funds
and hedge funds show little or no persistence. This persistence result
explains why limited partners often strive to invest in private-equity
funds that have been among the top performers in the past. Of course,
only some limited partners can succeed in such a strategy.
Some Speculations
Overall, then, the empirical evidence is strong that private-equity ac
tivity creates economic value on average. The increased investment by
private-equity firms in operational engineering should ensure that this
continues to hold in the future. Because private equity creates economic
value, private-equity activity has a substantial permanent component.
The evidence, however, also is strong that private-equity activity is

subject to boom andbust cycles, driven by recent returns aswell as bythe
level of interest rates relative to earnings and stock market values. This
pattern seems particularlytrue for largerpublic-to-private transactions—
thesortoftransactions that typified therecent boom period that began in
2005 and wound down as leverage became scarcer in 2007.
So, what will happen in the near future? Is the private-equity explo
sion temporary or permanent?
Given that the unprecedented boom of 2005 to 2007 has ended, and
as a result of the economic crisis that began at about that time, it is
virtuallycertain that there will be a decline in private-equity investment
and fundraising in the next severalyears. Consistent with the historical
boom-and-bust pattern, the ultimate returns to private-equity funds
raised during the recent boom are likely to prove disappointing.
Firms are unlikely to be able to exit the deals from this period at
valuations as high as the private-equity firms paid to buy the compa
nies. It also is likelythat some of the transactions undertaken during the
boom, particularly the larger deals, were driven less by the potential of
operating and governance improvements and more by the availability
of debt financing, which also implies that the returns on these deals will
be disappointing.
This also suggests that performance will turn out to be less persistent
than in the past. That is because the private-equity firmsthat becamevery
large and did the large deals (that are likely to perform poorly) tended to
be the better performing private-equity firms in earlierperiods.
At the same time, limited partner commitmentsto private equity will
decline for three reasons. First, the decline in the stock market and other
assets necessarilyreduces the amount of money limited partners have to
invest. Second, limited partners are likely to respond to the poor per
formance of the private-equity firms and shy away from making new
commitments. And, third, some limited partners, now having first-hand
experience with the costs of illiquidity in private-equity investments,
will want to reduce the illiquidity of their overall portfolios. It seems
inevitable, therefore, that the private-equity industry will contract.
That said, a significant part of the growth in private-equity activ
ity and institutions is likely to be permanent. First, the less fragile deal
structures (higher coverage ratios and looser covenants) of 2005 to 2007
relative to those in the first wave give private-equity investors more flex
ibility to rideout the current downturn. Second, private-equity investors
have expanded their operational engineering capabilities. This may help
their companies through the current downturn. Third, unlike the hedge
funds and investment banks, the long-term duration of private-equity
firm capital matches the long-term duration of private-equity firm as
sets, making private equity less subject to bank runs or redemptions.
Finally, unlike hedge funds whose returns are compared to Treasury
bills or absolute returns, private-equity investors benchmark returns
relative to public equity returns. Hedge funds failed relative to their
benchmark in 2008 whenthey declined bymorethan 20%. With public
equities declining on the order of 40% in 2008, private-equity funds
have a much better chance of outperforming such benchmarks.
Future of Private Equity

To modify Mark Twain's famous quip, the reports of the death of pri
vate equity are exaggerated. Although the private-equity industry will
not be as large as it was as its 2007 peak, five years from now I fully
expectprivate equityto havesurvived and prospered. The core private-
equity firm skillsof financial, governance, and operating engineering—
the sorts of techniques described by the pioneers of private equity who
share their experiences in these pages—are real and create real value.
Private-equity firms will retain if not improve those skills through the
current recession and financial crisis. At some point, financial markets
will thaw, and we likelywill return to a more normal or stable private-
equityindustry, one that adds value to portfoliocompanies and creates
value for investors.
OPERATING PROFITS: USING
AN OPERATING PERSPECTIVE
TO ACHIEVE SUCCESS
Joseph L. Rice m
Founder and Chairman
AUM: $10 billion Years in PE: More than 40
Location: New York, NY Year born: 1932
Grew up: Katonah, NY Location born: Brooklyn, NY
Best known deals: Uniroyal Goodrich, Scotts, Hertz, SallyBeauty, U.S.

Foodservice, Lexmark, Alliant, Brakes Bros., VWR,Kinko's, and Jafra
Cosmetics.
Style: Understated, direct, intellectuallygenerous

Education: B.A., Williams College, Class of 1954
J.D., Harvard Law School, Classof 1960
Significant experience: Has spent most of business career in the buyout
business
Personal interests: Family, education, tennis
The lesson: "Nothing in the world can take the place of persistence."
© 31 o
32 • THE MASTERS OF PRIVATE EQUITY ANDVENTURE CAPITAL
Today, many private-equity firms extol the importance of "operating

perspective," but Joe Rice and his firm, Clayton, Dubilier & Rice, were
first to make that a point of focus. Today, the firm is recognized as
the pioneer ofcombining operational and financial skills to improve the
performance ofportfolio companies. CD&R's unique staffing model has
permitted the firm to take the operational private-equity investment model
to high levels ofachievement. CD&R's deep bench ofproven corporate
leaders—most of them former chief executives of major multinational
companies—often take active roles in managing portfolio companies with
aneye toward improving execution and resetting strategy. After General
Electric chiefexecutive Jack Welch retired in 2001, Rice recruited him to
join the firm as a special partner, sharing his unique passion and vision
across thefirm's portfolio of companies.
Rice believes operating perspective is one of the essential elements that
helped his firm achieve everything from the unprecedented carve-out of
IBM's printing business to the purchase of Hertz from Ford Motor Co.
The result has been one ofthe best long-term performance records in pri
vate equity. Over the years, Clayton, Dubilier & Rice has, on occasion,
directed its operating expertise inward to improve its internal processes
and address issues that had created challenges for the firm. AsRice notes:
"You can't be in the corporate transformation business without a willing
ness to transform yourself."
Every successful private-equity firm excels in at least one partic

ular aspect of the trade. Some are superb financial engineers,
some specialize in turnarounds, and some focus on certain kinds of
industries. Clayton, Dubilier & Rice is unique because it combines
in a single organization both an operating capability and a financial
capability. The firm pursues an "industrialist" approach to the buy
out business.
An operating capability has been the essence of our firm from the
very beginning. Three of our firm's four founding partners—Martin
Dubilier, Gene Clayton, and Bill Welch—had extensive operating ex
perience before they got involved in buyouts. My own father was the
chief executive of Allegheny Power Company, and I suppose I picked
up some insights into howcompanies operate from him. From our very
OPERATING PROFITS • 33
first major deal, the $250 million spinoff of the graphics division of
Harris Corporation in 1983 that at the time was the largest ever buy
out divestiture, we applied an operating perspective to achieve success.
When we owned the Uniroyal Tire Company in the mid-1980s, one of
our partners ran the business after we merged it with B.F. Goodrich.
Afew years later, our operating perspective helped us emerge as the
chosen company to orchestrate the carve-out of Lexmark International
from IBM. That investment was truly a landmark for the industry and
became one of our firm's signature transactions.
The list goes on, but the lesson never gets old. Operating experi
ence can project an investment, and an investment firm, into the upper
reaches of success. I thought I knew this as well as anyone. After all,
I have been in the deal business for nearly half a century now. But the
lesson was brought home tome in a new way at our firm's 2008 annual
strategy meeting by Jack Welch, a special partner ofthe firm.
It isfair to say that almost any partnership holding a strategy session
in September of 2008 would have approached the event with a certain
amount of dread. Transparency had reached all-time lows. Lehman
Brothers, the venerable Wall Street firm, had failed. The U.S. govern
ment had been forced to bail out American International Group, AIG,
the insurance giant; orchestrate giant banking mergers; and infuse some
of the world's biggest banks with billions of dollars. The securitiza
tion of financial risk—collateralized debt obligations, mortgage-backed
securities, and other now-infamous instruments—was coming under
intense public and congressional scrutiny. The U.S. economy and much
of the world economy seemed to be verging on a free fall toward an
economic breakdown worse than any in our lifetime.
As our strategy meeting opened, several of the management teams
of our portfolio companies were scrambling to prepare for quarterly
operating reviews scheduled for the next week with the firm's operat
ing partners. Word had gone out that this was a time to be cautious.
With all that was going on in the financial markets and the rest of the
economy, we expected a set of very conservative operating plans and
financial projections from our portfolio management teams.
The economic circumstances had put manyseasoned finance profes
sionals into a defensive crouch. Certainlythe dire environment had that
effect on me. ButJack had another perspective. He took the floor at our
strategy meeting and transformed not just the tone of the meeting but
also the direction our firm would set through the tough economy.
"At a time like this, we want our companies to be aggressive," Jack
said. "They are all market leaders. They are all well capitalized. We
want them to take the appropriate defensive steps for sure, but we also
want them to do something else—play offense, because they can. By
virtue of their relative strength in the marketplace, each one is in the
position to buy or bury their competitors."
Jack counseled us, and the partners agreed tohave our portfolio busi
nesses adopt forward-looking strategies, such as taking market share, of
fering flexible terms tostrategic accounts, recruiting talent from weaker
players, and considering acquisitions. Rather than advising the need to
take a defensive attitude because the economy was going into a hole,
Welch was saying, "Hammer them. Don't play defense. Play offense."
That is exactly the reason why we have proven operating executives
deeply embedded into our firm's structure. Though Jack is a special
partner andisnot expected to roll uphis sleeves and dig into thedetails
ofour portfolio the way our full-time operating partners do, the contri
bution he made had the same sort of catalytic impact that our operating
partners have on our companies. They bring their breadth ofexperience,
at the highest levels of business, to the problems that the management
teams at our portfolio companies must address to take their businesses
to higher performance levels. Operating partners have lived through
business cycles before. They know how economic stresses can create
winners and losers, and they know from experience how the right moves
at the right times can mean the difference between success and failure.
Operating perspective is for us the single most important aspect of
our investment model, and its importance will only grow in the after
math of the economic crisis, as financial engineering becomes far less
prominent in terms of driving investment returns in the private-equity
industry. It will always be important to pay the right price for a com
pany, to structure the financing appropriately and creatively, to have
strong management and a powerful product portfolio. But, justasJack
Welch's aggressive view in the midst of economiccrisistransformed our
strategy meeting, an operations viewpoint can increase the chances of
success by bringing a world-wise perspective to the work.
Operating profits • 35
How Operating Perspective Works

An operating perspective also helps us, as buyers, make smart decisions
about the investments we make. It's no accident that our firm reviews
100 offering books for every one deal we complete. Often enough, our
operating partners spot something that our more financially oriented
partners might never have seen. They have different insights based on
what they have experienced in the day-to-day management of large
global businesses. And, when we bring that operating perspective to
bear on our assessment of management, it helps us quickly measure
whether the existing team does ordoes not have the natural talent and
the requisite experience to achieve our goals for the business.
Whatever the "it" factor is for operational excellence, our operating
partners have it. People such as George Tamke, who spent many years
at Emerson Electric before eventually rising to the top job, and Fred
Kindle, former CEO ofABB, one ofEurope's largest corporations, have
demonstrated the ability to work closely with our portfolio company
management teams to drive productivity, cost, and growth initiatives.
Ed Liddy handled a complex transformation ofAllstate's relations with
its insurance agents, and his tough-mindedness and acumen as a finan
cial manager certainly were as critical to our investment screening and
decision-making processes as they were when then-Treasury Secretary
Henry Paulson recruited him to salvage AIG when it was on the brink
of failure. When someone has that operational ability, it becomes ob
vious because it emerges as naturally as a hair color or ability with
languages. When someone does not have it, that shows up, too. People
such as Welch, Tamke, Kindle, Liddy, and our other operating part
ners, who have proven they possess that sort of intuition themselves,
can spot it—or, just as importantly, decide that it is missing—more
quickly than the rest of us.
A Personal Perspective
I learned years ago the importance ofnatural talent as a prerequisite for
success. After graduating from Williams College, I enlisted intheMarine
Corps, then went toHarvard Law School, and ended up practicing law
atSullivan &Cromwell. At this great law firm, I had the good fortune
to work for a born lawyer, John Raben. He had a very perceptive
legal mind. John could see all the issues, turn them on their side, and
view them in a way no one had thought of before. Clients respected
him tremendously. He was a great lawyer, and everyone knew it.
Irecognized that my chances for becoming alawyer on apar with John
fell somewhere between slim and none. Thatmotivated me to look for
a field in which I, too, would have that natural ability.
One of Sullivan & Cromwell's clients was an institutional research
firm named Laird &c Company. Its corporate finance practice was the
deal business: "bootstrap deals," we called them. Laird would find
companies they wanted to acquire, then go out and raise the financing
necessary to do the deal, "boostrapping" themselves into position to
make the purchase. As I grew to understand that business, it appealed
to me, so when a position opened at Laird, I left the law practice and
went towork doing deals. Very quickly, I found Iwas a better deal guy
than I was a lawyer.
Over time I learned thecraft ofdealmaking. I am nota great financial
analyst, but fortunately we have plenty ofpartners who complement
my weaknesses. When we are investing in a company and assessing its
management, we look for all the ingredients that contribute to making
a great company. If not all of them are there, we decide whether we
can provide the missing elements. Our operating partners are essential
in making these judgments, thanks to a sense ofperception that only a
former top executive with deep experience canmuster.
The importance ofanoperating perspective was brought home to me
relatively early in my buyout career. In 1969,1 had started a firm with
three other individuals whose skills, like mine, were chiefly financial.
This made us proficient in reading financial statements but not adept at
assessing the operating challenges that we might face inrunning a busi
ness. We had contracted topurchase a magnetic tape company together
with an individual who was to become the chief executive. He believed
that the company had a winning technology.
Our prospective partner was wrong aboutthe technology, but none
of us knew enough to challenge that assertion. Over time it became
clear that we did not have a technically advanced product, but rather
a commodity. The deal was a bust. That experience made meconclude
that I needed somebody—every single time—on my side of the table

who understood businesses and could evaluate markets, operations,
technology, and, importantly, the ability of the business to respond to
different cycles in the economy.
The importance of operational savvy as away to avoid losses, ifnoth
ing else, was at the top of my mind when Idecided to strike out in 1978
with Martin Dubilier and Gene Clayton. At the time, my new partners
had acrisis management firm. Along with Bill Welch, they were hiring
out their expertise on aday-to-day basis to manage troubled businesses
on behalf of banks and insurance companies that had taken control
ofthem. They were helping Jerry Kohlberg, and, after it was formed,
Kohlberg, Kravis &Roberts, to evaluate deals. So, when we eventually
came together as apartnership, each of them had some buyout experi
ence. My new partners were not financiers. That was the furthest thing
from their minds, but they wanted something more enduring than the
consulting work they were doing, and my experience, when combined
with theirs, permitted us to create aunique buyout firm.
Building the Pattern of Success

We started inthe middle of 1978 and over the next 3 years completed
a number of smaller transactions, but our 1983 purchase of Harris
Graphics was our first really noteworthy transaction. Harris Graphics
was the old Harris Intertype business. It manufactured printing presses:
small ones, medium ones, large ones. But the business was not central
to the corporate parent that was in the process of transforming itself
into a technology company. Our job was to liberate Harris Graphics
and provide itwith the monetary and intellectual capital necessary to
succeed as an independent enterprise.
The deal was remarkable in retrospect. We had no pool of capi
tal that we controlled, so all the financing, both debt and equity, had
to be raised by us from other capital sources. For our firm, relatively
unknown at the time, raising $250 million was a challenge, but we
plugged away at it and got the financing done. Interestingly, Harris
Graphics was one of Drexel, Burnham Lambert's early transactions,
and its success helped make Drexel a dominant force in the subordi
nated debt market.
The concept our firm was founded on was that ifwe combined within
asingle investment organization both an operating capability and afi
nancial capability we would be more effective investors. Through the
decades we have been true to that principle. We are constantly search
ing for individuals who can be operating partners in the firm. They are
ahard resource to identify because, first, they must have established
that they can successfully manage a multibiUion dollar international
business and, second, they have to want to continue to work very hard
in a partnership culture, which can be quirky at times. Not an easy
individual to find.
CD&R's operating partners are fully integrated into all aspects of
our business, unlike some other firms that have former corporate ex
ecutives as advisors. Our operating partners help to source new deals
and analyze proposed transactions, but their most important value
comes after the transaction is closed. We expect them to be very active
chairmen and be sufficiently conversant with the portfolio business so
they can assume the chief executive officer position if the need arises.
Over our history, CD&R operating partners have stepped in as interim
CEO in about a third of our investments. This was the case with our
investment in Uniroyal.
We got involved with Uniroyal in late 1985 almost by chance. The
maverick investor Carl Icahn had made ahostile offer for the company,
and Uniroyal management had hired Salomon Brothers to find a"white
knight" for the company. Salomon's investment bankers had just fin
ished visiting with KKR, and as an afterthought called us to ask if we
would meet the chief executive officer, Joe Flannery. Joe's presentation
was sufficiently compelling that we decided to examine the opportunity
in detail. After an extended period of due diligence, we were able to
fend off khan and acquire the business.
Amajor part of Uniroyal was its tire operations. It was an intensely
competitive industry, and when we were afforded the opportunity to
combine it with B.F. Goodrich's tire business, we did so. The entity that
resulted was atrue joint venture owned in equal parts by Goodrich and
CD&R. The executive positions were split equally: chief executive of
ficer for them, chief operating officer for us; chief financial officer for
them, controller for us; and so on. It was arecipe for disaster. So much
so that we eventually went to Goodrich and said to them, "One of us

has to go; either you buy us out or we will buy you out." We ended
up buying them out and installing Chuck Ames, one of our operating
partners, as chief executive officer. Chuck's enlightened leadership led
to a revitalized organization and ultimately to a very advantageous sale
to the French tire manufacturer Michelin.
Building an Operating Structure: The Lexmark Deal

There probably is no better example of our distinctive approach than
our purchase of Lexmark, the office printing products business, from
IBM in 1991. It is thought thatJohn Akers, the chief executive officer
of IBM, had decided that IBM had gotten to the point where it was
unmanageable and needed to be broken up. Because the operations of
the various IBM divisions were intertwined and were so dependent on
the corporate staff for many functions, asale toa private buyer was the
only sensible choice.
The decision to carve out the office products business was made
not long after the notorious battle for RJR Nabisco had wrapped up.
The bestseller written about that deal, Barbarians at the Gate, painted
an unflattering picture of all the participants. Supposedly, when Akers
decided to sell the printing business, he dropped a copy of Barbarians
on the desk of one of his subordinates and said, "I don't want to sell it
to anyone whose name is in this book." In retrospect, that turned out
to be a good thing for us. Our name was not in the book.
It was clear from the start that it would be impossible to auction
the business. Lexmark as a stand-alone business existed only in IBM's
mind. It was a product line and nothing else. It had no sales force, no
technology to call its own, no dedicated production plants, and nocor
porate infrastructure. It was a collection ofbusiness lines—typewriters,
impact printers, and suppliers. Even though the IBM Selectric was a
workhorse of American industry at that point, it was clear that com
puter printers would soon put the Selectric out to pasture. And the one
part of the operation that ultimately would become the backbone of
the business we were buying was not even a commercial product yet:
the laser printer.
40 • THE MASTERS OF PRIVATE EQyiTY AND VENTURE CAPITAL
Martin Dubilier had run a business products company at one time,

and even held the original patent on the daisy wheel printer, so he had an
intuition that, despite everything, we ought to be able to make it work.
"We can do this," we said. "This will be a great business."
We knew that turning a stand-alone typewriter manufacturer into
a dynamic developer of computer printers would be a tall order that
required all of the firm's resources, both operational and financial. But,
before we could transform the business, we had to complete the trans
action, and that required infinite patience. Don Gogel, now the firm's
CEO, painstakingly negotiated more than 80 transitional commercial
agreements with IBM covering trademarks, intellectual property, and
the like before we could complete the purchase.
There was something else that made this investment enticing for us.
It's difficult to fully appreciate today, when IBM is no longer the stan
dard inbusiness that it once was, but for that company to reach outand
choose us as the counterparty was huge. Itwas a turning point for us and
for the entire private-equity industry. Itwas asign that private equity was
acceptable—and thatwe were a worthy counterparty to IBM.
A Harvest and Grow Strategy

Our business planfor Lexmark was simple: use the cash flow from the
mature businesses to build the laser printer business. The IBM people
believed, and we came to agree, that the laser printer market could
become a significant one. Our chief concern was whether we could
develop the products and the market quickly enough to rely solely on
the dwindling cash flow from the mature businesses.
Negotiations over thetransaction took months—almost a year—and
ofcourse price became a key issue. Public companies, in particular, are
always sensitive about price, and IBM needed to show a big number to
Wall Street. As the first transaction in what might be a massive corpo
rate restructuring, they needed to set a high bar. Price was problematic,
in part, because it was difficult to say with any authority what theearn
ings of the underlying business actually were. There were no audited fi
nancial statements for the group ofproduct lines that we were buying.
Putting the pieces in place in a way that we could meet IBM's ob

jectives was a challenge. We knew IBM would not show a lot of flex
ibility. But we also felt we could organize the transaction in away that
would enable us to pay a relatively rich price yet still build a profitable
business. After all, Lexmark would not be completely independent of
IBM. We would still be buying products and equipment from IBM, and
they would be doing the same from us. By creatively negotiationg the
contracts arising from this interwoven series of relationships, we could
raise the purchase price high enough to reach IBM's price objectives
yet still have a robust enough revenue stream to make the independent
Lexmark business a success.
As negotiations wore on, we began addressing other challenges.
Staffing was a key concern. It was pretty obvious we would need to
pull the leadership team from within IBM. The IBM corporate culture
was so strong that outsiders would be rejected as if they were some
sort of biological antibody. We were fortunate to be able to recruit a
well-regarded IBMer, Marvin Mann, to run the business, and we ap
pointed as his deputy Paul Curlander, who had led the development of
the laser printer.
If we were going to succeed, we knew we would have to create a
distinctive corporate culture. The IBM culture was very strong—white
shirts, dark suits, and a very regimented training system—but not very
entrepreneurial. We focused on compensation, increasing the perfor
mance incentives built into the compensation scheme and reducing
the fixed compensation. Most importantly, we gave every employee
ofthe new company a direct or indirect ownership interest in it.When
the new company went public, the value of the employees' investment
interest was greater than $1 billion.
We also focused on the product development cycle. IBM had a
30-month product development cycle. Hewlett Packard's was
18 months. We needed to get to 15 months and at competitive price
and performance levels. We succeeded by introducing the concept of
pay-for-performance into the development lab.
The financing climate was very difficult in 1990 and early 1991.
It was only because IBM let it be known that they really wanted
to see this transaction done that the bank syndicate came together.
The transaction closed in March of 1991. By the end of the year, we

had paid down $300 million in debt, well ahead of schedule. We had
streamlined the manufacturing operations, cut the development cycle
in half, and succeeded in motivating our sales force. We brought the
company public in late 1995 and ultimately returned tolimited partners
over four times the original investment through a series of public
offerings, thelast ofwhich was made in 1998. Lexmark still exists asan
independent entity and is listed on the New York Stock Exchange. Ihave
always felt our operating perspective helped this transaction develop in
a way that this represented the buyout business at its best in creating a
dynamic, independent entity where one had not previously existed.
After the Close: Operating for Success

All investments present opportunities and challenges. Two transactions
with similar challenges—integrating and improving the performance of
multiple-location businesses—produced results at opposite ends of the
spectrum: Kinko's and U.S. Office Products.
With Kinko's, which we bought in 1996, we knew from the outset
that we would have a challenge combining 127 businesses into a single
entity and teaching them to function as one. The Kinko's outlets were
scattershot all across the United States. Each operated as if unrelated
to the other Kinko's units: different hours, different service offerings,
different customer orientation. George Tamke, the operating partner
who ultimately became responsible for Kinko's and actually ran the
company on an interim basis, found that one of his most effective tech
niques in producing uniformity of performance across the portfolio
was "quartiling." He would pick a particular attribute—revenue per
employee, for example—and divide the Kinko's stores into four differ
ent groups, based on how each performed against that metric.
Once Tamke had "quartiled" the Kinko's stores, he then studied the
top performers to determine whythey excelled. He identified the attri
butes of success and then worked them into the system. He also drove
the units in each quartile to perform at the level of the quartile above
them. It was common sense, and it worked. We eventually sold Kinko's
toFedEx. Tamke's by-now intimate knowledge ofthe company's metrics
also had persuaded him and his management team to build a fast-growing
document management business within Kinko's that became a logical
and profitable adjunct to its retail business.
The turn of the century was a tough period for our firm, and U.S.
Office Products illustrates one aspect of our challenges as well as any
company in our portfolio atthe time. U.S. Office Products was a roll-up
of more than 100 business-products distribution businesses. It had out
grown the abilities ofits founder to manage it, and as it turned out was
beyond our capabilities, too. Our due diligence effort was not what
it might have been, and we were unable to establish a control system
that permitted us effectively to manage the business. When the busi
ness began to slide, we could notstop the decline, andthe business was
eventually restructured and our investment was lost.
Fairchild Dornier Corporation, a manufacturer ofregional jets based
inGermany, and Acterna, a leader incommunications technology, both
faced unprecedented—and unpredictable—shocks to their respective
markets shortly after we acquired them. Fairchild, with a backlog of
over $10 billion when we acquired the business, saw its orders dry up
after the September 11, 2001, terrorist attacks, causing the business
to fail. Acterna, acquired in 1998, suffered a severe revenue decline as
customers cut back significantly ontelecommunications spending in the
face of the steep telecom industry downturn. The company ultimately
was restructured.
Looking back on this period, I believe we suffered because we thought
we were better than we really were. We thought we could do anything.
"Pride goeth before the fall." But I also believe that it is a measure of
our institutional resilience and the strength of the firm's underlying
investment model that, even with significant underperformance of the
investments made between 1998 and 2000, our overall performance
continued to be strong.
Turning Operating Perspective Inward

These disappointments happening as they did ina very short period oftime
made us reexamine the way we were conducting our business. It became
clear in retrospect thatwe had gotten too far up the risk curve. It served
44 o THE MASTERS OF PRIVATE EQUITY AND VENTURE CAPITAL
ourfirm well thatduring this period Jack Welch joined the firm. Given our
firm's management orientation and Jack's reputation as one of the most
creative and successful corporate leaders ofour time, he was a perfect fit.
We did not expect Jack to be an operations partner. Rather, we
wanted him to play a role that would span the entire portfolio. We
looked toJack for ideas that would help us focus, as a firm, on strategic
objectives. From there, the individual companies and our individual
transaction teams could focus on success. This is something that Jack
had done well at General Electric, particularly in the latter years ofhis
long tenure atthat complex, global company. We hoped he could bring
this sort of acumen to Clayton, Dubilier & Rice.
Inaneffort to improve our performance, we instituted two organiza
tional and investment process enhancements: the operating review and
an investment screening committee. We asked Jack to chair the first
ofthese and to participate in the second. The operating review brings
together all the operating partners ofthe firm with the management of
our portfolio companies. Infrank, detailed discussion, the management
teams have the benefit of the collective wisdom of seven individuals,
each ofwhom has been the chief executive officer ofa major multiple-
industry international business.The record demonstrates that their col
lective wisdom is of great value.
The screening committee imposes a system of quality control to our
deal making. Consisting of the firm's senior partners, the committee
meets with the deal team over the course of negotiations on a trans
action. It ensures that the team considers each of the issues that the
committee thinks is important to the investment and that the proposed
transaction will have qualities thatthe entire partnership will approve.
In many respects, weas a firm didwhat weask our companies to do:
respond tochanging circumstances decisively and effectively by making
positive, strategic changes.
Acting on Operating Insight

Consider the case of our 2008 strategy meeting. We had no idea in ad
vance that we would come to the collective conclusion that we needed
to seize on theeconomic opportunity thatwould emerge out of a global
economic collapse. But what was important to the firm, and ultimately
should be important to our operating companies, is that the partners
looked at the changing landscape and resolved to act.
When wetook a break from thestrategy session, we immediately got
word back tothe portfolio company management teams that they would
need toprepare for an entirely different sort of operating review than the
one they had expected the following week in New York. The deal teams
from the firm all called the CEOs of their companies and said, "You
know that presentation you were working onfor the operating review?
We are going to change the whole focus of it. It's now going to be,
'How do you play offense in the currentenvironment?'"
It would have been more convenient to just stick with the original
plan and merely talk about this changed focus in each ofthese operating
reviews. But that would have been a wasted opportunity. Ultimately,
it did our companies a lot more good to rip apart their plans, look at
them from a different perspective, and come in with new ideas.
I have spent a lot of time explaining how operating partners af
fect our firm's success, at the risk of neglecting the important role
played by CD&R's financial partners. That is because our operating
partners aresoclearly distinctive. There are, however, more financial
partners in the firm than operating partners, and they remain the
heart of the firm. Without them, there would be no deal flow for
the operating partners to evaluate. This is, after all, an investment
business. They are uniformly hardworking, driven professionals.
Typically they are a generation or two younger than the operating
partners. Importantly, because they are joined at the hipwithoperat
ing partners, CD&R financial partners must have a level of maturity
that extends beyond their years. Most of our transactions are dives
titures, which are complex and demanding. They require tremendous
intellectual capabilities and persistence, which our financial partners
have in abundance.
The most critical element of the firm we have built is the human
capital represented by our people. Just as we have developed an in
vestment style that is distinct from most other private-equity firms,
our balance in terms of operating and financial skills is what truly
sets us apart.
LESSONS FROM JOE RICE

Labor hard at the front end of an investment. Be patient
and careful in transaction structuring and analysis. Study the
operations as carefully as the finances, and shape the balance
sheet to fit the character ofthe business with plenty of liquidity
cushion for tough times.
Go beyond the numbers. Spreadsheets and balance statements

don't tell the whole story. It's important to understand the
operating challenges—and opportunities—when considering an
investment, as well as the skill and drive of the management team.
Be prepared to turn on a dime. Acompany is not fixed in a steady
state. Industry structuresand competitive dynamics change. In
the case of Lexmark, CD&R leveraged the cash flow from mature
technologies to fund the development and growth of an emerging
productthat transformed the company into an industry leader.
Look in the mirror. Be prepared to transform your own firm or
company. Insist on accountability, change people and processes as
necessary, and get everyone moving together toward success.
<$> Be passionate about your vocation. Great lawyers, managers, and

dealmakers mayactually be born, not made. Follow your heart, and
your natural talent, to achieve success. Do not remain in a profession
that seems a poor fit.
SKIN IN THE GAME:
INVESTING IN SERVICE
BUSINESSES
F. Warren Hellman
Chairman
Hellman & Friedman LLC
AUM: $25 billion Years in PE: Over 25
Location: San Francisco, CA Year born: 1934
Grew up: San Francisco, CA Location born: New York, NY

Best known deals: Levi Strauss & Co., Eller Media Company, Inc.,
Young & Rubicam Inc.,NASDAQ, DoubleClick Inc.
Style: Investing in high quality business franchises
Education: B.A., University of California at Berkeley, Class of 1955
M.B.A., Harvard Graduate School of Business, Class of 1959
Significant experience: Investment banking at LehmanBros.
Private equity and venture capital experience
Personal interests: Banjo playing, endurance horse racing, skiing,and
studying the Torah
The lesson: "Allpotential investments should beconsidered guilty until
proven innocent."
47 •
Though he comes from an almost royal line in the history of California

finance, Warren Hellman has a down-to-earth investment approach. The
great grandson of I.W. Hellman, who built the Wells Fargo Bank, and
son ofa prominent San Francisco investor, Hellman forged his ownpath
on Wall Street. By age 26 he became the youngest partner in the history
of Lehman Brothers and later served as president during a tumultuous
period for the firm.
After its co-founding in 1984, Hellman & Friedman quickly broke
into the ranks of leading private-equity firms with the $1.6 billion
management-led buyout of Levi Strauss & Co. Since then, Hellman
& Friedman has put together a string of successful deals including: the
recapitalization of ad giant Young & Rubicam, the demutualization of
the NASDAQ stock market, and the acquisition of internet advertising
manager DoubleClick. Hellman typically avoids heavy industry, preferring
to invest in non-capital intensive people-oriented services businesses. He
has developed an ability to work from a minority investment position
yet still provide strong guidance that helps create value in Hellman &
Friedman's portfolio companies.
A defining moment in my life occurred in 1959 when I had just

started my career as an investment banker at Lehman Brothers.
My father wasvisiting from San Francisco and marveled at the ways of
the "new" Wall Street.
We were in the midst of one of Wall Street's periodic booms in
initial public offerings, and the team I was leadingat Lehmanwas ex
ecuting public offerings for companies with modern-sounding names
and can't-miss technologies and products. Among them were Infra-
Red Industries, Microwave Associates, and Gulton Industries—names
that seemed important at the time but that almost no one would rec
ognize today.
As we discussed the economy, my father confessed to me how trou
bled he was by the frenzied state of the markets. "I feel as if I don't
understand the markets anymore," said Marco F. Hellman, my father.
"The things that I have always believed in most implicitly—fundamen
tal valuation metrics such as price earnings ratios, price to book value,
free cash flow—none of them mean anything anymore."
Skin in the Game • 49
"You are absolutely right," I told him. "You just don't understand
at all what is going on. It's a whole newworld out there!"
It wasn't long after his visit that the stock market crashed and along
with it, my proud portfolio of high technology IPOs. In a phone con
versation soon afterward, my father reminded me how much he had
enjoyed our conversation in New York.
"Clearly one of us didn't understand what was happening and it
wasn't me," he said.
Periodically, the markets go through a phase where the old eco
nomics seem completely outmoded. In the last decade alone, we have
seen this happen twice. During the dot-com boom, profits themselves
seemed a quaint way to gauge value. Rather, true value was all about
"eyeballs" and "cost per click"—or so the thinking went. More re
cently, we experienced the leverage frenzy that came crashing down in
mid-2007. These events led to the untimely collapse of my own Wall
Street alma mater.
In the end, there is little new under the sun. Old-line measures of
value continue to count. Companies that have lasting franchises, which
meet a need or provide a mission-critical service, that are run by high-
caliber managers whose interests are aligned with shareholders, that
produce strong free cash flow and don't require significant capital in
vestment to grow—those are the ones that will always last. My firm
seeks to invest in companies that possess these traits.
For many, the tide has shifted, of course. Broad market corrections
often force investors to refocus on fundamental value metrics, and that
is where we seem to find ourselves again today. Investors are migrat
ing back to basics in large part because they have no choice. With a
challenging economic outlook and constrained financing environment,
back to basics appears to be the way forward.
Back to Basics
For me, the move back toward value is a welcome re-awakening of in
vestment principles our firm has tried continuously to respect ever since
TuUy Friedman and I founded Hellman & Friedman in 1984. This is not
to sayour investment approach did not change overtime. In fact, it is not
clear to me whether one of our first major investments, the $1.6 billion
50 • the Masters of private equity and Venture Capital
management-led buyout of jean maker Levi Strauss & Co.,wouldstill fit

our investment approach today. Through time and experience, we have
focused oncompanies with fewer physical assets and lower capital costs.
There are certain common denominators that define our typical
portfolio company. We look for strong franchises with high barriers to
entry, plenty offree cash flow, a strong andcapable management team,
and a persuasive case that our investment can help grow the business.
Akey measurement inour cash-flow analysis relies ona concept called
"return on tangible capital." It is a modification of the typical cash-flow
model that takes capital expenditures into account. Stated simply, we pre
fer to invest incompanies that can afford to operate and grow "inexpen
sively." Ifthe business does require capital to grow, we expect the business
to earn a significantly above-market return on thatcapital outlay.
I also believe it is impossible to overstate the people quotient in the
investment decision. Even if a company meets all our firm's bench
marks, we can succeed only if the people running the company can
make it work. We change management teams if we have to, but we
prefer to invest behind and support an existing management team that
we believe canexecute a joint vision andwill be motivated bytheir own
significant equity stake in our deal. Often times, our investment serves
as a catalyst to help management acquire, or meaningfully increase,
their ownership in the business.
Major Successes from Minority Stakes

Unlike many private-equity firms, which insist on majority ownership
of their portfolio companies, we have a wealth of experience taking
minority stakes in companies and helping transform their strategies
even though we cannotexert the typical majority ownership controls.
This approach is somewhat unique in the world of large-scale private
equity and has facilitated our ability to obtain stakes in the Young
& Rubicam advertising enterprise and the NASDAQ stock market,
among others.
Though our founding partners all got their start as investment
bankers, we typically try not to rely on outright control or financial
engineering to makethe case for an investment. I have a saying: "Every
potential investment should beconsidered guilty untilproven innocent."
SKIN IN THE GAME ® 51
This is a shorthand way of saying that the fundamental business case

for an investmentmust be proven sound through rigorous due diligence
on the underlying industry and business.
As "recovering" investment bankers, weknowthat a smartfinancial
person can find a way to construct an elaborate capital structure that
will justify almost any investment. I do not believe that is the way to
create lasting value, and only lasting value can deliver the kind of in
vestment returns my partners and I expect.
Investment discipline is critical as well, and we hold that concept to
mean more than just sayingwe apply certain metrics when we commit
capital. To me, discipline means constantly re-evaluating investments.
In fact, every one of our portfolio companies periodically goes through
an in-depth evaluation process in which we re-assess our original in
vestment thesis and re-underwrite the expectedperformance, at least on
paper. Thisprocess has significant influence regarding our decisions on
when to exit an investment.
Learning from Mistakes

We began developing our "hold/sell" strategy after experiencing ourfirm's
most gut wrenching early loss, the bankruptcy of a paging network com
pany called MobileMedia Corporation. Ironically, the MobileMedia in
vestment got offto a healthy start. In fact, at one pointin our ownership,
the company was worth approximately three times our original invest
ment. However, the company—and industry—soon began to experience
significant pricing pressure, and MobileMedia wound up filing for bank
ruptcy protection before we had a chance to exitthe investment.
We learned several key lessons from the MobileMedia experience.
Among them were the vital importance of investing in high quality,
defensible businesses and being proactive in determining when to exit
an investment. Had we exited MobileMedia sooner than we did—as
soon as the business fundamentals began to change—we likely would
have avoided bankruptcy and made a healthy return. As it turned out,
though, the MobileMedia investment was a seminal eventfor our firm
and significantly contributed to our current investment philosophy.
Irrespective of the type of investment, I believe it is important to be
an active investor in the sense that we continuously reassess how we
feel about the underlying business, its management team, and our
prospective return on investment.
If this sounds carefully thought out and, to a point, almost regi
mented, let me tell you: It is. If it also sounds as if we had all these
concepts figured out when we formed Hellman &c Friedman 25 years
ago, let me tell you this: We did not.
We brought a few inklings of what we knew with us from our ca
reers on Wall Street and other work we did before landing, finally, in
San Francisco's financial district. However, we learned much of what
wenowknow aboutprivate-equity investment and the management of
our portfolio companies throughexperience, through trial and error as
owners or major investors in our portfolio companies. The errors have
hurt, but without them, we would not have learned the vitally impor
tant lessons by which we have built a record of success. It is much easier
to make a statement like that long after the mistake, after the hurt has
died down—not that it ever completely goes away.
The Long Trail to Wall Street

For nearly as longas I can remember, mylife seemed directed toward a ca
reer as a professional investor. Although to behonest, as memory serves,
I did have some early years when itwas notaltogether certain I was going
anywhere at all. This great revelation hitmy dear mother when, at theage
ofeleven andwithout any prior permission, I decided one day to ride my
horse on a 70-mile round trip excursion to Sacramento.
In retrospect, I like to thinkthat, at some level, mymother appreciated
myindependent streak. After all, she was a unique personality in herown
right. She had earned a pilot's license at the age of 16,and during World
War II shevolunteered for the service. TheAirForce required every able
bodied pilot to be flying bombing missions overGermany or the Pacific
Islands, so dedicated female pilots such asmy mother would fly airplanes
around the country repositioning them for the armed services.
When I returned from my long horse ride—and this, by the way,
was not the sole indiscretion of my youth—my mother responded in
the manner of many aggrieved parents through the ages. She sent me
to San Rafael Military Academy, otherwise known as reform school
for rich kids.
Skin in the Game <> 53
My family had a long history infinance. In 1871, my great grandfa

ther, Isaias W. Hellman, formed a bank in Los Angeles called Farmers
and Merchants Bank, which helped HarrisonOtis start the LosAngeles
Times and orchestrated several other notable financings. Isias is best
remembered as the person who bought Wells Fargo in a distressed sale
in 1905 and greatly expanded itsrole as the bankthat financed growth
throughout California and the West.
As a private-equity investor today, I like to think that I inherited
at least one trait from my great grandfather: The desire to own busi
nesses outright rather than just work for them. As it was, Edward
Harriman, the railroad baron who had gainedcontrol of Wells Fargo,
had approached my great-grandfather in 1905 and asked him if he
might be interested in running the bank.
Isaias had a simple response. "I don't run businesses. I own them,"
he said. He bought Wells Fargo, recapitalized the bank, and never
looked back.
The Hellman family name and connections were useful to me by the
timeI finished my undergraduate studies at the University of California-
Berkeley and Harvard Graduate School of Business. I was newly married
to my wonderful wife, Chris, and we were anxious to strike out on our
own. It seemed that I could best do that by heading east to Wall Street,
rather than going to work for my father's investment firm, which was
doing venture capital before anyone calledit that.
Lehman Days
In 1959, my uncle Fred Ehrman was a high-ranking partner at Lehman
Brothers and helped me land a job in the firm's investment banking
division. I quickly started putting deals together. At the time, the firm
was putting its own capital into deals, and I was drawn naturally to
that part of the business. We put up the original capital to form Litton
Industries and controlled Great Western Financial.
I rose quickly through the Lehman organization becoming, at age 26,
the youngestpartner in the firm's history. It was at Lehmanthat the asset
management business first piqued my interest. The asset management
division, which at one point reported to me, had incredibly consistent
earnings quarter over quarter. This was in direct contrast to the highly
volatile profitability swings among the investment banking and sales

&C trading departments. This interest in asset management would re-
emerge years later after I co-founded Hellman & Friedman.
Lehman Brothers always had a well-deserved reputation for being a
highly internally competitive firm. In fact, when Bob Rubin was a lead
partner at GoldmanSachs, he often used to sayto me that the main dif
ference between Goldman and Lehman Brothers was notin the quality
of people, but in the way people in the firms dealt with each other. The
partnersat Goldman Sachs understood that their real competition came
from beyond the walls of the firm. Lehman's partnersseemed to believe
their chief competition came from the inside.
Theinternal tension at Lehman Brothers constantly boiled beneath the
surface. Rivalries between factions—traders vs. investment bankers—
had intensified in the years after the firm changed from a partnership
to a corporate structure in 1970. Making matters worse, the old guard
leadership team hoarded power, kept people in the dark about their
chances for promotion, and paid themselves substantially more than
lower-ranking members of the firm, regardless of their contributions.
On top of it all was a lack of adequate controls.
The unhealthydynamics at Lehman led to an outright crisis by 1973,
just after I became president of the firm, when the fixed income desk
made an outrageously risky bet on interest rates that turned against
us. The fixed-income traders had purchased nearly $1.5 billion of long
government bonds at a time when the firm had less than $20 million in
equity, so the ill-advisedtrade was a huge problem, one that threatened
the verysurvival of the firm. Pete Peterson had left his job as Commerce
Secretary for President Nixon only a month earlier, and along with a
small group of partners, I helpedconvince Petersonto step in and take
charge. Once Peterson had agreed to the assignment, I personally had
to walk into my uncle's office with Peterson and another colleague and
fire my uncle. To this day, that conversation remains the most painful
thing I have had to do in business.
The Lehman Turnaround

Once in control, Peterson and I worked as hard as we had ever worked
to get the firm turned around and headed in the right direction.
Skin in the Game ° 55
The job ahead of us was just incredible. At one point we calculated that
we had gone three straight months without eating more than a handful
of meals outside the firm, including weekends. Obviously, there might
be more physically demanding jobs, but it was extremely taxing, dif
ficult work. We cut the workforce from 1,300 to 550 employees and
many of those cuts included partners with whom I had worked closely
for several years.
Among the many key decisions we made during that period was that
Lehman could no longer afford to be active investing as a principal in
corporate buyouts. An investment banking firm needed huge amounts
of capital to operate its underwriting and brokerage businesses, and
Lehman did not have enough capital available for it to act as a princi
pal investor, too. Since my true interest was investing, not trading or
underwriting, that decision more than any other probably prompted
me to leave Lehman in 1977.1 had run out of patience, too, with some
of the continued infighting that went on despite Peterson's hard work.
And since the rest of the firm was responding to his leadership, I no
longer felt indispensible.
I have said for years that in my work at Hellman &c Friedman I have
a simple rule of thumb: I decide how the old guard at Lehman would
have behaved, and then I do the opposite. It sounds like a throwaway
line, but it is not. Hoarding of power, internal intrigues, lack of ac
countability and intellectual laziness are all unacceptable to me. I had
so little patience with it all that from time to time I completely lost my
temper. It happened frequently enough back then that I was given the
nickname "Hurricane Hellman." The temper outbursts were another
part of Lehman that I did my best to leave behind once I departed from
the firm.
It was clearly time to go. After Lehman, I worked eight years in
Boston, forming two different investment firms. The more substantial
of the two, Hellman Ferri Investment Associates, was the predecessor
firm to Matrix Partners, which still exists. At Hellman Ferri, my partner
Paul Ferri and I invested mainly in venture deals, and even though Ferri
and I had to go through a fairly bitter breakup with our other founding
partner, the work in Boston provided valuable experience in principal
transactions. By 1981 I was back to California, and it was there, while
working on a project basis for Lehman Brothers to restructure the
56 • The Masters of private equity and Venture Capital
finances of Crown Zellerbach Corporation, that I first connected with

Tully Friedman, a managing director at Salomon Brothers who was
advising Crown Zellerbach.
Teaming with Tully

Fromthe outset, Friedman and I knew we wantedto go beyond invest
ment banking and eventually become principal investors in our own
deals. However, wedid not wantto raise third-party money rightaway.
Rather, we wanted to take some time working with each other and
workingwith a younger group of incredibly talentedpeoplewho joined
shortlyafter us, Matt Barger, Jack Bunce, and John Pasquesi. Our view
was, let's seehow we exist together as a firm for a few years before we
raise a fund backed by institutional investors. Until then, any invest
ments we did would be on a one-off basis.
The investment that first put us on the map was the $1.6 billion
management-led buyout of Levi Strauss &c Co. Levi's came to us at first
not as a potential buyout candidate, but because company executives
were seeking advice regarding capital structure. At Hellman & Fried
man, we were as much in the advisory business in those early days as
we were acting as principal investors, and as we dug into the business
in early1985 we kept looking at each other and saying, "This company
should not be public."
In our view, Levi's was one of the great global brands. This was in the
mid-1980's when college students from the U.S. would travel to Eastern
Europe and pay their expenses by selling Levi's jeans out of their back
packs. The company had huge market share and strong free cash flow—
it was a veritable cash machine. But the public market valuation did not
reflect that view. Since the family owned more than half the company's
stock, there was no takeover play and Wall Street had seemingly lost
focus on Levi's cash flow.
The investment case was simple. If we offered a premium to the
market price on behalf of the family shareholders, we could probably
succeed with a purchase. At the time, Levi's had no debt. To take con
trol of the company, we needed to borrow approximately $1.2 billion,
and roll approximately $400 million of the family's stock into the deal.
After the transaction closed, the Levi's family owned approximately
Skin in the Game * 57
93% of the equity, with Hellman & Friedman owning the remaining
7%, which we attained as payment for our advisory fee.
The Levi's deal was the largest leveraged buyout of a publicly held
U.S. firm to that point. We proudlytold anyone who would listenthat
we had just done the largest buyout of all time. Then two weeks later,
Storer Communicationswas taken private and we were the kings of the
buyout world no more.
Part of the formula for success when you're a principal investor is to
have the right chiefexecutive in place and to give him or her the right
backing—or to replace the CEO if need be. Fortunately in the case of
Levi's, the former was the case. Bob Haas, who actually is a distant
relative, proved to be a tremendous CEO, and he quickly took advan
tage of his status leading a company that no longer needed to answer
to Wall Street's obsession with quarterly earnings. Bob and his team
generated tremendous operational improvements and quickly generated
a series of impressive financial returns at Levi's.
Genuine Success
Prior to the buyout, Levi's had an odd mix of too many product lines
that were not making money and too few in the areas that were profit
able. Over the years, Levi's had acquired a bunch of cats and dogs. For
example, they owned Resistol hats, which simply did not fit. After the
buyout, we found ourselves in a seller's market for divisions of compa
nies like Resistol and we took advantage of it. Among the other product
lines Levi's divested was Oxxford Suits, whose Chicago-based buyer
was represented by a young Goldman Sachs banker named Hank Paul
son. Haas also shut down dozens of plants, cut redundant management
and reduced the 38,000-person workforce by more than 15%. This
was not easy, given Levi's tradition as a benevolent employer, but Bob
did not completely lose focus on that tradition, either. For example, he
created a systematic program for incorporating employee feedback into
product and manufacturing decisions.
One of the clear advantages of operating as a private company is the
ability to invest aggressively when opportunities arise without being
second-guessed by Wall Street. Haas invested in a new product line—
58 • The Masters of Private equity and Venture Capital
Dockers—that launched with a $10 million advertising program.

Atthetime of thedeal, Levi's was considering withdrawing from foreign
markets, where demand had fallen, in part due to the strong dollar.
Instead, Bob redoubled efforts overseas, and within five years sales in
more than 70 foreign countries were contributing more to profit than
domestic sales.
By the mid-1990s, Levi's had paid off over two-thirds of the debt
we had used to help the company go private. The company also was
aheadof schedule with debtrepayments, a condition that madepossible
a major recapitalization. Following the recap, we had approximately
$3.5 billion in debt, and despite the tough conditions that began in
the early2000s, we pared that down to about $1.5 billion by the time
I came off the board in 2008.1 served on the Levi's Boardfor 23 years.
The company proved to be quite cyclical, and it seemed Haas had to
reinvent it every few years. However, even in its tough periods, Levi's
cash flow and basic business remained strong.
Investment Banker No More

When Friedman and I first formed Hellman &c Friedman, we had de
cided not to begin raising funds from limited partners until we con
vinced ourselves that we could be successful investing as principals.
I always felt confident we would be successful. At Lehman, almost from
the time I started, I had gotten involved in investing the firm's capital as
a principal on behalf of the firm. Backthen, only we and Lazard Freres
were doing this on a regular basis. Then during the years in Boston,
I had succeeded as a venture capital investor and the Levi's investment
provided proof, right from the start, that we had the eye for a strong
deal and the requisite knowledge to structure investments to the advan
tage of both the companies we bought and our own firm.
Even so, we still had plenty to learn. Another of our early investments
fromthat timeperiod,the purchase of American President Lines, taught us
that we neededto change our mindsetif we truly were going to transition
into the private-equity business. We were advising the management
team on a restructuring when they offered us a 9% convertible preferred
security with a small conversion premium. We reacted as investment
bankers would. We thought: "This is a great deal. Look at this incredibly

lucrative security." We invested $50 million.
There was only one problem: At its core, American President Lines
justwasn'ta great business. The capital costs were too high, and it was
an average company in a mediocre industry. Further, our investment
was small enough that we did not have the clout to make much of a
difference in strategy. A Singaporean company came alongand offered
to take us out at a 13% compounded return on our investment. We
jumped at the chance to exit.
Guilty Until Proven Innocent

Though it did not result in a fantastic investment return, American
President was another transformative investment for our firm, one that
paid significant intellectual dividends. It became the turning point at
which we changed from being investment bankers dabbling in prin
cipal investments to being full-fledged private investors. A lot of that
transformation is about mindset. An investment banker will look at a
prospective deal and say, "We have an opportunity to do something,
so let's figure out how to do it."
As a principal investor, the mindset must be completely different.
It bears repeating, so I will restate the core principle: "Every potential
investment should be considered guilty until proven innocent." It is
fundamental to what we do and if we behave that way, there is no way
we end up in investments such as American President Lines. If someone
came to us today and said, "This is a great security, you ought to take
it," that alone would never get over our bar. As principals, we have to
really understand and like the business, we have to be able to diligence
the cash flow, and have a strong feel for the prospects to grow the busi
ness. We also have to like management and be able to work with them.
The whole mindset is completely different.
This revelation in the aftermath of American President Lines hit Fried
man and me at around the time our other partners were ready to change
course, too. A group of the younger partners came to us not long after
and said, "Look, we didn't leave investment banking careers on Wall
Street careers to give financial advice. We left to act as principals."
In the early days, Friedman and I looked at everything first as an

advisory opportunity and secondly as a principal opportunity. When
we decided to get out of the advisory business, at the urging of those
youngerpartners, it helpedto further our thinking about how to invest.
It marked the beginning of the end of our "Field of Dreams" style of
investing. From then on, we would build opportunities ourselves.
Principles to Invest By
It was also the beginning of a period in whichwe concentratedon what,
exactly, our management and investment styles should be. "Guiltyuntil
proven innocent" was just the start. The more investments we made, the
more I personally concentrated on setting forward a series of principles
to guide us. One of the most important principles for me personally was
to ensure that our team's interestswere alwaysclosely aligned with those
of both our investors and our management teams.
There are several reasons why an alignment of interests is impor
tant for any investment firm, but first and foremost is that it is simply
the right thing to do. It also is a very powerful internal management
strategy, as the investment team is always motivated by and working
towards the same goal. We always seek to ensure that both we and
company management have a lot of skin in the game through mean
ingful personal ownership. In fact, every active investment team mem
ber at Hellman & Friedman invests in every deal. I also have made it
my mission to share equity and not hog ownership at the top levels of
the firm, as the Lehman old guard had done.
Another critical aspect of this principle relates to the practice of
charging deal fees. We do not charge deal or advisory fees, as some
general partners do, for transaction-related work and we do not charge
monitoring fees to our portfolio companies. In the event that we are
partnered with another private-equity firm that does charge deal fees,
we credit 100% of our portion of those fees immediately back to our
limited partners. To me, these are activities that we believe are already
our responsibility as investors.
In recent years, the size of these deal fees, often charged as a per
centage of overall transaction value, have become so enormous that
they alone often represent a sizable payout to the general partner.

To me, that presents a huge conflict of interest. I never want to have
to look one of my partners in the eye and question whether they
were being influenced at all by the sizable cache of fees, rather than
the merits of the actual investment itself.
Purely from an investment perspective, one of the most important
principals was our decision early on to focus on projected return on tan
gible capitalin evaluating investments. Wecouldnot be successful if we
continued making humdrum investments such as American President
Lines. One that followed almost immediately, Great American Man
agement &c Investment, earned only an 8% return. If we were going
to attract limited partners to trust us with their capital, we needed to
improve our returns substantially.
Fortunately, it was during this formative period that as a result of
thinking by Matt Barger, an incredibly astute investor who in 1984 was
one of the first to join our firm, we came across the notion of return on
tangible capital. This idea, which some of our other younger partners
helped develop alongside Barger, became a second major revelation
that transformed the future of our firm. Most everyone knows that
cash flow is important in business, but how you measure that cash flow
can be the difference between success and disaster. In measuring cash
flow, we try to carry the cash flow calculation a step further, in a way
that reflects the longer-term demands an investment will place on our
firm. We take into account all the capital requirements needed for a
business to operate and grow. We like to know the expected return on
the tangible capital consumed and replaced through the normal busi
ness cycle.
An early investment made with our own money, before we began
raising institutional funds, illustrates the importance of the adjustments
we made to reflect return on tangible capital. In 1986, we invested in
Genstar Rental Electronics and believed we paid about three times cash
flow. This looked like a good price at the time. However, depreciation
expenses were huge. In the real world of real cash flow, the Genstar
investment was made at more like 20 times cash flow—a very expensive
purchase multiple. The company eventually failed and taught us yet
another huge lesson.
62 * THE MASTERS OF PRIVATE EQIJITY AND VENTURE CAPITAL
One other calibration that is vital to our measurement of return on

tangible capital is our assessment of how much additional investment a
company will need to succeed. When assessing a prospective investment
we need to accountfor future capital expenditures, not just the cost of
buying the company. To do otherwise isakin to buying a house without
taking into account how much it will costto replace the leaky roof.
The tangible cash flow calculation gives us an idea of what it will
take to run the business successfully, and how high the hurdle might
be for us to successfully invest. When measured this way, the typical
U.S. business might have a return on tangible capital in the range of
10%. We typically look for businesses that return in the 20% to 30%
range. Companies that have that kind of cash flow can fund growth,
pay down debt, and make dividend payments to owners.
The Perils of Industrial Leverage

There is one more personal bias that I layer on top of this analysis.
One of the things that I believe implicitly—at this point it's almost a
prejudice—is that I and my partners don't like companies that have
double leverage. Financial leverage is one thing, but industrial leverage
is another. Companieswith large amounts of physical assets, plant and
equipment, have heavy industrial leverage, and if a company has indus
trial leverage, it is veryhard, I think, to impose financial leverage on top
of the industrial leverage. Such double leverage can severely constrain
the business: If revenues shrink by 2%, you no longerhave any free and
clear cash flow to service the debt.
Our bias against industrial leverage, combined with our measure
ments of return on tangible capital, has led us away from investing in
conventional manufacturing companies and toward services-oriented
businesses. An exceptional company such as internet advertising
manager DoubleClick holds up against these filters. Its cash flow is
enough to support growth and pay down debt. Relatively weaker
companies, such as American President, Great American Manage
ment, and Genstar, cannot. We try to rule out companies where only
two cents out of every dollar are returned to us after running the
business. In general, more finance- and service-oriented companies
tend to fit our mold.
SKIN IN THE GAME • 63
Tale of Two Investments

In the early 1990s, after studying the wireless sector extensively, we
decided that we liked the industry and made two separate investments
at almost identical times. Our first investment was in Western
Wireless, which ultimately turned into two separate investments after
VoiceStream was spun-off, and made us more money than I thought
anyone could make on an investment at that time. Western Wireless
returned 10 times our investment while VoiceStream, the predecessor
to what is now T-Mobile USA, made us nearly eight times our money.
In those days, in every small rural town or medium sized city, there
were no more than two wireless operators. Western Wireless was one
of the leading wireless operators. We found it to be a strong business
with an absolutely fantastic CEO namedJohn Stanton running it.
The second wireless investment was MobileMedia. For reasons that
are no longer clear to any of us, we thought we should own a paging
company. So weacquired onemajor and some otherminor paging com
panies and created the second largest paging company in the world.
With customers migrating away to newer technologies, the paging
industry began to experience significant pricing pressure. MobileMedia
quickly felt the impact and management responded with several impor
tant missteps. The company ultimately went bankrupt. It was another
revelatory moment for our firm, because as we rode that investment
down, we sat down and talked to each other day after day about what
went wrong. Being financially oriented people, we looked at the bal
ance sheet; we looked at the company's acquisitions; we looked at the
problems in the back office and the call centers and wherever else the
company may have erred.
I recall asking our team, "Whatifwe put another $5 million into it?"
I also recall Matt Barger's response, "Over my dead body we will
invest another $5 million. I wouldn't put twenty-five more cents into
this investment."
Matt was tired of the meetings and tired of analyzing what went
wrong withMobileMedia. He kept saying he did not even want to talk
about it anymore.
Some timelater,whenlooking back at the investment, someone asked,
"By the way, what's happening withPageNet?" PageNet wasthe largest
paging company in the industry and had very modest financial leverage.
It turned out that while MobileMedia's stock had once sold at $29 a
share, and was by then worth zero, PageNet's stock had decreased in
value from $30 a share to 25 cents. We finally determined that Mobile-
Media's problems were not unique to it. The industry was the primary
culprit, and we had done a poor job ofindustry analysis.
In retrospect it sounds as if anyone could have or should have
thought of this. Regardless, I think that has been one of the most im
portant analytical experiences in ourfirm's history. Nothing we could
have done—changing the capital structure, consolidating the industry,
changing the management team, back-office improvements—would
have made a difference. We were in a dying industry, and our invest
ment was not going to bring it back.
Away from Industrial Assets

There was one certain way of escaping industrial risk, and that was to
invest in companies that were less heavily invested in physical assets.
One of our earliest such investments was in 1989, when we helped
Brinson Partners, an asset manager, spin outofits parent in a manage
ment buyout. We later invested in Young & Rubicam, the advertising
agency, in 1996, anothercompany that waslighton tangible assets, but
rich in "elevator assets." Elevator assets refer, ofcourse, to the people
who walk in and out ofa company's doors—and ride up anddown the
elevators—every day. Over time, this approach led usto focus on firms
in the advertising, new media, financial services, software and asset
management industries.
With such investments, we need the people running the companies
to be hugely motivated to be successful. Y&R is a perfect example of
how this works. When we invested in Y&R, in terms of pure arithme
tic, we could have controlled the company. In fact, that is what the
Bear Stearns investment banking team hadinmind when they originally
approached us with the deal. Senior partners of Y&Rwanted out, and
rather than selling to one of the big firms—WPP or Omnicom—CEO
Peter Georgescu wanted to recruit a new, financially oriented owner.
We had a differentviewfrom Georgescu's initial inclination of how
to approach the situation. I said to him, "Peter, I don't want to control
this company. The key to success with this company is you and the
SKIN IN THE GAME • 65
management team. We are not advertising people. I think there is a

lot we can do to help you, but we need you and your team to be fully
invested, too."
We were investing $240 million in the firm, enough to demand total
control, but I told Georgescu we wanted to put 10% ofthe voting stock
ofY&R into a voting trust, voted by management, notus. We wanted
them to understand that they controlled their company. We might still
try toforce difficult orawkward decisions on them: strengthening man
agement orcutting overhead, for example. But we hardly were going to
drive discrete advertising decisions and say, "Gee, we really don't like
the Ford campaign."
The Impact of Working Capital

One ofthe single greatest contributions we made to Y&R was introduc
ing agreater appreciation of working capital. The firm's biggest financial
problem was excess working capital, mainly in the form of accounts
receivable. Their networking capital was positive, while both Omnicom,
and WPP had anywhere from 0 to negative 20% working capital.
This disparity inworking capital had a big impact on thecompany's
operational flexibility. Y&R was one of those firms that had plenty of
assets, but because the assets were in the form of accounts receivable,
not actual cash, the firm had an impaired ability to pay down debt.
When it came time to pay their current liabilities—the other main part
of working capital—they would have a hard time getting the cash to
do so.
We spent a great deal oftime educating and focusing theY&R man
agement team on how tomanage the working capital and pay down the
firm's debt. They responded well and went at it aggressively, eventually
paying down 100% of the acquisition debt over two years primar
ily through changes in their working capital. In some cases, it was as
simple as calling a client and demanding timely payment. Once clients
stopped letting payments drag outfor 90days or longer, working capi
tal improved considerably.
Alongside the change to their balance sheet came a high-charged
operational turnaround engineered by the company's talented chief ex
ecutive, Georgescu. Born in Romania, and separated from his family
66 • THE MASTERS OF PRIVATE EQJJITY AND VENTURE CAPITAL
during World War II, Georgescu and his older brother were forced to
dig holes and clean sewers all day for the Nazis. That sort of life ex
perience stuck with him even after he reunited with his parents in the
United States, attended Phillips Exeter Academy, then Princeton, and
then Stanford Business School.
Georgescu's turnaround began soon after hewas promoted to chief
executive in 1994, two years prior to our investment, and accelerated
afterward. The firm won over $1.5 billon in new business in 1995.
They brought back lost clients, squeezed more business out ofexisting
clients, and recruited entirely new ones. I believe the increased activity
was generated in part by the fact that employees on the creative side
had a greater stake in results. A new pay-for-performance method of
charging clients yielded a more results-oriented compensation at the
firm, and with equity in the picture, many ofthe firm's employees had a
new motivation to help the firm succeed. By 1998, thefirm went public
and was acquired two yearslater in a transaction that returned us more
than four times our investment.
The Y&R transaction illustrates how we were able to take a minor
ity position and leverage that position into an outsized result in terms
of strategic impact and financial results. Part of the result, I am con
vinced, arose from the fact thatwe had left such a large portion of the
ownership in the hands ofemployees who then became exceptionally
motivated to deliver results. As word spread ofour approach, we began
to get access to other management-led buyouts in which our willing
ness to take only a partial share of professional services firms gave us
a competitive advantage. That advantage helped us prevail over other
firms for the right to invest in the carve-out of Delaware International
Advisors Ltd. from Lincoln National Corp, which was later renamed
Mondrian Investment Partners.
The decision came as a result of an unorthodox approach to ac
cepting bids. Mondrian's management team had issued a request for
proposals, similar to what a city does when asking for bids on a con
struction project. Mondrian requested, among other information, for
firms to list their experience investing as minority investors in asset
management deals. Our willingness to have management control a ma
jority of the firm, with the possibility of a larger future stake should
results improve, won us the deal.
Skin in the Game * 67
Outsized Influence
To some, it may seem counterintuitive that a minority investor
would be able to wield the control needed in order to bring about
strategic change, but our experience has been quite the opposite. One
of the most powerful cases in point is NASDAQ, the stock exchange
and automated trading system, where in 2001 we made our initial,
$245 million investment.
The most we ever owned of NASDAQ was about a 19% stake.
Despite that relatively small ownership position, we still had signifi
cant skin in the game—more than any other investor. That meant
that from the outset I was the director whom the others looked to
when a difficult question arose. "What do you guys at Hellman &
Friedman think we should do?" someone would always ask. This
investment amounted to roughly 10% of our Fund IV's committed
capital, a large stake for a single investment, but our firm has always
preferred to run a concentrated portfolio as opposed to a diversified
portfolio approach.
Oncewe were invested in NASDAQ, we brought plentyof ideasinto
play. At the time we invested, NASDAQ was on the cusp of significant,
strategic change. It was transforming from a regulation-dominated,
almost bureaucratic system to an entrepreneurial venture. At every
board meeting, there was a common interest in commercializing
NASDAQ, yet most of the people there didn't have the time or the
personal wealth at stake to really look atit every day, as we did.
As we got to know the company, itbecame obvious why other board
members were so willing to defer: The place was a mess. For example, the
NASDAQ was trying toform relationships with little stock exchanges all
over Europe, but virtually none of these deals made any sense.
"If we pay $20 million for one of these exchanges, itwill likely result in
a $20 million per year reduction inoperating income," I told the board.
The Greifeld Effect

Many ofthe problems turned around, though, when we went through
a new CEO search and eventually found Bob Greifeld. We had gotten
down to the wire and were deciding between a handful of candidates
when Bob surfaced as an innovator in the industry who had created
one of the earliest market-based electronic communications networks

called ECNs.
I ran Bob's name by Arthur Rock, one of the great private inves
tors of our time, who had an immediate, positive reaction. "This guy
has successfully done exactly the job you are looking for in nearly an
identical business," Rock said. "He'll simply have to do again what he
has done before."
On his first day in May of 2003, Greifeld laid off the top layer of
management. He killed a long list of foreign ventures, including that
$20-million-a-year sinkhole effort to expand into Europe. Within
weeks, he had axed the investment designed to replicate the NASDAQ
system on the other side ofthe Atlantic, NASDAQ Europe.
However, cutting costs was only part of the job. Greifeld had big
growth ambitions and with our support considered an initial public
stock offering. But before we could register for a sale, the IPO business
ground to a halt. Making matters worse, the exchange's closely held
stock dropped sharply invalue. NASDAQ members who had obtained
shares during the exchange's demutualization in mid-2002 began sell
ing, and the market capitalization dropped from just over $1 billion to
under $600 million in less than six months.
In my mind, the stock sales engendered near flashbacks of early
days, when we still had not cleansed our investment banker thinking.
In NASDAQ, Hellman &c Friedman owned a preferred stock that was
convertible at $20 a share, but NASDAQ common shares were sell
ing at $4. Still, "We own a great security!" I kept murmuring. It was
a sardonic riff on the lesson we had learned years ago that no matter
how good atrade may seem it's not agood investment if the underlying
business is not sound.
Greifeld seemed tosee the problem the same way, and the exchange
was having problems that went beyond the stock sales as the NASDAQ
demutualized. The company's debt level in 2003 when Greifeld took
the reins was high. And three years after the dot-com boom went bust,
the NASDAQ wasstill hit hard—far harderthan its rivalthe New York
Stock Exchange. The NASDAQ took years to recover in the new list
ings market.
Instead of panicking, though, Greifeld focused attention on the real
value of the business. Greifeld improved NASDAQ's performance.
He also saw that we needed to maximize revenues by increasing mar

gins on each trade. It was a return on tangible capital analysis, plain
and simple.
Greifeld's solution: Instead of fighting ECNs, and their lower
transaction costs, he would acquire one of the biggest of them and
export its technological expertise throughout NASDAQ system. He
targeted one of the most successful electronic networks, Instinet, and
in December 2005 we invested $60 million in new capital to make the
deal possible. From the start, Greifeld had pushed the company to get
costs below Instinet's, and now we owned this important rival. Itwould
not be long before Instinet's expertise in low-cost transactions would
spread throughout the rest ofNASDAQ system.
Pouncing on Transitions
Transition periods tend to create investment opportunities, as the
NASDAQ experience showed. In recent years, we have focused on
the major transitions and taken investment positions that comport
with our standards but might seem risky to outsiders. For instance,
at the time we acquired DoubleClick in 2005, the one-time dot
com darling had undergone a somewhat painful transition in the
aftermath of the 2000 dot-com crash. However, we had a unique
view: Digitas, a prior H&F investment, had been a large customer
of Doubleclick's services, which gave us differentiated insight into
Doubleclick's business.
We believed therewere certain strategic and operationalenhance
ments we could make that would help renew the company's focus
on its core business. For example, we structurally separated Double-
Click's two primary businesses, promoted operating management
to run those businesses, and realigned management incentives ac
cordingly. We sold the Abacus division to a strategic buyer and
strategically refocused the Tech Solutions business profile through
divestitures and acquisitions. These actions not only served to re
shape the business, but also dramatically increased new product
development initiatives. Two years later, Google agreed to acquire
DoubleClick from us for $3.1 billion, which returned over eight
times our original investment.
Staying in the Race

At the end ofthe day, we all can only do our best—not just in investing
decisions, but in the way we manage businesses and develop ideas for
success in whatever industries we address. We need to be confident,
but not overconfident; aggressive, but not foolhardy. I believe that an
investment and management style such as the one our firm abides by
is the best hope for success, and our track record would indicate I am
getting that statement mostly right.
Still, we must all guard against self-satisfaction, or perhaps satisfaction
of any sort. For me, that point was driven home at the unlikeliest oftimes,
in the unlikeliest of places, during my time as an ultra marathon runner.
Bluegrass music, running, and endurance horse racing are perhaps my
most important personal avocations. It was my passion for Bluegrass music
that inspired me to personally underwrite the annual Hardly Stricdy Blue-
grass Festival. Asmany as 700,000 people attend the free concert festival
each fall in San Francisco, in the shadow of the Golden Gate Bridge.
Then there is running. I run every day, beginning at 3:45 in the
morning, and there was a time when I participated in ultra marathon
events. Twice, for example, I ran the Western States 100—a 100-mile
race through northern California.
My wife, Chris, has a saying: "Nothing exceeds like excess." The
point is that we achieve our greatest successes only when we push our
selves to anexcessive degree.
Even so, no matter how hard we push ourselves, itis likely that some
one better will come along. Whether it's in deal making, investing or cor
porate management, orwhatever we might do, there isalways someone
else who does itbetter, faster, longer, and with more intensity. Ilearned
this lesson the last time Iran the Western States 100 race. Acouple days
after the race, Chris and Iwere at Crissy Field in San Francisco, running
out the lactic acid in my legs, when two frail women approached.
I was proudly wearing my t-shirt, "Finisher, Western States 100,"
when one ofthe women approached me and said, "Did you run the
race Saturday?"
"I sure did," I said, the words puffing from mychest.
She said, "Gee we were crewing at Green Gate," which is one of
the water and rescue points. "That race really looks great," she added.
"My friend and I are thinking about running itnext year."
Skin in the Game ° 71
I was flabbergasted. "Look," I said, "you can't even begin to un

derstand what it takes to run a 100-mile race. You have got to be in
shape like you have never been in your life. You can't even imagine
how difficult it is!"
"My friend and I ran across the United States last summer," the
woman responded. "I think we can handle a 100-mile race."
Yes, our firm is made of good investors, good strategic counselors,
and good people. We have afocused and disciplined approach, and we
have put billions ofcapital to good use for our investors.
But, lest we get complacent about our success, it's helpful to keep
in mind that, much like ultra marathon running, the race goes to those
who persevere, no matter how long the run or how unexpected the
competition. In the end, to finish is to win.
LESSONS FROM WARREN HELLMAN

<?> Guilty until proven innocent. No investment theory, management
hypothesis, orcorporate strategy should be accepted simply on face
value. Test all relevant scenarios before acting.
<$> Always align interests. Ensure that you, company management, and
investors are always working toward the same goal.
<$> Have skin in the game. Investors with meaningful capital at risk
care more, work harder, and get more respect than those with less
at stake. Likewise, giving management a stake in the company
increases both the desire for profit and fear of failure. Nothing
empowers and motivates people like a share in the outcome.
<|> Avoid the "good security" fallacy. Invest in companies with strong
cash flow that can grow overtime. Do not invest just because the
security offered seems to promise a good return. The health and
prospects of the underlying business count far more.
£&> Listen to your partners and associates. Surround yourself with smart
people and listen intently to their views—they often are smarter and
often better investorsthan you. Reward them accordingly.
THE PARTNERSHIP PARADIGM:
WORKING WITH
MANAGEMENT TO BUILD
TOWARD SUCCESS
Carl D. Thoma
Founder Thoma Bravo,
LLC and predecessor firms Golder Thoma & Co.;
Golder Thoma Cressey Rauner, LLC; and Thoma Cressey Bravo, Inc.
AUM: $2.6 billion Years in PE: 35

Location: Chicago, IL Year born: .1948
Grew up: Boise City, OK Location born: Roswell, NM
Best known deals: Paging Network, Inc., Global Imaging, Inc.,
American Income Life Insurance Company, IMS International, American
Cable, Tyler Refrigeration
Style: Skeptical, focusing' on what can gowrong; anticipatory
Education: B.A., Oklahoma State University, Class of 1970
M.B.A., Stanford Graduate School of Business, Class of 1973
Significant experience: Very fortunate to have gotten involved inprivate
equity early on; truly appreciate the difference strong management can make
Personal interests: Winemaking andmodern art. Owns VanDuzer Vine
yards in Oregon and investor inEight Modern Art Gallery in Santa Fe, NM.
The lesson: "Private equity isabout superiorly managed and performing
companies, not being an investor. It is aboutbeing proactive."
73
74 ° THE MASTERS OF PRIVATE EQJUITY AND VENTURE CAPITAL
Over the years, Carl Thoma and his partnerships have become known
for a f(buy and build" strategy that requires patience, industry-specific
knowledge, and an unrelenting focus on performance. Key to Thoma's
best deals is a focus on management as the key to success, especially
the chief executive, an approach summarized in his firms' longstanding
motto, "partners with management."
Thoma, who has operated from aChicago base for more than 35 years
has adapted to changes in the economy and in the industry by develop
ing an approach that more actively exercises the powers of ownership.
Part of the reason for this is Thoma's belief that time is of the essence.
Before a purchase even closes, as a condition of the deal, he insists on
changes that must be made and metrics met at or before the close ofthe
transaction. An investment firm can deliver its best results only when de
cisions and actions are taken quickly and effectively by the management
of portfolio companies.
I am aworld-class worrier, and, as much as anything, worrying—effective

worrying—is responsible for my success. Infact, I think anyone inthis
business needs to be an effective worrier in order to be successful.
I came upon this vital skill as a young person growing up ona ranch
in the western part ofthe panhandle ofOklahoma. Agriculture, whether
raising crops or raising livestock, is a business where worrying is a
major part ofyour work. You worry about blizzards, rain, lightning or
grass fires, grasshoppers eating your forage, and, always, the price of
cattle—both buying and selling. There is always something. Agriculture
is a great industry to teach you toworry because something can orwill
always go wrong.
That is how we try torun our companies. You just have to anticipate
things, especially the things that can go wrong. Worrying is one ofthe
most effective means of doing that, but worrying alone is not enough.
That'swhy the word anticipation is my favorite business term. Antici
pation starts with worrying and leads to thinking about and preparing
for taking action to mitigate business risk.
I think private-equity groups do a very good job ofthat—worrying
about and anticipating problems—in working with their companies. It
is important to be an effective worrier. Just wringing one's hands and
THE PARTNERSHIP PARADIGM • 75
fretting about what could go wrong is not enough. But ifyou're some
one who anticipates troubles and acts before they happen, then you
can be an effective business leader. And at the speed of business today,
timely mitigation of risk is more important to what we do than it has
been at any other time in the 30 years I have been in this industry.
For worrying to be worth the trouble, it has to be accompanied
by effective action. This is something I learned from my mother. She
always emphasized that, once you think you know what you want to
do, don't sit there: Do it.
Our industry has evolved over the years, and the opportunities and
challenges today require a different set of skills than when I started
out in private equity in the late 1970s. Yet, at the same time, there are
essential tactics and skills that do not change. Effective worrying is
one. So is a sense of urgency: the need to reach good decisions quickly
and execute them effectively in order to succeed. Of course, in private
equity, we're not always the ones who have to execute. In almost all
cases, we rely on managers we hire to actually implement strategy, and
dealing with management is not just a source ofconsiderable worry, it
is the key to success—or the cause of failure.
Making Management an Asset

Perhaps one ofthe most important, and most difficult, aspects to master
as conditions change is the way we deal with management. There are
times when management can seemingly do no wrong and other times
whenthe economic crosswinds are so greatthat it seems almostnothing
management does can make any difference. Achief executive who is a
star when building a business can lose his way when it comes time to
operate a more mature company. For the private-equity investor, such
turning points are key moments ofdecision. We have to decide whether
to stick with management and help them mature or make a change and
hope for better performance.
The essential element for success is the mindset that we as private-
equity investors bring to our investments. Inshort, we need to adopt an
ownership perspective and treat each investment not as an engagement
for short-term profit but as an asset we have invested in and one that
we must work to improve over time. The most important work we do
in this regard is select, work with, evaluate, and improve management.

Our roles and responsibilities have changed, too, due to changes inthe
economy, increases in leverage that leave less room for error, and the
growing sense that cycles of investment keep growing shorter.
I jokingly tell colleagues that the only position that is more senior
than the CEO is the owner, and so when we take on the role of an
owner, that defines a lot of the relationship with management. It's a
paradigm shift, one that is easily felt by everyone involved. If you ask
who controls the Dallas Cowboys, is it the quarterback or the owner?
I think there's not much doubt about who has control. Or, consider
the Yankees when George Steinbrenner was in charge. Nobody ever
mistook him for just an investor. Steinbrenner clearly viewed it that
way, and he felt free to make a change, even with managers who had
brought him a World Series ring, if their results slacked off.
As we exercise the prerogatives of ownership, we also become more
accountable for results than we had been in thepast. In fact, I think we
as investors share the same responsibility for the performance of our
companies as the CEO does. We bear responsibility for making certain
that the right people are in place and that we have the right mix ofoper
ations and sales people and the key technical expertise. It means setting
up the right compensation and incentives. It means creating a culture of
accountability. We have to have an involvement in and understanding
ofthe business at levels ofdetail thatwere notnecessary before.
Carried to its logical extreme, this change in orientation really has
had an effect on our role with our companies relative tothe one played
by the managements who operate them ona day-to-day basis. In some
cases, we are asking the CEOs of our companies to act more like chief
operating officers once did. We ask them to focus less on setting strat
egy andmore on execution. That's because the times are forcing us, the
owner-investors, to assume part of the leadership role that once was
exclusively held by the CEO.
The Platforms of Success

My observations about dealings with the CEO and management
may be particularly acute because of the sort of deal my firm is best
known for. Literally since our first investment, in a paging services
company called Paging Network, better known as PageNet, we have

specialized in buying small, multi-unit companies and building them
through acquisition into major national players. The technique came
to be called platform investing or leveraged buildups, but regardless
of the name, it seemed to us a sensible wayto use leverage, our ability
to work with management, and our strategic vision to create great
return on our investments.
We have executed a platform strategy in industries as varied as fu
neral homes, golf courses, and copier dealerships. At times, we have
actively identified industries in need ofconsolidation and then worked
to recruit a chief executive whom we think can execute a consolidation
plan. We did this, for example, with Kevin Rogers, who made the equip
ment rental company National Equipment Services a national power in
less than three years. The economic downturn in the early 2000s and
reduced rental rates from excess equipment ultimately forced NES into
bankruptcy, but his initial run was a remarkable bit of execution.
ACEO running a consolidation strategy can be particularly effective
if he hasthe ability to assess the leadership qualities at the firm's target
companies. We learned this through experience at companies such as
Global Imaging Systems, which was successfully sold to Xerox in 2007.
In that case, an assessment of the people and culture of acquired com
panies proved to be just as important as a close reading oftheir finan
cial statements. Costs can be cut and systems streamlined, but changing
culture or improving management is not always easy to do.
When I first came out of First Chicago along with Stanley Golder
to set out on our own as investors, we did venture deals as well as
buyouts, and in most ofthose early deals we got a number ofinvestors
together to spread the risk and the upfront investment. I think the in
vesting approach we used then, the economic environment, the lender
attitude, and everything else allowed us to be a little less demanding
ofmanagement than is necessary today. There was room for error and
less competition for deals, so purchase prices did notclimb as high, and
there was time to recover if we made a mistake.
No one has that kind of luxury anymore, and there are other, some
what more subtle changes at our firm and throughout the private-equity
industry that are affecting how we deal with the managers at our port
folio companies. These days, we are typically the only investor, so it is
ourcapital—our investors' capital—on the line. We typically have made

a large investment, which means we likely are using significant leverage.
The higher leverage means time isofthe essence. Toget the rate ofreturn
we need,we have to move quickly. Information flows a lot faster than it
once did, and there are about five times as many firms out there compet
ing for deals compared to when we started out. The competition has a
tendency to test our discipline when itcomes to negotiating our deals.
The CEO Factor

Given all these changes, we can no longer afford to work with any ex
cept the very best chief executives. But, we are less inclined to change
CEOs today than we might have been years ago, in part because any
management change costs valuable time, something we cannot afford.
This means that, quite often, we find ourselves coaching and encourag
ing the CEO today more so than in the past. The economic crisis that
began inlate 2007 has also taught us, innew ways, thatthere are some
problems no management can solve. We have to see far enough ahead
to avoid companies thatjust are notgoing to make it intough economic
environments, no matter how good management might be.
In many ways, too, all of these changes have forced us to learn new
ways to work with, coach, and encourage management. For starters,
in cases where we are more involved in setting strategy, we have to
make certain before our investment that the CEO will be comfortable
with such a close working relationship. Then, once we have made our
investment and begun facing challenges, it does not work any more to
just sit a CEO in the board room and berate him for missing goals or
making mistakes. That approach does notyield better management. It
might even make things worse.
This doesn't mean we have to coddle ineffective executives, either.
It means that, from the start, there has to be a shared understanding
ofour objectives, a clear path toward meeting them, and an agreement
about what will happen ifwe fall short. Accountability is the essential
element: if someone says they will deliver certain results, they need to
do that.
If we find that a CEO cannot deliver, there are times we must act,
even though we know a change at the top will cost us, because the lost
THE PARTNERSHIP PARADIGM * 79
time will hurt our investment rate of return. If ever there were a time
for "just do it," it comes at the moment that the board of directors con
cludes a management change needs to be made. Often, just after there
is a consensus that the CEO must go, someone on the board will sug
gest that perhaps the person deserves just one more chance to change
or improve. Take my word for it: By then it's too late. Unfortunately,
in 35 years, I have never seen a situation where it worked out to give a
second chance to a CEO who proved incapable in the first place.
The Ticking Clock

Time is crucial. In today's competitive environment, where companies
are selling for higher multiples of cash flow than at any time before,
time is the enemy. The difference between delivering outstanding re
turns to our investors and falling short is all related to how long we
own the company. It's a lot easier to hit that higher number if we can
improve performance in a shorter period of time. With that in mind,
there is no room for mistakes, little room for managementchanges, and
an absolute premium on accountability.
While some of thetime parameters and other pressures have changed,
other key components of success have not changed since our first deal,
nearly three decades ago, for the paging services company PageNet. At
First Chicago, we had carved out a business doing what today would
be called both venture capital and private-equity investing. At the bank,
we had won considerable attention for our decision in 1970 to back
Frederick Smith, who was investing his $4 million inheritance to start up
Federal Express. Leading a group ofventure investors, we raised another
$91 million in seed capital for an exceedingly capital-intensive business.
On the private-equity side of First Chicago, the orientation was far
more prosaic. Similar to the prevailing approach at other banks and
buyout shops at the time, we focused our attention on engineering buy
outs of companies that were undervalued, had strong CEOs in place,
and had promising growth prospects. At First Chicago, we mostly fo
cused on the manufacturing sector, but Stanley Golder and I started to
develop a theory that our impact might be just as good in the service
industries. Rather quickly, a couple of deals we did in cable television
and health care convinced us that we were onto something.
Eyeing Target Industries

I felt we could add more value by first identifying industries in need of
consolidation, where there were great disparities between topperformers
and weaker players and where we could recruit at least one key leader
and then a management team to operate the company. The setup was
simple. While we would scour the market for any acquisitions that
might fit into the company we were building, the CEO and management
would operate the companies. They would take care of integration,
which is always difficult, and improve the operations of the acquired
units. Formany ofthecompanies we added to our platform investment,
chances were thatthey had become available for us to buy because they
were poorly managed in the first place.
PageNetis a good example of how this process worked. This was the
early 1980s, before people had cell phones. Pagers were the best way,
really the only reliable way, to instantly reach people on the go. We
came across the paging industry almost by accident. We were investing
in a cable television company, andsomeone made thecomment, "Here
is a sleepy industry that most people don't know exists. It is primarily
doctors and plumbers who carry these devices all the time."
When we looked into it,paging fit the profile ofthe sort ofindustry
that made sense for us. Industry revenue was growing 20% a year.
There was no dominant national player. There were plenty of locally
ownedand operated, entrepreneurial companies that we couldroll into
one largeroperation. That done, theycouldsharecosts, distribute best
practices, and have greater purchasing power—all the benefits of size
in any marketplace.
Profiling for Success

Finding thechief executive was, ofcourse, our first key task. Wedid not
yet have a company to operate, butwe needed to put the right CEO in
place before westarted stringing together theenterprise. We were brand
new to the industry—remember, we had first come across paging as a
possible investment only a few months earlier—so we did not have the
connections with or knowledge of the top talent that we sometimes do
in industries where we have more background knowledge. We retained
a search firm to reach out to all the leading executives in the industry
and found George Perrin, who proved to be a remarkably good fit for
what we were trying to accomplish.
It is instructive to look at Perrin's profile when we hired him, not
just because he proved to be a particularly strong hire but because our
experience in this case demonstrates the sort of thinking that goes into
matching a CEO to the task at hand. Perrin had been the number two
person at Communications Network, Inc. the leading paging company
at the time. He had worked for the industry's best company, with mar
gins superior to those of everybody else. Literally, their margins were
twice what the other public companies were, so it was obvious he knew
howto run a company and knew how to do it better than anyone else.
Now, here is something that is easy to overlook. If you are going
to back management, especially someone you are recruiting into a
challenging situation like a start-up, you've got to make sure that they
have also had experience at the better companies. Management has
to be a big difference maker, and if they are going to make a differ
ence they have to know what the tools are to do that. A leader of a
company that operates pretty poorly is probably going to bring some
of those poor practices into the new job. A leader who has achieved
extraordinary returns has a better chance of achieving that kind of
performance in a new setting. It's common sense, but it's sometimes
not fully appreciated.
Of course, one can never tell how much of a firm's success is due to
the top leadership and how much comes from other factors, but Perrin
broughtto us other factors that clearly he couldcall his own. Commu
nications Network had grown through acquisitions, and Perrin himself
had worked many of their deals. Because acquisitions were a key part
of our strategy, this was a big plus. He would know all the would-be
sellers out there, they would know him, and he clearly knew how to
negotiate a deal.
What's more, Perrin was available. You're not going to get the CEO
ofa public company to come join a start-up for a private-equity firm. For
that sortofperson, therisk doesn't make sense. Even thenumber twocan
be tough to recruit out of a going concern. Perrin, though, had moved
to Boston to run a company for a private owner, and sometimes people
learn that working for a private owner is not always as attractive as it
sounds. Perrin had not been there long, but he was ready for a change.
He had just the profile we needed—the sort of profile that would fit in
any start-up, platform investing scenario—so Perrin was our man.
The Power of the Team

Over time, Perrin proved to be an even better fit than he had first ap
pearedto be on paper. Whydid we succeed? Firstand foremost, of the
first 13 people we hired in the company, 11 had worked for Perrin at
Communications Network.
With a team that cohesive, Perrin was able to operate a company
where there were few surprises. The management team knewthat was
important for him from their past experience. For us on the board,
this was important, too. It is far easier to set a strategy when the CEO
knows, from day one, that the people working for him can execute.
Perrin had a philosophy that people could lose their bonuses just as
fast by beating budget as bycoming in under budget. If one of his team
forecast a $2 million profit, that's what he wanted: not $1.8 million,
not $2.5 million.
"You need to know whatyou aregoing to do because I need predict
ability," Perrin would say. "It's kind of like a quarterback throwing
to a wide receiver. You can't be two yards further down the field than
where you are supposed to be or two yards short. You've got to be
exactly where you are supposed to be."
The incredible discipline of Perrin's management team gave us a
competitive advantage in the industry. To put it bluntly, the industry
just was not that professional. That was one of the reasons we had
found it attractive as an investment. If you have a team that can hit
budgets, that can set a good plan, that can execute as you want, in an
industry where the competition has a hard time doing all those things,
you're bound to make money.
Perrin was able to decentralize decision making, so we were able to
move morequickly than anyone else. Hispeople were versatile enough
that we could plug them in, very quickly, if problems developed
somewhere. If one of the acquired companies wasn't doing well, we
could drop a regional vice president in to start running it themselves.
They would stay for six months or so, get all of the standardized
systems set in place, then move out. The tactic was a bit unusual, but
it just absolutely worked. It also was just the kind of mindset that we
encourage as the owner-investors: do what you have to do to make
it work.
Tactical Execution
With Perrin and his team in place, and our investment hypothesis
proved out, we soon found we had to make adjustments as conditions
changed. We all saw that as this industry grew and the cost of the
equipment came down, prices were going to drop. As a major player,
we felt we could lead prices down. We would comeinto a new market,
build a state-of-the-art system, introduce new technologies, and lower
our prices. Within two to three years wecould have 60% of the market
and then just sort of start running the competition out of town.
Wequickly did seven acquisitions at PageNet, but then the prices got
too high. People knew we were buyers, so we decided to try start-ups.
There was no reason to buy somebody for $10 million when you can
start a companyfor $5 million, spend two or three years, and wind up
with the same size company, a lower cost basis, and probably a more
efficient operation because it wasn't started by an entrepreneur who
may have introduced some inefficiencies along the way.
We stayed in PageNet for 10 years. Our aggressive market entry,
with a very outstanding group of people, new technology, and an ef
fective management structure, gave us the momentum to eventually
become the largest company in the industry. We invested $8 million
in the company and netted about $800 million for our limited part
ners when we ultimately sold. That was 100 times their money, which
makes everyone happy, of course. And it was a big enough return to
put our firm on the map.
Of course, you jump forward 10 years and the company got wiped
out by cellular, but that was several years after we liquidated our posi
tion. Cell phones pretty much killed the paging market. Entire indus
tries get wiped out sometimes. In others, major economic dislocations
can overwhelm the efforts of management. Airlines are that way. There
are times when the differences between the top performers and the also-
rans are not that great because management, no matter how good, can
just get run over by industry fundamentals.
Refining the Strategy

Even so, as you do this kind of platform investing, there are lessons
you pick up as you go alongthat can applyin many kinds of industries.
Over the years, we have jumped in and out of the funeral home business
several times. Webuiltup Paragon Family Services in the 1980s, soldit,
and then built Prime Succession in the 1990s. In that deal, we bought
up 40 funeral businesses in five years and soldthe company in 1996 for
about five times the $29 million we put into it. We got in a third time
earlierthis decade, too, with Meridian Mortuary Group.
Our key insight with Meridian Mortuary, one that applies to other
industries, is that there is a certain minimum scale that makes sense for
investment. We bought up a few smalloperators—ones that would do,
say, 60 funerals, or "cases," as they're called, a year. We also had sev
eral that would do as many as 800 cases a year. The small ones could
never keep up with the performance of the big ones, and the smallones
were vulnerable because if the funeral directorleft you might just have
to shut down the operation altogether. It can bevery difficult recruiting
good funeral directors. Ultimately, with our funeral home investments,
our strategy would run its course. Wegot out eachtime because prices
for the acquisition targets got too high. It was better to sell the busi
nesses than to keep buying at those levels.
We madetwo forays into the golfcourse business. With golfcourses,
it was shockingly simple to bring operating efficiencies. For example,
in the late 1980s when we first got into golfcourses, many of them did
not even have cash registers, so it was almost certain there was a gap
between reported revenues and the larger figure the courses actually
took in. The most important lesson for us as a firm, though, was that
it can be hard for a CEO to repeat his success.
Our golf course CEO did a marvelous job for us the first time, but
the second time we worked with the CEO, just a few years ago, it was
difficult for him to bring the same intensity. He might argue it was the
weather, in that it rainedtoo much, but the business did not quiteachieve
the same levels of performance. Weas a firm felt that part of the problem
was it was more difficult for the CEO to investhimself totally in the busi
ness a second time. He possibly was not quite as hungry for success.
What we learned from the experience is that it probably is best
not to bring a CEO back in the same role he has already performed.
If we want to work with him again, it ought to be in a different role,

as a board member, maybe, or as a mentor to management of one of
our portfolio companies. At the same time, we want to make certain
the industry in the second instance is the same or similarto the one the
CEO worked in the first time around. We do not subscribe to the great
athlete theory, that a great CEO in one industry will automatically suc
ceed in another one. The skill set may be transferable, but the industry
knowledge and contacts are not. And in private equity, where time is
of the essence, we cannot afford to give the CEO time to develop the
connections needed to be successful in a new industry.
The Focus on Management

In all of these platform businesses, the management-centric approach is
extremelyimportant. As we developed and refined our techniques over
the years, not just in paging, funeral homes, and golf courses but also
in health care and software, we always asked ourselves how much of a
difference management could make. We answered that question using
a simple technique. We would look at an industry to see what sort of
performance gap existed between companies in the first quartile of the
industry and the third quartile.
In some industries, the differences would not be that great. In
others—the industries we picked—management can have a big impact.
The leaders might have 25% margins, while the third quartile margins
are 10%. That 15% gap is where we could make our money, bringing
the average or poor performers up to or abovethe standards of the top
performers. Once we identified the opportune industries, it was up to
us to recruit, motivate, and incentivize the sort of management team
that could give us a competitive edge.
We got to the point in the late 1990s where two-thirds of our in
vestments fit this model. Other firms adopted the approach, too. Go
recruit a great managementteam and give them capital. Go out and buy
companies, and then they run them for you.
We as board members stay very involved.We've got to watch for the
pitfalls as well as the strengths of our managements. For example, we
must make sure that an aggressive acquisition pace does not become
an excuse for failing to achieve better margins and revenue growth.
We must also make sure the acquisitions we make meet our standards
and that the leaders of the companies we acquire as part of our plat
form strategy understand the expectations as to performance. As direc
tors wemayalso need to bethe governor on the pace of acquisitions, as
we must make sure management depth and systems stay in sync.
A Changing Relationship
This balancing actbetween the investor and the CEO isnever easy, and
it is changing over time. In the early years, we developed a slogan that
reflected our mindset: "Partners with Management." That worked for
us for a quarter century, but in more recent years the relationship has
changed.We used to be able to operate with the notion that 20% of the
time we would hit a home run, 60% of the time results would land in a
the middle, and 20% of the time things would just not work out.
The industry has changed now. Prices are more competitive. There
are more firms chasing the deals. We have adopted a new strategy
where we in effect are trying to bat 100%. No more 20/60/20. We
especially are trying to getrid of that bottom 20%. In the old days, we
used to buy companies at four or five times cash flow. Now, we often
have to pay upwards of eight times. It's just a different game, and the
old investment process no longer works as effectively. Execution is
critical as we need to lower the effective purchase price as fast as pos
sible by increasing earnings. We or the board have to take on some of
the strategy-making role that CEOs traditionally play because there is
just not enough time for the CEO to oversee both execution and long
term strategy.
The upshot of all this is that the decision on hiring the CEO has
become less of a final point in our success. These days, we tend to look
for companies first. We look more at the complete management team
and less just at the CEO. We want strong operators or teams at these
companies who are competitive and want to improve and grow. We
will accept a "good" executive with a team that we feel we can coach
and develop into an "excellent" or grade-A manager versus an A+ CEO
and no team. There's a company in our portfolio now whose man
agement team really had not done anything special prior to the time
we bought the company, but with some encouragement and training,
THE PARTNERSHIP PARADIGM ° 87
they quickly went from producing limitedearnings two years before to

producing excellentearnings—in a very tough economy. That does not
happen unless you can coach, inspire, and discipline the capability of
your people.
While we are investors with an ownership mindset, we still do not
want to be in the position of managing the companies we own. As a
board member of PageNet, for example, I worked closely with George
Perrin, but I never wanted to take charge of the company personally or
crowd Perrin out in areas where he could manage capably on his own.
With the company now in our portfolio, our firm got involved in en
hancing the management tactics of the executives, but we expected and
wanted them to implement and refine to fit the needs of their specific
company.
The Worrier's Rewards

Because we have to take our hands off the controls, we by definition
wind up worrying more about what might happen at our companies.
It's tempting just to step in and fix every problem yourself, but once
you decide you cannot do that you've got to grow comfortable with
letting the management team handle most of the challenges they face.
This means, by definition, that you wind up doing a lot of worrying.
My parents were ranchers, raising cattle, on about 12,000 acres or
so near Boise City near the New Mexico border. Twelve thousand acres
is a small ranch in that part of the country. My dad died when I was a
sophomore in high school, and my mom took over the ranch after that.
She had a great influence on me, obviously, as did an uncle nearby who
was a great rancher and a good business man.
I did a lot of things as I grew up. I was one of a handful of kids
in my class who went to college. I attended Oklahoma State Univer
sity for undergraduate study and then Stanford University for business
school. My wife and I both got our M.B.A.s from Stanford in 1973.
She took a job at Quaker Oats in Chicago and I went to work at First
Chicago, whose primary asset was the First National Bank of Chicago.
But, probably nothing affected my career as much as growing up on a
ranch, watching my father, my mother, and my uncle raise their cattle
and learning to worry.
As I said earlier, though, worrying alone is not a secret to success: Ef

fective worrying is. By "effective worrying," I mean the sort of fretting
that leads to anticipation and from anticipation to smart and strategic
action. My uncle was an effective worrier and a good cattle rancher
because of it.
"If it might not rain, then let's not have too many cattle," my uncle
would say. Then he would figure a bit and say, "If one feeder cattle
really needs 10 acres to live on in grass, well, in case it doesn't rain, we
better always just have one animal for 12 acres. That way, we've built
in a buffer for where things can go wrong."
This sort of mindset—anticipating the worst possible outcome and
taking steps to avoid it—is one of the reasons I typically do not expect
salespeopleto become CEOs. Salespeople simply do not worry enough.
In fact, it's quite the opposite. They are born optimists.
For salespeople, every person they meet is their next prospect. In real
life, the one that looks like a prospect could actually be a rattlesnake that
bites you. You just never know. If you have 10 salespeople, and each can
make $2 millionin sales,they will budgetfor $20 millionin revenue. But,
in the real world, one will get sick, one will quit, something will happen
to another. You've got to say, "I know something will go wrong so I
guess I better put al0%orl5% cushion in there."
Farmers and ranchers also learn how to measure people and insist
that they deliver what they promise, and these traits, too, are essential
to success in private equity. If you hire somebody to truck your cattle
to market but they show up late, you just don't use those people again.
You go with people who are reliable. Some people are just accident
prone or tear up the equipment, and you just don't get those people
on your team. And, if you're a good worrier, all that worrying should
cause you to anticipate the problems.
Beating the Clock

One way to minimize risk is to shrink the time that you are exposed to
any one company or industry. Over the years, I have really grown to ap
preciate the fact that time in our business is the enemy. We have to create
value very quickly. The way to get in the upper quartile of all private-
equity funds is to give investors a 32% return instead of a 22% return.
The partnership paradigm • 89
The simplestway to do that is to make an impact quickly and then get

out of your investment just as fast, in three years rather than five years.
Each company has performancetargets, and the faster you reach them,
the better.
To do that, you invest in industries you understand. You try to
work with a CEO who can maintain a stable management team. You
do plenty of upfront work before investing in a company. In fact,
we have made it a practice to insist on changes that must be made
before or at the time of the close on our transaction. That jump-
starts our push toward a fast, profitable turnaround. Beyond that,
we agree ahead of time on performance metrics with management of
the target company. This is another way of making certain there are
no surprises.
It's not easy getting in and out of companies as fast as you need to,
but one way to make it happen is to do a lot of the work up front,
before the money is invested and the investment clock starts ticking.
Tom Johnson at Global Imaging was one of the very best at this. He did
more than 100 deals for that company before it was sold to Xerox for
$1.5 billion. Only one deal, the first one, didn't work out as expected,
and that probably was our fault.
Tom's secret was to always buy a good corporate culture. Before
the investment, he would have someone go in and interview all the key
people in the company. It was always amazing what people would tell
an outsider or consultant as opposed to their boss or new boss. After
interviewing, say, ten people, we'd have a pretty good idea of that com
pany's culture and whether it would fit into Global Imaging.
Tom also believed very strongly in benchmarking. Before a deal,
he would sit down with the company's numbers, compare them to
the results he was getting in some of his best operations, and then
say, "OK, how are we going to hit those numbers?" He did all this
before we decided if we wanted to buy the company. We have fur
ther refined this process today by bringing in operating executives we
know, with industry expertise, and having them look at the target
company's metrics, too. If, for example, margins at a top-tier com
pany in the business are 25% and our target company is at 20%, we
want to set a path toward reaching a 25% return before we close on
our purchase.
A lot of times in our purchases, we have to downsize staffing in an

organization. When we approach a purchase with all this upfront work
in hand, as with Global Imaging and other companies, we insist that,
as part of the transaction, at the closing these adjustments are made.
This makes for a lot better process all the way around. We maybe are
able to persuade the sellerto pay the severances instead of making this
a cost born by the buyer.
We also can potentially pay a higher price if we know the seller has
streamlined the company before we own it. That way, when we are
welcomed in as the new owner, we don't have people worrying about
their jobs. We can tell them we are goingto focus on growth, and it just
makes for a lot better transition. From the day we own the business, we
want to start growing the business.
We can use this upfront approach particularly effectively in the
industries where we have deep knowledge—software, for example.
Over the years, we have bought and sold many software companies
and today would be among the nation's top ten software compa
nies if you total the earnings of all the companies in our portfolio.
We know, for example, that when times are tight it makes sense to
reduce or slow development of new products as customers are slow
ing their upgrades; however you must keep your sales force fully
staffed so as to take market share. Many times your competitors who
might be lead by someone with an engineering background will do
just the opposite. With one of the companies in which we made an
equity investment, we insisted that a facility be shut down and sold
before we invested. Thank goodness we did, because we could not
have given it away once the economy broke down in 2008. In that
business, it was pretty hard to justify having $20 million tied up in
a single building.
Starting Larger
A recent change we have made is to start with larger platform
companies than we once did. This gives us a deeper team that can
then build the company faster. When starting from a small platform, it
takes too long to recruit a CEO capable of operating a larger company
and then stringing together a number of smaller deals. The CEO who
The partnership Paradigm • 91
comes along with a larger platform already knows how to run a large
company, and we're working from a base that wecan leverage, quickly,
to build a big business.
Prophet 21, which develops software for distribution companies
such as electrical or pumping supplies is a good example. We bought
the initial platform company with $7 million in earnings before the
$2 million of profit improvements which were implemented at clos
ing. By comparison, when we acquired Global Imaging years earlier
it had only $800,000 in profits at the time we bought it. In less than
three years with Prophet21, after a stringof acquisitions, an improved
operational focus and emphasis on sales growth, cash flow more than
tripled, from $7 million to $25 million. We like to think our coaching
and operating discipline contributed to the company growing faster
than it historically had—and with better margins. After we sold the
company, Chuck Boyle, the CEO, started mentoring another company
we recently acquired, called Manatron, which provides property tax
software to local counties and cities.
Right from the Start

We as investors feel we can make a difference. We bring a lot of
expertise to the table with our industry perspective, contacts, best
practices, and outside consultants or operating executive relation
ships. Probably most important is that we bring high expectations
and a disciplined mind set, which we feel helps a company grow and
helps explain our investment success. At the end of the day, though,
it is the CEO of our portfolio company and, to a lesser extent, the
management team around that person who are key to making the
investment work.
Stan Golder used to kid me and say I had a tendency to try to wish
a deal to success. This would happen, in particular, when the industry
fundamentals and the company's products or services were strong, but
management's ability to successfully execute was weak or in doubt.
I've learned over time that, when we're looking at a company, we have
to avoid wishing for the CEO to be a success when, in fact, it might
be better to just pass on the whole opportunity. In about half of the
companies we look at, this is the case. Spending time with the company
92 • The masters of private equity and Venture Capital
and management before the deal can give us a good view as to whether
there is something worth investing in.
While we hustle hard to get an investment and can spend significant
time working with a management team, we have got to have that
discipline to say no. This is not easy. No one likes to think they have
spent six months looking at a deal only to say no. It's difficult to walk
away. You've got, hopefully, not millions but hundreds of thousands of
dollars of due diligence invested andit hurts to throw that away. We just
had a deal like that. Thankgoodness wedidn'tdo it. Thesign that finally
soured us on it was that we spentso much of our time arguing with this
CEO, who was obsessed with whether his old bonus program would
remain intact.
It is important to learn to trust your gut. If the deal doesn't feel right
at the end, at the time you are ready to close, it's going to be awfully
tough to make it work over the long haul. You will wind up feeling
frustrated that you were not more decisive before it was too late.
When you're looking at a deal and considering the management per
spective, you've got to always be paying attention to the question of
whether you can really work with that manager and the management
team. In the old days, there was the idea that if this person doesn't work
out we will just fire him. I think that today, there's no time for a mistake
like that. We are going to be stuck with this person, so if we think we
might have to fire the person then we shouldn't make the investment.
Although we must continue to improve, I feel very good about how
we have evolved in working with managers. It starts with picking the
right companies to acquire. We now have great people running our
companies whose sole job is to make sure they are better run and grow
ing. We may lay people off initially, but at the end of the day, we have
more people working at our companies when we sell them than when
we bought them. The best way to make that happen, consistently, is
to develop a plan for partnering with management and serving as the
supportive coach, cheerleader, and disciplinarian while being adaptive
as markets and the economy change.
Once we set up a strategy that way, there's little reason to worry
about the outcome. That doesn't keep me from worrying, of course,
but it helps me worry a bit less to know that, really, I have little reason
to be fretting so much.
The partnership paradigm * 93
LESSONS FROM CARL THOMA

«$)> Time is the enemy. The longer an investment is held, the more
difficult it is to achieve superior returns. Be decisive, act quickly,
and measure results.
<^> Develop industry-specific expertise. Contacts, sector-specific

knowledge, and a sense of industry history are keys to achieving
timely success. Hire CEOs who know their industries.
$•*> Act before the deal closes. Do enough upfront research and
negotiation to have performance and "best practices" metrics,
optimal organizational structure, and other targets set in place.
This makes it possible to grow the company from day one.
^ Find bigger platforms. In seeking to build acompany through

a series of acquisitions, it is more effective and quicker to use
existing management operating from the base of a larger platform
company than starting with a new CEO and a smaller platform.
<^> Worry, worry, worry. The time spent nervously pondering all
possible negative surprises—and how to respond to them—is time
well spent. Think ahead, plan ahead, and act on your "gut" so as
to prevent calamity.
BEYOND THE BALANCE SHEET:
APPLYING PRIVATE-EQUITY
TECHNIQUES TO
NOT-FOR-PROFIT WORK
Jeffrey Walker
Managing Partner and Co-Founder
AUM: $12 billion Years in PE: 25
Location: New York, NY Year born: 1955

Grew up: In the Southuntil 17 Location born: Knoxville, TN
Best known deals: Office Depot, Jet Blue, Guitar Center,
AMC Theaters, House of Blues
Style: Integrative
Education: B.S.,Universityof Virginia, Class of 1977

Significant experience: Worked in the investment bankingand finance
divisions of Chemical Bank, predecessor to today's JPMorgan Chase
Personal interests: Bungee jumped from Victoria Falls bridge in Zambia,
Africa; music (played tuba and bass in junior high and high school); four
great kids and amazing wife
Thelesson: "Ifyou think you are ontheright path, you areonthewrong path
because there is no path. You arecreating yourownunique path every day."
95
When veteran private-equity investor Jeff Walker was approached by

Jeffrey Sachs, the noted economist and poverty fighter, he was faced with
a simple question: Could the disciplines that work in private equity also
apply in the not-for-profit world? The answer is an affirmative yes, as
Walker has found through his work atMillennium Promise, a nonprofit
working with Columbia University and the United Nations in an effort
to cut extreme poverty in half by 2015.
Walker began his private-equity career a quarter century ago, when
he persuaded Chemical Bank to invest $100 million in a new private-
equity fund. He soon found that active boards, strong chief executives,
and effective growth strategies were key tosuccess. He isexporting those
notions to Millennium Promise while also helping to build a model that
may be of use to the promising new field ofsocial entrepreneurship.
W e live in a time of greatinequities, of mind-boggling wealth, and

heart-wrenching poverty. In theworld of private equity, we op
erate near the top of the global economic pyramid. Financial pressure
and the weight of worry increase as one moves down the economic
levels. Anentire middle class scrambles to paythe bills, to put the chil
dren through college, or to buy even the simplest luxuries. There are
several billion more in the bottom strata of society for whomsurvival is
a struggle. Food and shelter are not a given: they're a daily challenge.
It is this lower level, the level of daily survival, that has become the
focus of my current work. I spentalmost myentirecareeras a leaderof
the private-equity operation of Chemical Bank and its successors, the
last one being JPMorgan Partners. Today, as chairman of Millennium
Promise, I am helping to lead the work of many exceptional colleagues
by applying the techniques of private-equity investing to the effort to
make good on the goalof the United Nations to cut poverty in half by
2015.1 have not entirely left the private-equity world behind. Rather,
I am using the tools I worked with during a career in private equity to
help ease the pressures of survival for people half a world away from
my mid-town Manhattan office building.
This is a humanitarian effort that also is serving as a test case in ap
plied economics: taking the disciplined, performance-oriented methods
BEYOND THE BALANCE SHEET • 97
ofprivate investing from the capital markets of the United States and
applying them to address poverty in the villages of Africa. Through
our experience so far, we have learned that the management techniques
and business skills are remarkably transferable, even while addressing
poverty-related issues in some of the most deprived places on Earth.
There also is an element of social entrepreneurialism at work, as we,
in essence, conduct field research into the use of venture and private-
equity methods in a much broader realm.
The challenges we address while building an effective charitable
organization—one operating on a multinational scale and addressing
some ofthe most vexing health, environmental, andsocial issues of our
time—parallel those we often face while building a successful for-profit
company. There are certain questions we have to ask in both circum
stances. How do I organize people? How do we build partnerships?
How do we manage the board? What is our strategic vision? Where
are the market opportunities? What can we do that is not redundant?
What's our unique niche?
From Private Equity to Not-for-Profit

These were all questions I had dealt with, time and again, during a
career in private equity that began in the early 1980s. I had founded
the private-equity operation at Chemical Bank in 1984 and had
overseen some $12 billion of private-equity investments by the time
I decided to retire from the firm in 2007. Over the years, I had been
through incredible ups and downs. In 1999, we invested $2.3 billion
and took out $2.5 billion in capital gains. Then, in 2000, we had to
take a $1 billion write-down of assets in a single quarter. This was in
the aftermath of the dot-com meltdown, and we took our dot-com
losses alongside many other investors. Still, in the time I managed the
private-equity operations for JPMorgan Chase anditspredecessors, our
operation posted a 30% compounded annual return oninvested capital.
At the time I left, we had just spun off the firm and became CCMP, an
independent private-equity firm, and had just raised $3.4 billion from
outside investors. It seemed like a good time for me to focus on the
nonprofit world.
Even as my responsibilities and our investment portfolio had ex

panded beyond anything I could have expected, I had taken an ever-
greater interest innot-for-profit work. I have been involved at my alma
mater, the University ofVirginia, practically for as long as I can remem
ber, as president ofits undergraduate business school foundation, and
I have chaired the Thomas Jefferson Foundation, which operates and
preserves Monticello, his home. Jefferson isone ofmy personal heroes,
so Monticello really is a passion for me.
Ihave done substantial work on the board atthe Quincy Jones Musiq
Consortium and Big Apple Circus, and I've particularly enjoyed being
involved with nonprofit start-ups. One ofthose start-ups is NPower, a
not-for-profit that provides technology services to charitable organiza
tions and also teaches inner-city kids how to become computer techni
cians;it is reallyhavingan impact. AsI became more involved in NPower
and other organizations, I realized that they bear so many similarities to
start-ups and growing private firms I had worked with inmy day job that
I really felt I could bring proactive, private-equity skills to bear.
The key to success in the nonprofit world, just as it is in business, is
to have a powerful idea backed up by sound management. The Robin
Hood Foundation here in New York City has set a standard, apply
ing management metrics to everything it does and demanding results
from any partners it works with. That process is similar to managing a
private-equity portfolio. The Robin Hood Foundation explicitly states
thatit takes a private-equity approach to philanthropy. It even borrows
a page from Jack Welch's management practices at General Electric
in that it reviews performance results ofall the entities in its portfolio
each year and stops funding the bottom 10%. It is a very bottom-line
approach, obviously, but it seems to work.
My own work in private equity gave me plenty to draw from as
I began looking for techniques to apply in charitable work. As an
investor in Office Depot during the 1980s, for example, we had helped
a company start with a couple of prototype stores, and it became a
national operation. At Doane Pet Care Co., a private-label pet food
manufacturer, I had seen the transformative effect of charismatic
leadership. At a variety of our portfolio companies, I had learned
the importance of management metrics, planning and execution, and
holding people accountable.
The Call to Service

The timing was fortuitous, in other words, when I received a phone
call in 2004 from a friend of mine, Ray Chambers, one of the vision
ary pioneers of private-equity investors. I had known Chambers for
twenty years, first as a partner with former Treasury Secretary William
Simon in one of the most successful private-equity firms ever, Wesray
Capital, and later through our shared interest in philanthropy. Cham
bers had done great things for his home town, Newark, N.J., establish
ing a performing arts center there and creating the public entity that
helped bring aprofessional basketball team to town. Nationally, he had
funded the Points of LightFoundation. The list goes on.
Lately, Chambers and I had begun talking about the problem ofpov
erty in Africa. Discussing the UN led effort todrastically reduce extreme
poverty in the world by 2015—the "Millennium Development Goals,"
as they are called—Chambers and I had begun wondering whether it
might be possible to bring a private-equity approach to such a seem
ingly insurmountable effort. On this particular phone call, Chambers
informed me thatJeffrey Sachs, the noted economist and pioneer inad
dressing the health and economic needs ofthe world's poorest people,
had some ideas he thought I should know about—a new effort to fight
poverty in Africa.
"I think this is something that you would really be interested in
working on," Chambers said. "Come meet with us."
I would like to say I was hopeful, but frankly, I was fairly skeptical.
I had not been to Africa, but I had read enough about the problems
there to know howtough it would be to have anyimpact. There wasn't
enough money to cure Africa's problems, and even if there was the
widespread corruption in many countries on the continent meant much
of what was spent would be stolen anyway. There were tribal wars,
HIV/AIDS, famines, and droughts. To me, it had always seemed the
United States was the place to focus my efforts. The systems were in
place for me to have the most impact, I thought. I had always thought
Africa would be the next generation's problem.
The dinner withJeff Sachs and Ray Chambers changed that percep
tion. At the time, Sachs was finishing his work drafting a blueprint for
meeting the Millennium Development Goals. Then Secretary General
Kofi Annan in 2002 had asked Sachs to write a report focusing on the
approaches to addressing the UN goals ofcutting poverty, hunger, and

AIDS; educating people; reducing environmental threats; encouraging
development and so forth. Sachs' studies had led him to a humbling as
sessment ofthe daunting labors at hand. With a decade to go before the
Millennium Development Goals deadline, little progress had been made.
Sachs at this point felt that we needed to prove the community driven,
holistic strategy topoverty elimination was the best way togo.
While we talked over dinner, Sachs and Chambers said they were
searching for new strategies for attacking the entrenched scourges of
extreme poverty. I asked all the hard questions I could muster. Money
in Africa just seemed to disappear into the hands of the cleptocrats
or the inefficiencies of aid distribution. National programs had been
tried before, but virtually all failed. The UN apparatus might be too
unwieldy and bureaucratic to make much progress.
As we discussed all this, I began to appreciate the desperate need
for new approaches. Chambers and Sachs were exploring a new idea
ofsetting up a separate, privately financed entity, outside the UN, to
help improve execution and accountability. This struck me as a clas
sic private-equity solution to the problem. Ifthis separate entity could
take charge ofa failing enterprise, bring in new management, rational
ize operations, and push toward measurable outcomes, it might make
progress. Inthe efforts so far, under the direct oversight ofthe UN, the
Millennium Development Goals were just one ofmany important items
ona complex and demanding global agenda, and the goals seemed out
of reach. Addressed under the care of a separate organization, perhaps
more progress could be made.
From Field Research to Start-Up

The more we talked, the more interested I got. This was an opportu
nity, if I could find a way to contribute, to have a huge impact in an
area of urgent human need. Sachs and Chambers made it clear they
wanted me to get involved. The least I could do, I agreed, was to visit
Africa and see the challenges at ground level. To help make the issues
more real, I brought my 17-year-old son, Ryan.
Our trip took us to Kenya, Malawi, and Tanzania, allcountries with
existing UN programs, all in dire need of more help. One village we
BEYOND THE BALANCE SHEET ® 101
visited, Sauri, in western Kenya, still sticks out in my mind. Eighty

percent of the population survived on less than $1 a day. Three-
quarters of the families went to bed hungry, and the harvest never
lasted between rainy seasons. Starvation was common. More than a
third ofthe children had lost both their parents, often to HIV-related
diseases. More than 60% ofchildren were affected by malaria.
Everywhere we went on the trip, we saw signs of breakdowns in phil
anthropic efforts. In Malawi, at afeeding station for the UN's World
Food Program, my son and I saw babies literally dying in the arms of
parents who were waiting in line for food. The difference between life
and death for some of those children was a failure to distribute food
that was literally within their reach.
In one country, we saw how local politics can get in the way. We met
with a high government official responsible for a malaria-fighting pro
gram. He showed little interest in the details of the program to distribute
bed nets impregnated with a mosquito-killing insecticide. This politi
cian's top priority was to make certain he was in front of the television
cameras when the plane landed inNairobi and the bed nets came out.
When we got back to the United States, I realized that the exist
ing approach toward the Millennium Development Goals, relying on
governments to roll out national programs, was not going to work. An
approach modeled on private enterprise seemed our best hope. With the
Millennium Development Goals seemingly out ofreach, it was time to
starttheMillennium Promise Fund. The idea, after the launch in 2005,
was to open pilot programs in 10 African countries, "Millennium Vil
lages," we called them, which are clusters of villages, 80 villages in
total, in shared geographic areas. Sachs proposed a holistic approach
inwhich we would work toimprove agricultural practices, health, edu
cation, and infrastructure simultaneously at the village level. Working
with the villages over five years and applying Sachs' program, we would
work to prove that we could move the villages toward a sustainable,
self-supporting state. Then, after obtaining external verification of our
results, with the support ofthe national governments and the UN, we
could scale these proven models to reach over 100,000 villages across
Africa and other continents.
The questions I started asking were a variation on the ones I would
ask in a private-equity setting. What is the five-year plan for a village?
102 • THE MASTERS OF PRIVATE EQyiTY AND VENTURE CAPITAL
Is our distribution system for malaria bed nets up to the job? What is
the schedule for bringing lunch programs in? How many water wells are
supposed to be built? Where are they? Where are the red flags to warn
us if we are falling short? Are we watching the impact on the health
system? The education system? What measures are we using that the
schools are actually achieving? Who is going to manage this on aday
day-to-day basis? How can we use the strength of Columbia University
and the UN without being slowed down by their bureaucracies?
Rather than simply asking these questions and dutifully noting the
answers, we developed a comprehensive means of notating each an
swer and tracking itover time. This way, we would keep track ofwhat
had been done and what needed to be done. Over time, we would be
able to track cause and effect from our efforts. Using this information,
we could invest more aggressively in those initiatives that had positive
impact and reduce our expenditures ofcapital and effort in areas that
had less impact.
Management by Inquiry
This iterative process, sort of amanagement by inquiry, is something I
had developed during the course of my for-profit work. I began to see
how all my work experience could be put to good use in the villages of
Africa. For example, going back as far as our very first deal atChemical
Venture Partners in 1984,1 quickly learned the importance of partnering
in order to absorb risk and share expertise. When Merrill Lynch first ap
proached us to buy a group oftelevision stations in 1984, the deal was
too big and the risks too great for us to go it alone. Once we brought
in Wind Point Partners and First National Bank of Chicago's private-
equity unit, though, we felt comfortable taking on the challenge. The
strategy worked. We purchased for eight times cash flow and sold, fairly
quickly, for 12 times cash flow. We shared not just capital and back-
office resources, but also expertise in how to structure the deal, how to
work with management, and when to exit the investment.
The partnering approach—shared risk, shared effort—has been an
essential strategy for Millennium Promise. In fact, it is built in. Mil
lennium Promise brings resources of the Earth Institute at Columbia
University, Jeff Sachs' operation, which has primary responsibility for
BEYOND THE BALANCE SHEET * 103
managing the on-the-ground programs. The UN Development Program

has been helpful, too. They are in the field throughout Africa, and can
draw on decades of experience activating local programs that have a
national impact and support global development goals. We also rely
on corporate partners, turning toEricsson AB, the telecommunications
giant, for example, to bring phone and Internet capability to the Mil
lennium Villages. We also have partnered with 62 wealthy individuals
to help fund our five-year experiment.
A further refinement is the way we rely on experienced operating
partners in the same way that aprivate-equity firm uses consulting part
ners for expertise. At JPMorgan Chase, we hired general partners with
very specific areas of knowledge—a financial specialist, ahuman capital
specialist, someone experienced with workouts, and so on. These peo
ple, six in all, served as auniversal resource for our portfolio companies,
and the chief executives loved having them to drawon. One of themwas
an experienced executive recruiter, Dana Ardi, who worked with our
investment professionals to find the best talent and search firms for our
portfolio companies. She was key in helping us find numbers of great
chief executive officers, chief financial officers, and other senior talent
for companies such as 1-800-Flowers.com and AMC Theaters. We've
done something similar in the Millennium Villages. The Earth Institute
alone has more than 100 sociologists, biologists, engineers, and public
health experts who have specific, world-class knowledge in their subject
areas. Their talent has given Millennium Promise access to incredible
resources that other nonprofits in Africa lack.
Inthe not-for-profit world, we can take this consulting approach to
an even deeper level by asking corporate partners to provide resources
and know-how that goes beyond anything we would be entitled to ex
pect from, say, a board member or an informal advisor inthe private-
equity setting. In Millennium Promise, for example, we are working
with a potential corporate sponsor, Tyson Foods, to offer expertise in
raising poultry. In our villages, there are chickens present and some
basic understanding of how to raise them and propagate them, but
there is virtually no notion ofhow to turn those chickens into a prof
itable business on any kind of scale. Working with Tyson, we devel
oped a plan to send their people to our villages for three-month stints.
They would provide technical advice to the villages and nearby towns,
help build processing centers, and equip them with machinery. Inciden
tally, Tyson would benefit, too. This work will give their people expo
sure to early-stage markets and achance to do something that really has
an impact on the lives of people on the other side of the world.
There is one other aspect of running the firm at CCMP and its prede
cessor companies that really set the framework for how we approached
the set-up at Millennium Promise, and that is the international partner
ing. Almost from the time I started at Chemical Bank, through eight
bank mergers in all, we always were focused on developing our in
ternational contacts. Chemical Bank always had a strong presence in
Asia, but over time we established private-equity efforts in a number
of places: London, Hong Kong, India, you name it. This gave us the
capability to analyze deals and execute strategies around the globe.
When putting together the boards for our portfolio companies in our
international deals, we always added people from the local market as
well as Americans. We don't know all the answers. Local knowledge
tied to a global network is key to a successful investment.
Looking for Two-Way Benefit

Itturns out that international exposure can be one ofthose things that
brings benefits to everything it touches. At CCMP, we saw how this
played out when we backed the buyout of Parker Pen, the London-
based unit of Manpower, Inc., the Wisconsin-based temporary ser
vices firm. Our role was to help spin out Parker Pen from Manpower,
and soon after we got involved, we worked with a London buyout
firm named Schroeder Ventures to bring in new management and re-
focus the brand. With its local savvy, the new management team was
able to increase the rate of new product offerings and push toward
an upscale market.
In the process, we did more than just grow Parker Pen's business.
We also learned that international experience was good for our own
firm, too. Parker Pen had a global presence, including a decent business
in Asia. This was the mid-1980s, and we in Chemical Bank's private-
equity practice really had done nothing in Asia to that point, so we
learned a lot about how to operate in Asia from our involvement with
Parker Pen.
For me, it was one of those ah-hah moments: If we were smart, we

would learn to use knowledge from our brethren in other areas of the
bank, with their on-the-ground expertise, as we rolled out Chemical's
global private-equity strategy. We could draw on their insights as we
partnered with private-equity shops in relatively unfamiliar places. It
was essential that we recruited and worked with the best professionals
on the scene, a point Parker Pen underscored for us with its success,
not just in its home base in Europe, but in Asia, too. It was not just a
one-way exchange, I would add. We introduced expertise to non-U.S.
deals that we had developed inworking with management and boards
at hundreds of portfolio companies here in the United States.
That international perspective and the focus ona two-way benefit, are
pretty much baked into everything we do atMillennium Promise. We take
advantage ofthe global connections at both the Earth Institute and the
UN. Then, on the boards of each country's operation—whether it's our
work in Malawi or Kenya or Tanzania or the seven othercountries—we
mix localknow-howwith world-class expertise. We also make a practice
ofsharing experiences from one country with another, aiming toreplicate
what works and avoid what does not. This, too, is an adaptation of an
approach we developed as aninvestor inhundreds ofcompanies.
Back to the Roots

For me personally, having an impact on lives on the other side of the
world is the culmination of a life's work that I never expected while
growing up. My father was a computer engineer for General Electric,
working on the space program. We moved about eight times before
I graduated high school. Dad programmed the first computer GE used
in Louisville, Kentucky, in the mid-1950s, and later,I saw all the space
launches in the 1960s. I wanted to be an astronaut until I got glasses
and realized that would never happen.
My uncle, Bill Franks, was the entrepreneur in the family and a role
model for me. He started a landscaping business, then built hotels and
a race track, bought some radio stations and some fast food restau
rants in Illinois and Florida, and finally purchased a very successful
coal mine. If there was anyone who gave me the notion that I could
buy and sell businesses for a living, it was him.
As a college student at the University ofVirginia, I took a course of

study that split liberal arts and business classes. For a while I wanted
to be a corporate lawyer, because I just loved the contracts course
I had, but I realized I would be bored with the rest of the things a law
yer does, so I decided tofocus on business. Itwas atVirginia, too, that
I came to love Thomas Jefferson—all ofthe founding fathers, really.
I joined a group called the Jefferson Society, which helped me develop
a deep understanding and love for Jefferson and his ideas about the
importance of the well-rounded life. Jefferson probably has had as big
an impact on me as anyone. Until Millennium Promise, I probably have
spent more time working onbehalf ofMonticello and the University of
Virginia than on any of my other not-for-profit work.
Aftergraduation,I was admitted to Harvard GraduateSchool of Busi
ness, but on a deferred-admit basis, so I went to work for two years as
an accountant at Arthur Young. Some ofthat experience still sticks with
me. Iran across a Foreign Corrupt Practices Act violation while auditing
a company that was doing business with PEMEX, the big Mexican oil
company. One ofthe company's executives was borrowing money from
the Las Vegas mob. Finding a bribe and deciding how to handle it and
reading FBI wire taps as I followed up on it was quite a unique experi
ence. After Harvard, I got a job at Chemical Bank, and I went to work
for the CFO, Alan Fishman, who was head of investment banking.
At the time, investment banking was a new line of business for
commercial banks like ours, and I helped develop business plans for
different investment banking units. After working on four of those
start-up units, I told Alan I wanted to write up a plan for a ven
ture capital unit operation that would do what today we would call
private-equity investing, particularly focused on small- and medium-
sized companies. This was 1984, and the term "private equity" had
not been coined just yet. Alan and I brought the idea to the CEO,
Walter Shipley, and then to the board, and in the end, they decided to
fund us with $100 million.
Chemical Bank had tried to start private-equity groups of various
types before, but they never were successful. Chemical and other banks
at that point had begun to realize they were losing good people to
private-equity firms because the compensation was better and autonomy
compelling. In 1979, Patrick Welsh and Russ Carson had left Citicorp
to form Welsh, Carson, Anderson & Stowe. Later, John Canning left
First National Bank of Chicago to start Madison Dearborn Partners in
the early 1990s because he felt he could operate more independently
on his own.
Part of the reason Chemical was willing to put $100 million into
Chemical Venture Partners and let us operate as a fairly stand alone
unit was that my colleagues and I were only paid when the bank also
got a good cash return. This gave the bank assurance that they would
get a good deal, and it gave us the ability to operate independently, to
build our own book of business, earn our money, and not worry about
micromanagement from the corporate side. One ofthe reasons why we
were able to retain our staff and our franchise over the years was that
when we started the group, we structured the compensation as if we
were anindependent private-equity fund paying a share ofthe profits to
the investment professionals through a carried-interest format through
a formal partnership agreement.
Building to Scale
Perhaps our most important early deal was our investment in Office
Depot, which quickly became a hit and brought us a lot of support at
the highest levels of the bank. We built a huge portfolio of businesses
over the years, and also went through a series of bank mergers: the
purchase ofManufacturer's Hanover, the merger with Chase Manhat
tan, and eventually, the merger with JPMorgan and the purchase of
Bank One.
The deals kept adding breadth to our portfolio and talent to our
team. The most impactful acquisition, not in the best way, was Ham-
brecht &C Quist, which had a big portfolio of technology investments
we inherited that went bad with the dot-com bust of 2000. We bought
trouble, but wealso compounded it withour ownexposure to the wire
less and telecom sectors. We made, in 1999, almost $3 billion in profit
and accounted for about 25% of the bank's total earnings. Then, in
2000, we lost about $1.5 million. Our CEO at the time, Bill Harrison,
stood by us, though. Heknew we had gotten caught in a position where
our investments were illiquid and losing value, and because of the ac
counting rules, there just wasn't anything we could doexcept write them
up when they went up and down when they went down. His support
of uswas appreciated andwe paid the organization back with excellent
returns and performance over the twenty-five year period.
Looking back on the 25 years I spent at the bank, I realize that one
ofthe most valuable attributes I have taken away, for purposes ofmy
not-for-profit work, is the ability to take a good idea and build it to
scale—adding resources and support where needed and just letting or
ganic growth occur where it has not. That idea of building from small
scale to large, literally from the villages to a continent-wide effort, is
built into what we are trying to accomplish at Millennium. If anyone
is going to make the kind of dent that the Millennium Development
Goals require, they're going to have to leverage everything they know
in order to be successful.
From Small to Huge

While we were building the partnership infrastructure at Millennium
Promise, the real challenge that surfaced was how to move toward
large-scale implementation of any poverty-remediation efforts. There,
too, we were able to draw on experience from private equity that had
a direct bearing on what we could do at Millennium Promise. Office
Depot served asa case study ofhow to build a new, national enterprise,
starting smallbut expandingrapidlyoncea successful modelwas found.
We helped start up Office Depot in 1986, first with a store in Fort Lau
derdale and pretty quickly a second one, experimenting with a new retail
concept—office-supply sales, something that previously wasdominated
by catalogmerchants or large-scale distribution to national accounts.
From the start, we had tough competition: Staples had started a
few months ahead of us, backed by some smart consulting work from
Bain & Company. By starting small at Office Depot, though, we could
experiment with the merchandise mix,with pricing, with all the details
that go into running a successful business. There were surprises, of
course, as there always are. The founding executive, F. Patrick Sher,
was diagnosed with leukemia soon after the first store opened, and he
died the next year. But the concept was strong enough, though it took
nine months to find a successor to Sher, David Fuente. We were able to
take Office Depot public in 1988, two years after start up, and today
the company has some 1,700 locations worldwide and sales of more
than $15 billion.
The idea of prototyping andtesting a concept, then rolling it out big,
has caught on in private equity. Petco is another company that started
that way. El Polio Loco did it in 2005, changing the face of an existing
chain after trying prototypes ofa new concept inseveral of itssouthern
California stores.
I also have seen this approach work exceptionally well in the not-for-
profit world. NPower is a good example. We created a way to roll out
technology to small-scale not-for-profits. We started in New York City
nine years ago and teamed up with Microsoft, Accenture, JPMorgan
Chase, and the Robin Hood Foundation to fund its growth. After hir
ing anentrepreneurial chief executive, Barbara Chang, we began rolling
out NPower offices around the country. Within three years, NPower
had 12 operational locations, a really remarkable growth record in the
not-for-profit world. NPower, inturn, is helping hundreds ofnonprofits
operate with modern technology that expands the reach oftheir work.
NPower has been successful in leaning on corporate backersto help
build itself up. There is another step, though, that not-for-profits need
to take: They need to get better at sharing experience and expertise
with each other. Too often, it seems, they are competitive with each
otherwhen they should becooperative. They seem to fear that there is
only so much charitable money available, only so many good executive
directors, only so many volunteers. More often than not, charities op
erating in the same space—conservation groups, human rights groups,
even poverty-fighting groups, perhaps—act as rivals when there might
be opportunities to get more done as partners.
The Networking Effect

Competition can be healthy. There's no mistake about that. Butin pri
vate equity we have learned the art of competing against someone on
one deal only to partner with them on the next. Take Thomas H. Lee
Partners, a big private-equity player. At JPMorgan Partners, we com
peted against T.H. Lee for Dunkin' Donuts, and they got that deal.
But then, when we got a chance to invest in ARAMARK, the food
service company, Lee was our co-investor and fellow board member.
We shared resources to ensure success. We also share and compare our

views. Working with them and other groups over the years gives you a
chance toask, "How am I different? What makes us be someone people
wantto partner with?" Over time, we candecide whom to partner with
because we know how they operate and whom we can trust.
The networking effect inthe private-equity industry can be powerful.
At Millennium Promise, it has been one ofour key strategic insights. At
the time I joined the Millennium board in 2005, we still were struggling
with how to develop the best model for implementing the Millennium
Development Goals. National programs seemed doomed to fail. There
was too much exposure to corruption, to inertia, to all the problems
that have caused philanthropy in Africa to run aground for years. We
decided to start small—with 80 villages in 10 African countries—and
develop models that we could then scale. The idea was similar to the
experiences we had at Office Depot or NPower. We also could build
networks and amplify our best practices just as we had at JPMorgan
Partners by partnering with other firms.
The crux of the Millennium Promise model was for us to start with
clusters of small villages in geographically compact locations. Similar
to what we had done with Office Depot or even NPower, the Millen
nium Villages would rely on a home office—the Earth Institute and the
Millennium Promise office in New York City—to provide the essential
resources common to all of the field operations. The difference between
this effort and prior, national efforts, though, was that our approach
was to start verysmall, find out from our pilot programswhichmethods
worked, and then replicate them on as broad a scale as possible. We
wanted to build a solid foundation at the village level and grow from
there to a national level. Again, this was the Office Depot model, applied
inAfrica. We wanted experimentation according to local needs and op
portunities, and we wanted to create affordable, repeatable models in
four key sectors: agriculture, health, education, and infrastructure.
Putting Pieces in Place

We set reasonable spending plans, a subsidy of $80 per villager each
year, just what was promised by the Group of Eight countries at the
Gleneagles Summit in 2005. The start-up costs were higher than that,
BEYOND THE BALANCE SHEET ° 111
though, around $110 per person in the first couple of years of our pro
gram. Even so, we figured we could get those numbers down as we fo
cused on simple, repeatable interventions, suchas introducing fertilizer
and seeds to boost crop yields, giving out mosquito nets impregnated
with insecticide, and providing lunch meals at schools, all of them de
signed both to provide nutrition and to get children to attend classes.
Just as a powerful business idea will attract private-equity backing,
the Millennium Promise approach began to draw financial support.
George Soros gave us $50 million to set up prototypes over a five-year
period. That helped us raise another $70 million from wealthy individ
uals and corporate foundations—again, a parallel with what happens
in private-equity fund raising. Once you get those first commitments,
which always are the most difficult, more is sure to follow, especially
when the first mover is a name like Soros.
With the Soros commitment in 2006, we were able to operate in
80 villages in a dozen countries, directly affecting the lives of 400,000
people in all. One of the most successful interventions has taken place
in our agricultural program in Malawi, a small country in east-central
Africa south of Tanzania. Beforewe got to the seven villages where we
operate in Tanzania's Mwandama district, the villages often ran out of
grain in August and had to do without for six months of the year. We
introduced a program of vouchers for fertilizer and seeds and provided
training on farming techniques.
The impactwas practically immediate and very real.The Millennium
Promise money is helping the community to build a large grain bank,
which will enable the village to store grain so it can be marketed when
prices are high. The program has been so successful that the president
of Malawi rolled out the fertilizer voucher program throughout the
country, and Malawi has now become self-sufficient. In addition, we
have five other countries that have asked us to help them raise funds to
roll out the village models across their countries.
Going by the Board

One of the reasons why Sorosbacked us, and a bigreason for our success,
I am convinced, is the strength of our board and our eye for managerial
talent. In private equity, building a board is not all that complicated.
Each of the firms with an investment stake gets a board member, and
management has a couple of seats. There are always a few outsiders
with relevant industry experience or specific knowledge: international
operations, financial, or legal expertise, for example.
In the not-for-profit world,it is a bit morecomplicated. Because fund
raising is sucha crucial part of the enterprise, youneed people who can
bring in money aswell asgive it.You need knowledgeable experts, and
most of them, if you pickright, should be willing to work.
The board we had at Parker Pen was one of the best I have seen. Its
members had vision, industry knowledge, and geographic expertise.
Richard Winkels, who represented the investment money from the
Schroeder Ventures of London, had been at Dr. Scholl's, the foot
products company, before he went into private equity. He brought all
kinds ofEuropean retail insight. Atanother ofourportfolio companies,
1-800-Flowers.com, the board found one of its essential tasks was to
support the vision of a remarkably giftedfounder who had a vision for
the company, a strategic vision, that no onecould match. Jim McCann
was the first to use a telephone number as the company name, among
the first to recognize the power of the Internet, and quick to see the
need for add on investments such as The Popcorn Factory.
There are mistakes that not-for-profit boards make that they likely
would avoid if they took a closer look at private-enterprise boards.
Board size is one of them. Youcan't get anything done with a board of
32 members—a feature all too common on the boards of not-for-profit
entities. Board attendance has to be as close to mandatory as possible,
which is the case in private industry these days. The celebrity board
members at nonprofits, if you have them, have to carry their weight. At
Millennium Promise, Quincy Jones gets on thephone and calls people he
knows to help us getthings done. Angelina Jolie, anotherboard member,
has funded two of our villages and makes herself available to help.
Management Leadership
Theultimate predictor of success, in the end, isthe quality of the person
at the top. Doane Pet Care, one of our portfolio companies at CCMP,
is a good exampleof this. We had invested $20 millionor so in Doane,
BEYOND THE BALANCE SHEET ° 113
but after three years we had the chance to change chief executives.
The company had succeeded in becoming the largest private-label dog-
food supplier to the big-box retailers: Wal-Mart, PetSmart, and others.
But, in mid-1997, commodity prices started going up and the com
pany's profits were being squeezed. Most people thought, "Good luck
raising prices with Wal-Mart, the toughest customer on the planet. It's
just not going to happen."
We recruited a guy I had known for a long while, Doug Cahill, to
be the CEO for Doane. I said, "Doug, what would it take to make you
really join Doane?" Cahill said the answer was simple. He wanted to
run Doane with the team he selected, and he wanted the team to have
a chance to make a lot of money.
Cahill had worked for Olin Corporation and sold pool chemicals
and Winchester products into the Wal-Mart system. He brought
six or seven of his team from Olin. Cahill visited all the factories,
worked the midnight shift, and had seen what the line people go
through. Most importantly, he got Wal-Mart to trust him and to
share in the financial risk of the commodity cycle, so when corn
or soy prices went up or down, Wal-Mart shared the impact. He
convinced them to accept this deal because Doane was making Wal-
Mart's house brand of dog food, Ol' Roy. It's named after Sam
Walton's dog. Cahill convinced them that we were a strategic asset
to them. He put in a great hedging strategy, too, and the company's
results just took off. We sold Doane to the Canadian Teachers'
Pension Fund for a solid return on our investment, and Cahill and
his team made a lot of money—just as he had wanted right from
the start.
In not-for-profits, the chief executive officer factor can be tricky.
Sometimes you've got a founder with a vision, but that person can carry
the operation only so far. Or they get very proprietary and don't want
to stretch the organization. Then there are the people like Jeff Sachs.
I would compare him to Jim McCann at another portfolio company of
ours, 1-800-Flowers.com, who is a passionate visionary but also listens
well to others and takes their good ideas in as his own. You're lucky to
have him, and as a board member, your job is to just do whatever you
can to support him and his team.
114 © THE MASTERS OF PRIVATE EQUITY AND VENTURE CAPITAL
Turning Philanthropy into Profit

The next stop for us at Millennium Promise, and for the not-for-profit
world generally, isthemove toward social entrepreneurship. This notion
ofthe hybrid mix offor-profit techniques with charitable objectives really
is the ultimate move toward sustainable philanthropy. At Millennium,
we have worked with the Acumen Fund, which is one of the leaders in
thisnewfield. One of our people, Rustom Masalawala, runs our business
development strategy and joined us after working at Acumen. He has
identified a number of business opportunities that will help our Millen
nium Villages create jobs and significant cash flow for themselves. We
have teamed him up with several of our investors, people with private-
equityexperience, and board members who can help him structure deals
so that otherinvestors would beinterested in funding them.
When some of the agricultural experts out of the Earth Institute at
Columbia University suggested that the area in eastern Ethiopia where
we have a village cluster is a potentially rich area for bee keeping,
Masalawala wasable to help us recruit investors with a background in
foodstuffs and food products to help make that happen. They will not
have to invest much—$1 million, maybe $1.5 million in seed capital—
but once they get started, we can startsetting up a loan system to help
the local people raise crops that they can then market to the food ser
vice partner, who is also an investor. It's a virtuous cycle.
If that model succeeds, then we've got something that could work
in other villages, with other natural resources. We can then start mov
ing some of our operations into the cities where some of the products
would need to be distributed. Integrating into the cities is part of the
Millennium Promise plan. We make a village sustainable byhelping to
start businesses, then continue to make them sustainable by marketing
some of those village products in the cities.
I can't really say if poverty will be cut in half by 2015, in time to meet
the Millennium Development Goals deadline. By the same measure,
I never would have predicted, coming out of Virginia, that I would wind
up running a private-equity firm that managed $12 billion in assets in
vested aroundtheworld. Theexperience doing theprivate-equity workhas
given me a chance to contribute to the effort to assist in the fight against
poverty. I feel fortunate that theworkI didfor a quarter century gives me
something to offerto one of the most important pursuitsof our time.
Beyond the balance Sheet • 115
LESSONS FROM JEFF WALKER

<$$> Private-equity techniques have broad application. The financial
disciplines, accountability, and growth strategies of private equity
apply in multiple settings, including the not-for-profit realm.
<^> Pilot small, build to scale. The same technique of proving concept
that worked for Office Depot applied in Millennium Villages, and
can work in building many businesses.
<^|)> Turn competitors into colleagues. Just as private-equity

professionals share insights and practices with colleagues,
competitors can become colleagues in the right not-for-profit
circumstances.
<^> Learn across borders. Instead of seeing organizational,

geographical, cultural, or other differences as barriers, look at them
as opportunities to gain knowledge, experience, and competitive
advantages.
<^> Leverage early successes. Agile, scalable projects with the right
people attract attention. The Chase board backed the author's
private-equity unit, and early progress with Millennium Promise
drew support from George Soros.
THE INSIDE GAME: MANAGING
A FIRM THROUGH CHANGE
AFTER CHANGE
Chairman
AOM: $18pffion Years in PE: 29

Location: Chicago, EL Year born: 1944
Grew up: Long Island,NY Location born: Tucson, Arizona

Best known ideals: PayPal, Cinemark, Nextel Communications,
Ruth's Chris "
Style: Fan*, s^aigKt,unpretentious

Education: A«B^ Denison University, Class of 1966
^%X>^S0^takf^ Class of 1969
Signifjcarit experience: 11 years practicing law and 29 years as head of
a private-equity firm
Persona! interests: Own part of Milwaukee Brewersand four minor
league teams
the lesson: "My leadership and influence are predicated on my being

seen as fair."
<^»
o 117 o
118 ® The Masters of Private Equity and venture Capital
With four decades ofsuccessful private-equity investing tohis credit, John

Canning knows all about getting deals done. He has seen the private-
equity business change from small-sized transactions in the early 1970s
to the leverage-fueled frenzy of the early 21st century. In 2007 alone, his
firm put together a string of five deals with a total price tag exceeding
$25 billion. The economic crisis, though, means the big-deal era is in
eclipse, and Canning has called for a reassessment of strategy and an
adjustment to a new, low-leverage future.
Through years of economic change, Madison Dearbornhas remained
remarkably stable. Eight ofits founding partners remain atthe firm today,
where a flat compensation structure and careful recruitment contribute
to success. So does an exacting management of the firm's investments,
both before and after deals close. The Madison Dearborn experience
shows that management of the firm can be as important to success as
investment know-how and strategic vision.
Private-equity investing has gone through certain distinct phases.

A handfulof venture investments in the late 1950sset the stagefor
what we knowof todayas private equity. In the 1970s came bootstrap
deals, in which private-equity investors raised moneyfor buyouts on a
transaction-by-transaction basis. Late in that decade, the major banks
and investment banks began developing an expertise in usingleveraged
transactions to buy companies, whilerelying on improved performance
to deliver investment returns.
Duringthe 1980s,whenthe term "privateequity"firstcameinto com
mon use, certain partnerships that began expanding their deal size and
the use of leverage drew major public attention—and some criticism—for
the first time. The contentious bidding over tobacco and food giant RJR
Nabisco led to a $25 billionpurchase by Kohlberg, Kravis, Roberts &
Co. that remains the biggestleveraged buyout ever. The 1990s saw the
industry mature and a dramatic increase in the number and size of deals.
The first decade of the 21st century started with the dot-com and tele
com bust that hurt many firms and is ending with an economic crisis
unlike any before. The crisis has challenged many private-equity inves
tors to scale back on the size of deals and the use of leverage and made
it more difficult for many firms to raise money from investors.
THE INSIDE GAME * 119
Through all of these changes—the growth and retraction, the booms

and busts—there has been one constant: the firm. The partnership form
of investment is at the heart of the way we do business, and manage
ment of the firm is perhaps one of the least discussed but most im
portant aspects of our trade. It is through the firm that we, as general
partners, raise capital from our limited partners. As a firm we evaluate
investment opportunities, make investments, interact with our portfo
lio companies, and decide on exit strategies. As members of our firms,
we distribute the wealth created by our activities. We distribute to the
limited partners who make our investing activity possible while also
distributing investment proceeds and bonus payments among our part
ners and associates.
Management of the firm is essentialto success. While no one can suc
ceed in this business without investment know-how, industry knowl
edge, negotiating abilities, and strategic vision, effective management
of the firm helps sustain and enhance the deployment of those skills.
When a firm is well run, the professionals can concentrate on their chief
purposes of deploying and managing the limited partners' capital. The
fewer distractions from that essential activity, the better.
A firm that is well run avoids falling victim to the factionalism, con
flicting and shortsighted interests, and disruptions that occur at those
that operate without paying attention to such potentially divisive prac
tices. Well-run firms retain their key partners, take advantage of the
skills they develop, and have little to fear from seeing a partner or group
of partners take their experience, contacts, and investment know-how
to some competing operation. For an industry in which we spend so
much of our time advising executives how to manage their businesses,
I believe we sometimes do not spend enough time focusing on how we
conduct our own affairs.
No firm is without its troubles, and any firm that has lasted as long as
my firm, Madison Dearborn Partners, likely has gone through periods
of robust growth and occasional difficulty. Although difficulties may
be inevitable, we can work our way through them more effectively and
get back to the investing and other work we enjoy if we are operating
from the strong base of a well-run firm. In fact, issues that might sink
or splinter some firms become quite manageable challenges at those that
are effectively run. Firms that keep compensation disparities, decision
making, interdisciplinary rivalries, and generational differences well in

hand can survive and prosper. The best private-equity firms make their
mark through a mix of savvy investing and a keen sense of corporate
strategy, but none can reach its potential unless someone in the firm's
leadership has an ability to direct the firm toward long-term prosperity.
The Roots of a Firm

Madison Dearborn Partners today is one of the larger, longest lived
private-equity firms, but what is not as well known is that eight key
people in our firm have been together for an average of 25 years. Our
roots trace to the early 1970s, when I began work as a lawyer advis
ing the venture capital arm of the old FirstNational Bank of Chicago,
which over time transitioned into more of a private-equity approach.
My predecessor, Stanley Golder, beginningin 1970 had taken a small,
money losing activity of the bank and turned it into a substantial busi
ness. In 1971, he provided funding that enabled Frederick W. Smith to
found Federal Express, one of the greatest venture investments ever.
I had played a small role in helping Golder get the First Chicago
venture operation started. As a young lawyer out of Duke University
Law School, I helped provide the legal underpinning for the bank as
it set up an operation to move into direct equity investments. My job
was to make certain the bank's new private-investment operation com
plied with the Bank Holding Company Act amendments. Golder's suc
cesses in his years running First Capital Corp. of Chicago showed that
changes in the law can create expansive new opportunities, but only
those who—like Golder—are ready to seize them will fully benefit.
By 1980, Golder became restless at the bank and decided he could
expand his business more aggressively operating on his own. Along with
Carl Thoma and Bryan Cressey, he raised $65 million, an astounding
figure at the time, second only to Kohlberg, Kravis, Roberts & Co.,
which had raised $100 million. Ironically enough, KKR actually had
helped First Chicago Capital build a profile in bank-owned private-
equity investing by inviting First Chicago to participate in some of their
early deals. When Jerome Kohlberg, Henry Kravis, and George Roberts
started their firm, and before they raised their $100 million, they would
come to us, Security Pacific, Mellon Bank, and a few others who were
THE INSIDE GAME * 121
dabbling in direct investment at the time. Theywould take our capital

and give us preferred equity or subordinated debt, and this helped us
all because our banks began building experience and a reputation in
private equity even as KKR became perhaps the best-known firm of
the early era.
At the time Golder left the bank, in 1980,1 had seniority over any
one else at First Capital, so I was the logical person to take charge of
the bank's venture and private-equity business. It was hardly an auspi
cious moment in terms of the broader economic environment. Condi
tions were not on the order of the crisis that began in 2008, but they
were extremely difficult. The prime interest rate hit 18% in 1981, and
we used to joke that it would be cheaper to fund a buyout with a credit
card than to borrow the money from a bank.
Still, we persisted, and we strungtogether several largedeals, includ
ingthe buyoutof household metal products company Norris Industries,
and car parts makers PT Components and Imperial Clevite. Their mar
kets were all hard hit by the economic conditions, but the lowest result
we got on any of the early deals was a 20% rate of return. This under
scored an insight that has proven useful to us over the years: Solidly
run companies, even in bad economic conditions, can still be profitable,
successful investments.
Our biggest success at First Chicago was the investment we made
in Nextel, a company that bought up radio frequencies that had been
used to dispatch taxi cabs and turned them into a successful wireless
communications company. Jim Perry, who remains one of my partners
today, was contacted in 1987 by two somewhat unlikely entrepreneurs.
One was Morgan O'Brien, who had represented taxi companies and
other users of special mobile radio frequencies before the Federal Com
munications Commission. The other was an accountant named Brian
McAuley, who had experience at the cell company Millicom. These
two would-be entrepreneurs wanted to collect all these 900-megahertz
licenses—held by the taxi company, the pool guy, other very local
companies—and build a national phone service. Perry thought it made
sense. Without any real leverage, O'Brien and McAuley strung together
a company by picking up mom-and-pop outfits, hundreds of them,
literally, and we had our biggest success in the time that I was running
First Chicago Venture Capital.
Carry and Confusion

I finally left with my team of 13 other people to set up Madison Dear
born in 1992, and it was in this transition period that I learned a good
deal about how to manage a firm. When Golder had leftFirst Chicago
more than a decade earlier, he had taken with him all but a couple of
the best people. That meant I needed to hire the team who would work
for me at the bank. This made for a tough transition, but it served me
well over the years. I had gotten to hand select some of the brightest
young people in the business, and right from the outset there was no
question about who was in charge. That helped streamline our operat
ingstyle at the bank, and it helped when the group of us decided to go
out on our own. I was at least 10 years older than everyone, and I was
going to be the boss; there was no question about that. To have that
clarity, right from the start, was good for our firm.
Aswe began laying plansfor the newpartnership, there was a ques
tion about how we should allocate the carried interest—or share of
profits—in our funds. I felt it was importantto be fair to everyone and
suggested that perhaps we should vote on the matter. That turned out
to be a spectacular mistake. We took a blind vote, and when one of our
partners tallied it he discovered all kinds of shenanigans had gone on.
Everyone gave me the biggest percentage, but after that it was a
free for all. We had already decided to set up the firm according to a
number of teams who specialized in certain industry sectors, and the
teams were smart enough to figure out that, for pay purposes, they
were in competition with the other teams. When I looked at the vote
results, it was clearwe had a mess on our hands. I immediately tore up
the results and just decided that I should allocate the carry according
to what seemed fair based on the work that was expected from each
team. I announced this at a strategy session in Kohler, Wisconsin, and
some people were shocked, but before any discussion could get going
one of our founding partners said resolutely, "Next item. That one's
done." And that was it.
Incidentally, that first fund was the only one in which I had more
carry than the other senior partners at the firm. By the time we raised
our second fund in 1997, my carry was set at the same level as about
five other senior partners. It has been that way ever since. I think it's
important, for the good of the firm, for people to feel that at a certain
The Inside Game • 123
level we're all in it together. We want people concentrating on putting

gooddeals together, helping theircompanies perform, developing good
exit strategies—the important elements—and not on who has a slightly
higher percentage than someone else.
There was a more important point being made by this relatively flat
compensation structure. There isan element of basic fairness, of equity,
among our partners that is reflected in the fact that we do not sanction
large disparities in compensation. In a larger sense, our partners and
associates have to believe that we operate our firm according to basic
notions of fairness. The minute I am seen as unfair by the people I work
with, I can no longer lead them. I am out of a job. That is something I
can never allow to happen, and keeping compensation on a relatively
even footing is one way to make certain that everyone sees our firm as
being essentially fair minded.
Dry Run to Start Up

With our compensation levels set, we began raising money to launch
the firm. I was the chief fund raiser, along with Kent Dauten, who was
my most senior partner. The fund raising process itself taught me an
important lesson about how our firm might look to outside investors.
A chief issue, one I had never anticipated, had to do with our succes
sion plans. Around the time we had decided to go out on our own,
I had briefly considered retirement. Only a few people knew this,
Dauten being one of them, but given the high profile I was assuming
with the fund raising, it was inevitable that the succession issue would
comeup. It did, in fact, even before we hit the road to raisewhat turned
out to be $550 million from a group of limited partners.
A private-equity investor in Chicago named Bon French, who had
been a great friend and supporter of us at the bank, offered to sit in on a
dry run of our fund raising pitch. So we went through our presentation:
How much we planned to raise, the industry sectors we thought we
would target, the experience of the partners in the firm. As we wrapped
up, I turned to French and his partners in the room for questions.
"Now, what are the succession plans?" French asked.
Dauten and I looked at each other. Everyone else looked at us. We
had no answer. It was just something that had not crossed our minds.
"I think this needs some work," French said.

By the time we delivered our presentation to someone less familiar
with us than French, we had decided Dauten would be the successor
if anything happened to me. The irony of that decision is that Kent
wound up staying with the firm only a little longer than it took to raise
the first fund. A year afterwe closed on fund raising, Dauten realized he
could not commit himself over the long haul. He had come from an en
trepreneurial family, and he wantedto set out on his own. He struggled
with the decision. After all, Dauten had been out on the road with me,
the only other guy pitching to investors, and I think he felt conflicted
about leaving. He feltloyal to meand to the other partners. In the end,
though, there was no fighting his desire to be on his own. Fortunately,
he has been spectacularly successful, so he made the right decision.
One last step before we set up shop was the meeting in which I had
to tell Richard Thomas, who was president of First Chicago at the time,
that I was leaving along with 13 of his other top equity-investment
people. Of course, I handled the conversation with a bit more finesse
than that. After all, there were strong business reasons behind our de
sire to leave. One was that we were running up against the legal limits
on a bank's ability to invest in unrelated businesses. The other—and the
more important element in terms of First Chicago's future—was that
mark-to-market accounting was coming.
Mark-to-market accounting was going to be bad for First Chicago
Capital, because it would change how our activitieswere treated on the
bank's balance sheet. Before the accounting change, the bank could use
us to help level out its earnings. The bank's lenders were always step
pingin holes somewhere aroundthe world, creating a need for earnings
on the income statement. We had a portfolio of unrealized gains, of
course, so when they needed earnings they could ask us to sell assets,
book those gains, and offset the losses elsewhere in the bank.
With mark-to-market, we were going to become a liability, because
as stock prices climbed, the value of our portfolio would rise, too. That
would be reflected on the bank's income statement. But, if the market
went down, we would suddenly have to call up the chief financial of
ficer to announce the bad news that we were delivering a large loss he
had not expected. Beyond that, mark-to-market would erase our abil
ity to help the bank log asset sales in a timely way that helped level its
The Inside Game * 125
earnings performance. I could see wewere going to become worse than

not useful to them. We were going to be a problem. And this meant it
was time to get out.
When I walked into Thomas' office, though, I did not put the em
phasis on mark-to-market. I painted a scenario that showed that the
bank could have the benefit of our investment work but without the
costs of our salaries and operations. I showedhim how much moneyhe
could save. Investing has a long tail on it, and the earnings do eventu
allycome in, but on the front end, as the bank put on the investments,
it wasexpensive. Wewere getting paidand investing the bank'scapital,
but there were no gains for several years. After all, the bank did not
book gains back then until it realized them through a sale or a public
offering or some other event. The bigger the portfolio got, the more
costly our operation looked to the bank's investors. I explained that it
would be cheaper for them to have us on our own and give us a cut of
the upside.
"We would like to do this," I told Thomas.
He had a simple response. "OK," he said. "But once you make the
decision, you are gone."
We left, but we did not completely sever the relationship. We con
tinued to manage the bank's $2 billion portfolio of equity investments.
In addition to Nextel, the portfolio had a stake in Fortune Computers,
which got very hot before it crashed. It also invested in U.S. Windmills,
a company that was a generation ahead of its time. These investments
looked good to the bank at the time, and Thomas made certain that the
bank was a participant in our first fund.
First Funds
It was a very tough year to raise money. We were one of only a few
firms out there trying to do so. Our first commitment came from Wil
liams College, where an old friend and private-equity investor, Joe Rice,
was on the board. We had been good to KKR, and the KKR guys indi
viduallyput in money and gave us a full list of investors whom they said
we could call. We lined up meetings with some Japanese banks, Shell
Oil, and pension funds from General Motors, General Electric, and
AT&T. None of them said yes, but we did get the California Teachers'
Pension Fund and California Public Employees' Retirement System to

make large commitments. Then we got the commitment ofsome highly
regarded endowments such as MIT, Princeton, and Yale and we were
offand running. The only local money we got, besides First Chicago,
camefrom Aon, the big insurance company.
First Chicago initially had committed to 25% of the fund, but after
seven months of fund raising we realized we could not take the entire
amount. One ofthereasons we hadsucceeded with thelimited partners
was that we had agreed not to raise more than $550 million. But, if
we gave First Chicago a quarter of that, we would have needed to turn
away otherlimited partners whowanted in. Accepting all of the bank's
money would have put us over the $550 million limit. Quite graciously,
Thomas agreed to limit the size of First Chicago's investment so we
could bring the other limited partners into our fund.
Path of Surprises
I have to admit there was some exhilaration, along with a certain air of
suspense, for me personally as we set up shop at the corner of Madison
and Dearborn streets in Chicago. Since my days as a freshman in high
school, I had wanted to make a lot of money. My father was a doctor
on Long Island where I grew up. He was an artist and sculptor, too, but
making money initself was nota major focus for him. Mylife was pretty
sheltered. I had70kids inmy high school class andplayed all the sports,
so money was not a chief focus for me, either, during thoseearlyyears.
That perspective changed quite abruptly one summer during high
school while I worked at a gourmet food store owned bythe father of a
friend. Investment bankers, lawyers, stock brokers, and doctors would
come into that store, and there was something about their lives that
seemed so comfortable. I was on the other side of the counter but did
not want to stay there all my life. I decided then that I wanted to make
a million dollars. That would be a measure of success.
In those early years, I had a hope that I might be able to play
professional baseball. I was a catcher, and between high school and
college I had a week-long tryout with the Atlanta Braves organization.
It turned out I couldn't hit minorleague pitching, and exactly how that
contributed to a feeling of homesickness I developed, I do not know.
THE INSIDE GAME • 127
I was slow and couldn't hit, but I still had an arm that was strong
enough for me to play college ball at Denison University. Fortunately,
the colleges did not check into amateur status very carefully back
then, so when I enrolled at Denison I was still able to play. Much has
been made of my baseball career, because today I own a stake in the
Milwaukee Brewers and also had bid to buy the Chicago Cubs from
the Tribune Company, but to imply that I was a superstar ball player
is an exaggeration.
When I was 20, my mom and brother both died within a week of
each other. My brother died in a car wreck, and my mother choked to
death while eating in a restaurant. I was a senior at Denison and on my
way to law school. It's hard to put into words how tough that was. Let
me just say it taught me I could survive anything. Failing in business
is not the end of the world, and as long as we have our health and our
loved ones, life can be okay.
One irony ofmy life isthat I had never intended to goto law school.
I had always planned to go to business school and had taken the en
trance exam. Meanwhile, I had a friend who needed a ride to Colum
bus, Ohio, to take the law boards, and I figured, as long as I was
driving him there, I might as well take the test myself. It turned out
that I bombed the business boards, but I got the highest score ever in
Ohio on the law boards. The Vietnam War was getting started, and the
only way to skip the draft was to stay inschool, solaw school suddenly
sounded like a great idea.
I wound up at First Chicago almost by happenstance, too. In my last
year at Duke University Law School, a First Chicago lawyer visited,
and I applied for a job. The Vietnam War was still escalating, and I
listed my draft status as 1-Y, which meant I could be drafted. But the
recruiting lawyer didn't know what that meant, so he offered me a
job anyway. The lawyers back in Chicago were not happy about that,
especially when I wound up with No. 12 in the draft lottery, which
meant I soon would ship off for Vietnam. When I went for induction,
though, I flunked the physical, so the law department had its newest
associate after all. I started work, in fact, on the day the First National
Bank Building opened. The building is a landmark in Chicago, with its
sweeping, curved, white exterior walls, and I have always enjoyed hav
ing something in commonwith that great building.
The Firm Is Flat

I had wanted to be a principal investor since a time early in my career
when I was a young lawyer representing First Chicago Venture Capital.
One day we were working on an investment with KKR in the offices of
the buyout boutique Simpson Thacher & Bartlett when Henry Kravis
told another attorney and me to draftup some documents while he and
the other principals went to dinner. I said to myself at that point, "I
want to be the guy who goes to dinner."
Now, at long last, I and my 13 partners were setting up shop as
principal investors. One ofour first major successes was in a company
called OmniPoint. It was a wireless phone company in which we in
vested $30 million, and like many telecom startups it went through
about four different boom-and-bust cycles. We were always living by
FCC limits on our expansion and who would let the company put up
cell towers. It was a precarious ride.
OmniPoint was a no-leverage deal, but that was not the norm. We
set a course early onsuch thatabout 60% ofourdeals would be growth
equity investments, like OmniPoint, and the remaining 40% would be
buyouts, which by definition were bigger deals. OmniPoint ultimately
became T-Mobile, and they were acquired by Deutsche Telekom. As a
firm, we took $600 million outofthat deal. The people who sold their
Deutsche Telekom stock are happy with what they got, but that com
pany has fallen on hard times, so the ones who held onto their shares
probably regret it.
The end result of the investment for the partners in our firm always
boils down to the share they hold in the form of carried interest. Over
the years, we have learned to develop a very flat carry system. Inourlast
two funds, no one person has more than 10% of the carry, so the gap
between individuals at thefirm isnot great. Now, ifyoudon't have this
sort of flat setup, you are notgoing to be able to govern a partnership,
because there will be too much infighting. Sooner or later, the partners
will storm thecastle andtry to take over to show they can do it better.
A flat compensation system also has the effect of making a point
within the firm that we do not operate under a star system. We do not
view our firm asgroups ofpeople, operating from silos of expertise and
all competing for the same resources. Equitable distribution of carry is
a persuasive way to make this point.
Hot, Cold, and Sitting on Hands

From time to time, each of our industry groups is going to be playing
a hot hand. Telecom gets hot and then turns cold; the manufactur
ing sector rises and falls. It is the job of these sector groups to jump
on such opportunities, but by retaining a relatively even approach to
compensation we make it clear that no individual group is respon
sible for our success. Likewise, when conditions change and results
turn against a particular group, everyone tends to be more tolerant of
those conditions, as well. These broader points are made, too, by the
way we evaluate deals, the way we manage our ongoing investment in
companies, and through a variety of other methods. It is an intrinsic
part of our firm and one that contributes to our even-keeled style and
our success.
We keep the partners aligned with the firm's objectives by distribut

ing carry at the start of a fund. We do not allocate based on deal flow
because we do not want to build in a volume incentive for people to do
deals. Given the choice between doing no deals and doing bad deals,
I'lltake no deals every time. We don't want to penalize our people for
not doing deals, especially ifthey are focused on anindustry thatis just
not attractive at the time. We do not want any of our people to feel
they are not going to get paid because they are sitting on their hands,
especially in tough economic times when perhaps that is precisely what
they should be doing.
Everyone has meaningful investments in the funds, too. Many of
our partners and associates have to borrow money to make their
investments, particularly the younger professionals. That way,
they are fully committed. There is no temptation to throw in the
towel when things go bad. After all, the firm has guaranteed their
loans. They know we will hunt them down in the night if they do
not pay.
We use a compensation structure to provide incentive for manage
ment at our portfolio companies, too. One of the reasons why private
equity is a better approach than hedge funds or public companies, in
ourview, isthat we canalign with management by requesting that they
put a meaningful amount ofmoney into the deal. When things do get
tough, they can't walk away. They can't say, "Well it didn't work out,
but I just had options, so it's no big deal."
Growing Pains
Every deal we did in ourfirst fund turned outwell, not just OmniPoint.
We got four times the total amount invested. By 1997, we were ready
to raise a second fund, targeted for $900 million. Some of our limited
partners thought that was too big a step up—nearly double our first
fund—but the second fund turned out to be very successful, so we
quickly raised a third fund, which capped at $2 billion.
That fund became the source ofsome ofour firm's biggest mistakes.
Part of it, I think, was that we were taking in the returns from our first
fund, so we probably were acting with some overconfidence. After all,
we were cashing checks for $600 million for OmniPoint, so nobody
was going to say we did not know what we were doing with our new
round ofinvestments. We were investing in 2000, at the height ofthe
dot-com bubble, and because of our experience we weighted very heav
ily toward the telecom sector. After the telecom bubble burst, we hadto
close down 25 companies. Some ofthem were hitting their plans, but
we had toclose them down anyway because the lenders had no patience
with anything in the sector.
We had never known much stress before. We had only known suc
cess. Nowwe were facing a lot ofstress. In one of ourcompanies, Focal
Communications, we had invested $15 million, and at its height the
investment was valued at $1.4 billion. We never got a nickel out of it,
though. The stock topped out, but we could not sellbecause that would
have undermined the whole market for the company. As we looked
back on it, the mistake we made was that we concentrated too much in
one sector, telecom, which had been so hot.
The blistering experience with the telecom boom and bust taught us
a few lessons about managing a firm under changing market conditions.
Mainly, welearned that it isa mistake to get too excited aboutinordinate
success. It isequally an error to overreact when the markets turn against
us. At the height of the telecom bubble, those of us in leadership of the
firm spent a lot of time deciding how to compensate our telecom group.
After all, they were doing most ofthe deals, and they were having remark
able success. At one point we considered launching a sector-specific fund
that our telecom people would manage. We changed our hiring so sector
groups—the telecom group, in particular—could hire associates without
having them interview throughout the firm, as had been our practice.
The Inside Game • 131
Confidential Compensation
We did not change our carry structure. That was sacrosanct. But we
did make certain that the telecom group received hefty bonuses. It was
important, though, to make certain that the bonuses remained confi
dential. We published the bonus pool each year, so everyone in the firm
could estimate how large a share they had gotten. Ourown experiences
told us, though, that itwould be corrosive to let everyone know exactly
how much a particular team received.
Inthe end, we did not permanently change the structure ofour firm,
either when telecom was on its way up or on its way down. We never
launched a separate telecom fund, and we decided, after experimenting
with new hiring practices, to return to our old style.
Our decision to continue with our traditional hiring approach is
having an important impact on the firm. Letting one industry team
take responsibilities for hiring had the potential to have a corrosive
effect on the firm's sense of cohesion. Instead of feeling loyal to the
firm, we thought that our young people over time would develop that
commitment only toward the particular group that hired, trained, and
mentored them. Their commitment inevitably would be to the group,
not to the entire firm. This, in turn, might create a sense of competing
fiefdoms at the firm rather than the notion we prefer—that we all con
tribute, from our different disciplines, to our shared success.
We now believe it is important that everyone in leadership at the firm
meet every new person we hire, and we work to make certain our new
associates also develop this firmwide perspective. We make clear to new
associates that it is the firm, and not a particular team, that hires them.
We assign our new associates to apool from which they might be called to
any industry group, depending on the firm's needs. Only after about three
years of experience do we allow the new associates to pick a specialty.
Giving Back Fees

Ultimately, the most dramatic impact on our firm from the telecom bust
that began in 2000 was the decision we made to quit taking manage
ment fees. We hadfinished raising ourfourth fund, $4 billion, andwith
the telecom sector collapsing we had our hands full monitoring our
portfolio. We were focused on ensuring that our third fund's relative
performance would be as good as possible. I raised the idea of forego

ing our management fee, which would mean giving up a $15 million
revenue stream thatarose from our .75% assessment against the fund's
$2 billion of capitalcommitments.
We did not even send out an announcement. Word got out when we
started getting calls from the wire rooms of our limited partners. They
had expected invoices, telling them they owed us so much money, but
the notices never came.
Soon after that, we decided to cut the amount of our fee for our
fourth fund. In this case, the reasoning was different. The buyout mar
ket was dead. After the telecom bust and the dot-com bust, deal flow
had just dried up. It seemed difficult to justify collecting our full fee
when there was goingto be so little deal flow.
Wecut our fee on the fourth fund from 1.5% of $4 billion to 1.5% of
$3 billion. With the cuts from those two funds, we were giving up $30 mil
lion ayear in fees. Itold our partners that I believed we were not the only
firm being hit by these conditions and that, before long, all the other firms
would follow suit. Venture firms had already begun giving back money to
investors. Ifigured private-equity firms would match, in their way, by cut
ting management fees, and we wanted to be the first firm to do so.
As soon as we announced the cut in our fees, I got a call from the
CEO ofa major buyout fund. "What are you guys doing?" he wanted
to know. "Everybody in the world is talking about this. They're all
angryat us because we're not doing it."
The call was hardly asurprise. Our cut in fees breached along-standing
protocol of the industry and was controversial atthe very least. We simply
felt it was the right thing to do for our limited partners.
As itturned out, I had misread the situation inthe industry. Noother
major firm followed our lead and cut its own fees. Still, to this day
I think the move was a good one. We earned all kinds ofgood will with
our limited partners. Until that point, some of our limiteds had raised
questions about the size of our newest fund. They told us they were
concerned about "style drift"—the tendency tochange investment style
when a firm raises too much money. What they really meant, though,
was that they were concerned about paying such large fees when there
was so little action in the marketplace. Once we cut the fees, the ques
tions about style drift went away.
Style Drift and Vintage Risk

Style drift was not accurate in describing what happened during the
telecom bust, but some think it is fair to apply the term to what hap
pened during 2006 and 2007, when our firm and many private-equity
firms began doing extraordinarily large deals. This was the height of
the deal frenzy, when credit was cheap and money just flowed. Heading
into this period, we were raising a $6.5 billion fund and had to turn
down a $500 million commitment from a large pension fund because it
would have put us over our cap.
The deal flow and the price tags were just incredible. At one point,
we had three different teams in our firm, in three different industries,
working three major, multi-billon-dollar deals. The size of the deals
had gotten larger. We invested 45% of our $6.5 billion fifth fund in
just three companies.
As itturned out, we were not facing industry concentration risk, as we
had with telecom, but what we and the industry were facing more than
anything else was vintage risk. In other words, the bulk of these deals all
were getting done around the same time, with similar debt profiles, and
they would respond similarly ifthe economy turned against us.
Before 2006, the entire private-equity industry had done only one deal
larger than $10 billion—KKR's $25 billion purchase of RJR Nabisco, the
infamous "Barbarians at theGate" deal. Beginning in2006,18 deals were
$10 billion or larger. Because many of these deals had similar debt pro
files, the entire industry would be facing vintage risk, especially once the
economy tightened in late 2008 and it became challenging to comply with
debt covenants asthe economic performance ofcompanies declined.
An Uneasy New Era

The easy credit was creating an uneasy amount of leverage the likes of
which our industry had never seen before. Total debt during this period
was 6 times cash flow, nearly double what it had been in2001, when le
verage multiples fell to a 10-year low of3.5 times cash flow. Money was
easy. Loans were offered with liberal amortization schedules, without re
strictive covenants andwith the ability to pay interest inkind. Some ofthe
best financial minds in the world had beenaskedto create innovative new
products to help fund the financing frenzy, and they did not disappoint.
The deals that have gotten into trouble are in industries that were
most adversely affected by the economic downturn and have done so
because the extraordinary amounts of leverage left them little room
for error. Prices ran to remarkable levels, in part because the avail
ability of cheap credit tended to drive prices skyward. The bankers
were so anxious to lend, they were offering us more than we were
willing to take.
Protective Measures
The experience from this period has taught us the value of extreme
stress testing when we are evaluating an investment. Like most firms,
we have always conducted tests of how apotential portfolio company
might perform under tough economic conditions. Over time, we have
refined this into what we call a "waterfall analysis." The term is meant
to reflect what can happen when a stream of bad news cascades, like a
waterfall, on anygiven company.
Before investing in one retailer, for example, we looked at how the
company would operate even in the face of a series of extreme occur
rences. We looked athow they would do ifthe company signed no new
accounts, if wholesale margins fell by 1%, if sales in new stores fell
dramatically, if same-store sales growth flatlined for four straight years,
ifthe company failed to open more than 10 stores a year, and other
factors. The company expected to sign an important new customer, but
we estimated the impact of what would happen if the deal would fall
through. Then, we added all those negative occurrences together and
looked at the numbers.
We learned from experience that reality sometimes might be tougher
than even our worst-case scenarios. The economic assumptions we
made prior to the economic crisis of 2008 clearly were not severe
enough. From this recent experience, we have extended the duration of
our worst-case assumptions by several years, to take into account the
possibility of an economic downturn that persists for five years. Perhaps
we did not take into account the more global effects of an economic
downturn—a lack of credit, a dysfunctional banking system, 10%
unemployment, and so on. Previously, our assumptions had focused
more at the internal nature ofthe business than at any potential for a
THE inside Game • 135
collapse of the global economy. From this point forward, we know we

need to give particular emphasis to the impact of the world economic
situation, too.
The careful calibrations do not change once we close on our deals.
On an ongoing basis, we reassess our investment decisions. Each year,
as we review the performance of our portfolio companies, we treat each
one as if it were a new investment. The deal team that was responsible
for the investment has to justify sticking with the company, as ifkeep
ing our money in it is no different than committing the capital in the
first place. They have toset out a timetable for when they expect toget
liquidity on the investment—in other words, when and how we expect
to exit—and then thatgoes on a big master schedule. These timetables
are reviewed quarterly, and any delays have to be explained.
We look at stress tests on an ongoing basis, too. If the stress test
shows that a default may occur on any of the company's loans, the
team is required to create a scenario for how we will prevent that from
happening or, if necessary, how we will deal with the problem. As a
matter of practice, we generally do not put new money into a com
pany that is running into trouble. We did that once, early in Madison
Dearborn's history, when the chief executive of the company came
to Chicago and laid out his case for additional investment. We had
invested $50 million in the company at the start, and the chief execu
tive felt he could get out of trouble if we put in $10 million more. It
was an extraordinary circumstance and a good presentation, and we
went against our gut and contributed new capital. That additional
investment actually turned out well. We just distributed some of the
company's stock. But let's just say that this case was the exception
that proves the rule that we do not believe in putting in good money
after bad.
An Altered Economy, A Changing Business

As the crisis that began in 2008 extends and expands into historic
proportions, the private-equity business is changing and presenting
new challenges for us as managers ofour firms. For me, personally, the
change has coincided with the transition, beginning in March 2007,
from my day-to-day role as chief executive to becoming chairman of
136 • The Masters of Private Equityand Venture Capital
Madison Dearborn. My partners, Sam Mencoff and Paul Finnegan, now

share the CEO duties. The industry is in transition, too. The days of
easy credit are over, and we are experiencing a return to smaller deals,
virtually all of which must be funded without the use of leverage.
There literally is no leverage available. I do not expect leverage ever
will return to the levels we just experienced, at least, not while I am
around. Leverage will return, though, once banks feel more comfortable
with their capital structure and once amarket recovery gets the capital
markets flowing again. Regardless, we have adjusted tothis new era of
low- or no-leverage deals. We have said internally that we are going to
limit ourselves to investing no more than 10% of the fund in any one
transaction. We prefer tokeep the average investment lower than that,
if possible. Even though we have raised over $4 billion we expect deal
size to remain relatively small.
For the time being, deal flow will be rather thin. For more than a
year we did just one deal. Right now we are saying our current fund
will last us for a good, long time. There is nothing on the horizon to
suggest that broad economic conditions will change any time soon, and
our business tends to reflect the underlying economy.
Private equity is entering a distinct new phase. We are back to basic
values and growth-oriented investing. Leverage is out of the picture for
now, but will almost certainly make a comeback at some point. Much
will depend on how and when the economy regains its strength. The
new phase has a familiar look, one that harkens back to the conditions
that prevailed when I was first getting into the business.
What shape our economy, and our business, will take in the future
remains to be seen. As ever in private equity, uncertainty creates oppor
tunity. Itis up to us tofind opportunity where others see only trouble—
and make the most of it.
LESSONS FROM JOHN CANNING

<f> Use leverage prudently. The days of runaway borrowing, with few
loan covenants and seemingly endless access to debt, fueled a flurry
of large highly leveraged deals. Agrowth investing approach is not
only necessary but also leads to more careful investment decisions.
4&> Assess risks carefully. Before investing, take into account all the
negative contingencies. Add up their impact, over an extended
period oftime, to see how the investment would hold up under
the worst of circumstances.
<<$> Get skin in thegame. Management should have a substantial

personal investment in a deal. Partners ofa private-equity firm
should also be heavily invested in the firm's funds.
<$> Avoid large pay disparities. Large inequalities in pay can cause
friction in a firm, and rewarding a hot deal team can backfire if
economic conditions change. Use bonuses to recognize extraordinary
performance but keep base pay relatively flat among partners.
<|> Adjust to economic conditions. The economic downturn is sending
clear signals that investing styles will have to change. Experience
shows, too, that it is bestto use caution when money and credit
are easy.
PART II
VENTURE GAIITAI
llil
7
THE ENTREPRENEUR AND THE

VENTURE CAPITALIST
Garth Saloner
Philip H. Knight Professor and Dean
Graduate School of Business, Stanford University
Garth Saloner has both studied and practiced entrepreneurship, leaving

Stanford University business school in 2001 for a two-year stint working
at start-up companies. An authority on the role venture capital plays
in spurring economic activity, Saloner has researched and written
about e-commerce, strategic management, organizational economics,
and competitive strategy. Named in early 2009 as dean of Stanford's
business school, Saloner has focused his recent research on advancing
our understanding ofhow start-ups and established firms setand change
strategy.
Training his eye on the complex ecosystem of venture capitalists,
entrepreneurs, and investors, Saloner here explains how all these groups
work together, despite some inherent conflict, to promote innovation
and create new industries. Venture capitalists must make risk-reward
calculations that drive their decisions, while entrepreneurs often lack
such an objective appraisal because they have so much of themselves
invested in the commercialization of their ideas. Recent, historic stresses
in the financial markets and economy have added to the complexity of
these relations.
141
The venture capital industry is an important part of the engine of

growth in developed and, increasingly, in developing countries as
well. As the stories in this book illustrate, many ofthe largest compa
nies formed as new ventures in the last several decades emerged from an
ecosystem in which angel investors, venture capitalists, entrepreneurs,
and university research all play a role. Yet the relationship among these
participants is not always easy. Despite the enormous benefit to society
and the substantial creation of wealth arising from the relationship
between venture capitalist and entrepreneur, each tends to consider
the other as a necessary evil for the success of the venture. To better
understand this complex love-hate relationship, it helps to understand
the goals and incentives ofthe typical venture capital firm.
Clearly, the goals, incentives—and ultimate returns—of venture
capital investment are desirable enough that legions ofinvestors forego
other possibly lucrativepursuits to devote their careers and substantial
pools of capital to entrepreneurial start-ups. Since 1970, venture capi
talists have invested $466 billion into more than 60,700 companies,
according to the National Venture Capital Association. In that same
time, asthe venture capital industry has become more institutionalized,
total assets under management have grown from $1 billion in 1970 to
$197 billion. Atits height in2000, before the collapse ofdot-com and
telecom companies scared substantial capital away from the venture
sector—the figure reached $225 billion. All told, companies formed as
a result of venture-backed investment today account for 10.4 million
U.S. jobs and 18% of the U.S. gross domestic product (Table 7.1).
Total Total Capital Avg. Avg.

Cumulative Cumulative Managed Fund Size Firm Size
Year Funds Firms ($ Billions) ($ Millions) ($ Millions)
1980 186 117 4.1 31.8 44.6
1985 539 320 17.9 33.1 60.3
1990 1,055 457 29.2 39.8 74.3
1995 1,527 615 40.6 57.4 94.6
2005 3,677 1,428 271.4 152.6 265.0
2008 4,273 1,648 197.3 144.4 223.7
Table 7.1 Source: National Venture Capital Association/Thomson Financial.
THE ENTREPRENEUR AND THE VENTURE CAPITALIST * 143
In the midst of the current economic turmoil, with both the credit
markets and the economy under significant stress, it is hardly surprising
that venture capitalists are particularly selective in the companies they
choose to support these days. In prior times, cycles of venture capital
tended to rise and fall with the ebb and flow of the market for initial
public stock offerings. As the initial public offering market seized up
beginning in2008, broader economic conditions and the availability of
credit tended to become the overriding factors.
This is not to say that venture capital investors have left the field
altogether. Rather, they are merely more careful than ever about
their investment decisions. Venture capital investors are ever more
vigilant to ensure that the companies they do support have enough
cash and "runway" to manage the rate at which they spend—or
"burn"—their way through capital or spend and burn through a
difficult period.
Likewise, venture capitalists themselves are finding that their own
access to capital is limited in ways few have seen before. Fundraising
from limited partners typically is taking longer and yielding less than
in prior periods.
Over the longterm, venture capitalfunds have generated a net inter
nal rate of return in the range of 15% to 20% eachyear to their limited
partners, butthose rich andreliable returns no longer seem quite so de
pendable to their limited-partner backers who have suffered economic
loss due to recent market and economic conditions. Chastened by losses
in the stock market and other forms of investment, the limited partners
are putting pressure on venture funds not to make a call on their capi
tal. In short, the limited partners are asking the venture capitalists to
avoid demanding that the investors actually produce the capital they
promised at the time the fund was formed, unless such a capital call is
absolutely necessary. Venture capitalists are now much more solicitous
of public pension fund investors whom until recently they had often
dismissed in favor of more sophisticated endowment funds. Indeed,
endowments these days frequently are retreating from the business
of meaningful venture exposure, as theyrecover from significant equity
market losses and move toward a more conservative mix in their invest
ment portfolios (Table 7.2).
Net IRR to Investors for Investment Horizon

Ending 12/31/2008 for Venture Capital Funds
Fund Type 1YR 3YR 5YR 10YR 20YR
Seed/early venture capital -20.6% 1.7% 3;7% 36.0% 21.8%
Balanced venture capital -26.9% 4.6% 8.4% 13.5% 14.5%
Later stage venture capital -6.8% 9.5% 8,7% 7.5% 14.5%
All venture capital -20.9% 4.2% 6.4% 15.5% 17.0%
NASDAQ -38.1% -10.3% -4,6% -3.2% 7.3%
S&P 500 -36.1% -10.0% -4.0% -3.0% 6.1%
Table 7.2 Source: National Venture Capital Association/Thomson Financial
Thanks, but No Thanks!

These are the novel and stressful market conditions under which ven
ture investors and entrepreneurs are undertaking the age-old court
ship by which both hope to find a way to build a successful and
profitable enterprise. No matter how robust or weak the market con
ditions, the rituals undertaken by investor and entrepreneur remain
essentially the same. One of the most frustrating experiences for an
aspiring entrepreneur is a meeting with a venture capital firm that
goes splendidly in all respects except one: no investment comes forth!
The presentation went well, the discussion was lively and engaging,
and it seems as though all the bases were covered. The technology is
sound, customer satisfaction with the beta version is high, there are
more customers hungry for the product, the unit economics of the
business are promising, the team is well qualified, and the financial
projections all make sense. Yet, in a polite but firm way, the venture
partner delivers the news that this is not a venture that is suitable for
this venture firm at this particular time.
What went wrong? To understand what probably went wrong, the
aspiring entrepreneur needs to understand the financial model of the
typical venture firm. Thatmodel begins with therisk-return aspirations
ofthe limited partners who invest inthe venture fund in the first place.
Whether made by a pension fund, a university endowment, investment
fund, or other investor, the venture investment is a dicey proposition.
Yes, many ventureinvestments havebeenwildly successful, but venture
capital is a risky investment class, one in which one's money will be tied
THE ENTREPRENEUR AND THE VENTURE CAPITALIST <> 145
up for a long time and in which there will be limited visibility into how the
investment fares along the way. In exchange for tolerating this risk and
uncertainty, the limited partner requires a risk premium over and above
what itexpects itcould obtain by simply investing in, say, anequity index
fund. If, for example, they expect U.S. equities to return an average of
12% over time, the limited partners in a venture fund might expect a 10%
premium for the risk and illiquidity associated with venture investing. All
told, the limited partner might be looking for an expected 22% return.
As ifthat22% expected return is notsteep enough, the capital allotted
toward venture investing has even more demands placed upon it. The
typical venture investment must return more than that 22% on average,
because the economic return to the venture firm itself must be factored
in. In a typical 2/20 fund, the firm takes an annual management fee of
2% and also shares in the upside of the investment by taking 20% of
the return on investment—an allotment referred to as "carry" in the
trade. Venture firms with extraordinary track recordscan demand carry
rates as high as 30%. Taking into account the additional demands on
thecapital invested in a typical 2/20 fund, then, the actual investments
must deliver nearly a 30% return in order for the limited partner to
receive the expected 22% rate of return.
It is hardly surprising that theeconomics of the typical venture fund
have a substantial impact on the investment strategy of venture capital
firms. Imagine that the venture firm thinks the typical life of its fund
will be five years. Inorder to average a 30% return oninvestment, $100
invested on dayone must within five years yield almost $400. Although
many simplifying, and sometimes unrealistic, assumptions have been
made here, that is a daunting prospect for many new ventures—the
enterprises that must create the actual economic activity that creates
the outsized returns that the venture funds need in order to meet the
expectations of their investors.
The real-life picture actually is a bit grimmer than the basic
numbers relate. After all, many of the investments that are made
by the venture firm are not going to pay off anywhere nearly this
handsomely. Some will go bust altogether, while others may exceed
expectations and deliver substantially more than expected. It is fair
to expect that of $100 invested, roughly 40% will return nothing to
the venture firm.
One of the great virtues of venture capital is that it is willing to take

risks where a significant number of ventures simply will implode. For
argument's sake, let us suppose that another 30% return the amount in
vested and a further 20% do quite well and returnthree times the amount
invested. At that point, $90 of the $100 that was invested has returned a
grand total of $90. But remember that the $100 invested has to return a
totalof$400. Thatmeans thattheremaining $10 that was invested must
return a staggering $310, or 31 times the amount invested!
Tough to Predict
Ofcourse, the venture capitalist cannot tell which ofthe many opportu
nities thatcross his or her desk will be the one thatisa "30 bagger"—in
other words, the big payday. By the same turn, it can be nearly as
difficult to predict which of the investments will return zero. These
uncertainties—and the almost irresistible allure of the 30 bagger—drive
the typical venture investor toward a home-run model of investing.
Such investors puttheir money down knowing thatthe glowing average
return they expect from their portfolios likely will stem from a small
number of very spectacular successes.
But, matters do not end there: There ismore bad news for thetypical
investor. Not only must theventure firm's partners identify entrepreneurs
whose ideas deserve financial backing, but they also must maintain and
monitor those investments over time—all the while scouting for new
investment opportunities coming around the bend. Let ussuppose, hypo-
thetically, thatourventure firm with $500 million incommitted capital is
composed of eight venture partners. That means that over the life of the
fund, on average each partner will invest a little more than $60 million.
Thismaysoundlike a lot for a single individual to control,and it is.In
fact, mostventure partners feel they cannot adequately oversee morethan
about eight portfolio companies at a time. One of the most important
things thatthe venture capitalist brings to the entrepreneur isrisk capital,
butasthe pages ofthis book make clear, they also bring advice, networks
of potential customers, and potential team members or employees. The
venture partneralso likely will sit on the boardof the portfolio company
and takea leading role in helping to move thecompany along itsnatural
growth curve, from start-up, to success, to potential candidate for an
IPO, or—in these more stringent market conditions—to a buyout by a

larger, more established corporation or group of investors.
It is difficult to do that effectively while fulfilling the fiduciary re
sponsibilities of oversight and monitoring if a single venture capitalist
is responsible for many more thaneight portfolio companies. Whatthis
means, of course, is that an average venture must enable the partner to
put $5 million to $10 million to work over the life of the venture.
Every venture firm differs from every other with respect to each ofthe
elements in this hypothetical example that I have drawn largely froman
analysis that my colleague Mark Leslie, the Veritas founder, presented
when wetaught a venture class together at Stanford University's graduate
school of business. The required rate of return, the size of the fund,
the number of partners, the target distribution of returns, and so on
are drawn from our research and experience. Regardless of the precise
numbers, though, the basic structure of the economic argument holds.
The bottom line is that a typical investment must,on average, be quite
large and must have the potential for a very large rate of return. A new
venture for which a $7.5 million investment returns 30 times its money,
where anyventure firm may beonly one ofseveral in thedeal, andwhere
the venture firms collectively may only end up with 50% or 60% owner
ship of the company, must have the potential to have a very large final
valuation indeed. Historically, most of the companies successful enough
to achieve such rates of return to the venture investor did so through an
IPO. As the IPO market enters an extremely constrained period during
the late 2000s, the barriers toward success seem to rise even higher.
Whose Side Are You On Anyway?

Now we are in a position to return to the disappointed aspiring
entrepreneur with whom we started this section. In many cases,
the entrepreneur emerges extremely disappointed from this initial
exposure to the venture marketplace because the basic economics of
venture investing were not clearly understood. The business plan might
indeed be completely sound and may even be the basis for a perfectly
viable new venture, but the potential market may not be big enough
or the expected rate of return too difficult to achieve. Fortunately, a
mismatch between the size and expected return of the venture and
148 * THE MASTERS OF PRIVATE EQUITYAND VENTURE CAPITAL
the requirements of the venture capitalist need not spell doom for the
nascent venture. A variety of other sources of risk capital are available
to fill the gap—with friends, family, and angel investors often being
the most likely source.
For the entrepreneur who does obtain venture capital, the fundrais-
ing phase is only the first of manysources of possible conflict between
the entrepreneur and the venture capitalist. At the heart of the issue is
the fact that, while both the entrepreneur and the investor meet their
respective goals when things go well, there are many respects in which
the parties' incentives are misaligned. These misalignments often cause
friction along the way.
For many entrepreneurs, financial success is only one—and often not
the most important—source of their passion for their ventures. Their
commitment to the idea itselfand to seeing it to fruition is often what
compels them. For the venture capitalists, on the other hand, as proud
as they may be of the successful companies they have helped spawn,
their fiduciary responsibility is to their investors and the return that
they expect. This difference often manifests itself at inflection points
where there is a choice between a low-risk, moderate-return alternative
and one that requires "hitting for the fences."
The typical venture investor has every incentive to play long ball,
while many entrepreneurs will be happy simply to see their product
come to market, even if there is little hope of achieving substantial
scale. The venture capitalist may often be more aggressive than the
entrepreneur when the venture investor begins to suspectthat this par
ticular enterprise is a low-probability, high-return investment. On the
otherhand, once theventure investor believes that the enterprise likely
will never hit it big, the interest in the investment maywane—regard
less of whether or not the entrepreneur still believes in the business.
This disparity in perspective is rooted in two concrete aspects of the
entrepreneurial opportunity. The first is that a venture investment is
usually structured so that the investors hold preferredstock whereas the
founders and employees hold only common stock. This means investors
get their money back before the founders can. If the outlook for a
typical, $30 million investment is such that continued investment is
unlikely to return much more than that amount, the investors would
typically be motivated to exit as soon as possible, almost regardless of
any marginal extra return. They want to selland get their money back.
The entrepreneur, meanwhile, may prefer to keep going in the hopes
that this particular venture might yet turn into something big.
The second reason for the difference in perspective is that, as a ven
ture capitalist once told me, venture investors are investing two things:
time and money. The concern with the financial investment is obvious.
Lessobvious, however, is the opportunity cost in terms of time. Because
the cost of continuing to investtime in the entrepreneur's venture is the
inability to take on another, potentially much more lucrative venture,
the venture capitalist often has an incentive to shut down the venture
and move on before the entrepreneur is willing to do so.
Success in the venture does not necessarily eliminate this tension be
tween entrepreneur and investor, either. They may also differ in their
patience when it comes to the timing and form of an exit for a success
ful venture. Venture capitalists are more likely to favor IPOs and to
favor them sooner than entrepreneurs will. An IPO provides liquidity
for the venture firm's limited partners and provides a concrete measure
to bolster the return on the current fund. Such concrete data can be
useful to have in the bag as they raise subsequent funds.
The entrepreneur may prefer a longer time horizon, both because it
may be possible to demonstratemore progress and also because the IPO
itselfand the public scrutiny that comes with it may be unwelcome dis
tractions from continuing to grow the business. Of course, in the longer
run an IPO is a welcome liquidity event for the founders and team as
well. As other forms of exit become more common, it is possible that en
trepreneurs will more readily welcome those that do not involve greater
public scrutiny, as long as the financial returns are commensurate with
what had been expected when IPOs were more readily done.
Yetanother frequent difference of opinioncenters on the abilityof the
founder to "scale" the firm as it grows. Although many venture capital
ists eschew the claim that they often are unwilling to give the founder an
opportunity to stay at the helm oncethe company is big,that is certainly
the perception and fear among many venture-backed entrepreneurs. It is
interesting to note that manyyoung entrepreneurs who managed to build
their companies with littleor no reliance on venturefunding have indeed
managed to scale very well with their companies. Bill Gates, SteveJobs,
Michael Dell, and Larry Ellison are notable examples. Critics wonder
whether these successful individuals—among the wealthiest and most

successful captains ofindustry today—would have been given the oppor
tunity with venturecapitalists in controlof the board room, where a bias
for introducing "professional management" is sometimes in evidence.
Conflict may also arise over issues as prosaic as compensation, de
mands on time, and commitment to the enterprise. Compensation for
the founders and the management team, whether in the form of cash,
stock, or options, comes out of the investors' hide. And the company
wantsthe full attention of its venture capitalist—admittedly on its own
terms—whereas the latter has more to gain by spreading the time and
attention across a portfolio of investments.
A Successful, If Uneasy, Marriage

The venture capitalists' business model allows the venture investor
to commit capital to only a few of the entrepreneurs who seek back
ing each year. Moreover, the small number of entrepreneurs who do
secure venture funding must navigate a number of inherent misalign
ments of incentives, even as the venture investors who have provided
capital to the enterprise manage the same issues from a sometimes
opposite perspective. Nonetheless, the existence of venture capital has
proven essential to the formation of numerous companies that are
household names and which have contributed products, technologies,
and jobs to millions.
InSilicon Valley, wenowtake forgranted theability ofanentrepreneur
withnothing more than a germ of an idea to gather together the human
capital, financial capital, legal advice, and governance talent to test the
proposition that the idea can become a company. Often those ventures
amount to nothing, and it is a testament to the resilience of the system
that entrepreneurs who fail on their first venture often are as capable,
if not more so, of obtaining funding for their next one. This ability for
ventures with significant capital requirements to form, dissolve, and
arise again, in ever-changing configurations—to fuel economic growth
and technological innovation—would be much diminished without the
contributions of venture capitalists and the risk-minded entrepreneurs
whose backing they receive.
8
PIONEER INVESTING:
TAKING VENTURE CAPITAL
FROM SILICON VALLEY TO
BANGALORE AND BEYOND
William H. Draper m
General Partner
Draper Richards L.P.
G3*&>-
AUM:$1 billion Years in VC: 50
Location: San Francisco, CA Year borh: 1928
Grew up: Scarsdale, NY Location born: Scarsdale, NY
Best known deals: Apollo Computer, LSI Logic, Hybritech, Skype,

AthenaHeMth, ^pehTable, Activisiori
Style: Intuitiyip
Education: B*Av, Yale University* Class of 1950
;M.B.A^Jfarvard Graduate School of Business, Classof 1954
Significant experience: Co-founder, Sutter Hill Ventures, President
and Chairman of the Export-Import Bank of the United States,
Under-Secretatry-General, United Nations
Personal interests: Tennis, chess
the lesspn: "A venturecapitalistis only as good as his/herentrepreneurs."
-—" : (S?^X)
© 151 ©
William H. Draper HI helped to pioneer a new age of technology-

focused investing. From LSI Logic to Apollo Computer to Activision
to Skype, he has invested in companies that became household
names in the new Information Age. In doing so, Draper built on
and expanded the legacy of his father, William H. Draper, Jr., who
founded Draper, Gaither & Anderson, the first venture capital firm
on the West Coast.
Late in his career, Draper took his work abroad and set up Draper
International, thefirst U.S. venture fund focused on India. That country's
largest Internet portal, Rediff.com, was among Draper's investments.
Draper then dispatched an associate to Europe, leading Draper to
become thefirst venture investor in Skype, the internet-based telephone
service. Now, even in his 80s, Draper is exploring the latest trend in
venture investing, social entrepreneurship, funding the micro-lending site
Kiva.org, Room to Read, and dozens of others through the Draper
Richards Foundation. His latest work keeps Draper where he likes to be,
ahead of the crowd and leading the way.
Every form of investment entails some risk. By definition, venture

investors put their money into technologies that have not yet come
to fruition, untested business ideas, undeveloped markets, and, often,
entrepreneurs with virtually no track record.
While I'm still a strong proponent of higher education, there is a rea
son why it has become clicheto talk about the bright young person who
drops out of Harvard to start what becomes a billion-dollar company.
In point of fact, more than a few people from Harvard, Stanford, and
a few other schools have done just that. They have succeeded in part
because venture investors have been there, willing to put money behind
the notion that these young people just might succeed.
Venture capital is by definition a pioneering form of investment.
In most other forms of investment, it pays to follow what others have
done. The returns are nearly as good, and the risks not nearly as great.
In venture investing, it is beneficial to be first because that is where the
highest returns are found. Of course, the cutting edge often turns out
to be a bleeding edge, a place where success or failure can turn on the
smallest of factors.
Pioneer Investing • 153
A Fiery Start
I learned about this knife's edge betweensuccess and failure right at the
outset of my career in venture capital.In 1967, as the co-founderof the
newly formed venture firm Sutter Hill Ventures, I was trying to raise
$10 million in investment capital from a Canadian construction and
cement company named Genstar Ltd. A friend of mine from college, a
fellow Yale University alumnus, had told me that Genstar was looking
for a way to get into technology.
We took the president of the company, Angus McNaughton, on a
tour of a half dozen of our portfolio companies. One of the entrepre
neurs whom we visited in Los Angeles had started a company called
Duplicon, and he had developed a new technology that he believed
could put Xerox out of business. He had built his first prototype and
wanted to show it to us.
The guy was a showman. As if he were putting on some sort of
start-up magic act, he asked McNaughton to take a bill out of his
wallet. McNaughton took one out, a $100 bill, as he remembers it,
and handed it over. With a flourish, our entrepreneur lifted the cover
of his machine, slid the bill onto a sheet of glass, and closed the cover.
So far, so good. Then he flipped the switch. A motor whirred—and the
whole thing burst into flames!
The place went into a panic. Someone grabbed a fire extinguisherand
sprayed down everything so the whole building wouldn't burn down.
I thought, "Oh my gosh, not only is his $100 bill burned up but there
goes our $10 million."
Luckily, however, McNaughton liked our other innovative invest
ments, and Genstar wound up investing with us anyway. We signed
them up for a $10 million commitment, though we only ended up using
$6 million. For years, the returns from our firm, Sutter Hill Ventures,
filled in the gaps when Genstar's cement, construction, and housing
businesses were not doing well. We were a counterweight to their
otherwise very cyclical business. McNaughton told me recently that
over the years Genstar made more than $700 million in profits on that
$6 million. Sutter Hill had an internal rate of return of just about 40%
a year for the 16 years that I worked there.
To me, the experience with Genstar and Duplicon is illustrative of
what it means to be a venture investor. The work is not predictable.
154 ° THE MASTERS OF PRIVATE EQUITY AND VENTURE CAPITAL
Something that looks like a disasteris not necessarily so bad—although

there are, from time to time, actual disasters that really do hurt your
reputation or your earnings statement, and sometimes both. When we
do our jobs well, when the entrepreneurs are right about the oppor
tunity they see and we give them the capital and advice they need, we
have the chance to be part of something big,part of helping, say, Skype
or Activision or Measurex get started.
The work even gets the heart racing from time to time. After all, you
don't get to spray a fire extinguisheron a flaming copy machine in just
any line of work. The rewards, however, can come in at multiples far
beyond what anyone had a right to expect.
The Family Business

My first experience in venture capital was at Draper, Gaither &c Ander
son, the first venture capital company in the West. The Draper in the
group was my father, William H. Draper, Jr. His phase as a venture in
vestor filled the middle chapter in what was a most remarkable career.
As a young man, my father worked in Paris after World War II as an
assistant to W. Averill Harriman, who was responsible for implement
ing the Marshall Plan. After that, he moved to California and started
his firm.
Fifty years ago, in 1959, when my father founded the firm with Fred
Anderson and Rowan Gaither, I joined as a young associate. By this
time, I had studied economics at Yale, earned an M.B.A. from Harvard,
and worked as an executive at Inland Steel in Chicago. We were helping
to pioneer venture investing in the San Francisco area when the land
around Palo Alto, Menlo Park, and other communities on the outskirts
of Stanford University were still mainly fruit orchards and ranches.
There was no Silicon Valley at this point because, frankly, silicon-
based computer chips were just becoming of interest, and the actual
term would not be invented for more than a decade. It had only been
three years, in fact, since William Shockley left Bell Labs in a dispute
over credit for his invention of the transistor. He had shared the 1956
Nobel Prize along with two colleagues, but Shockley felt that he was
not adequately compensated for his innovation. Shockley formed his
own technology company, Shockley Semiconductor Laboratory, but
PIONEER INVESTING • 155
soon after that watched in dismay as his own top engineers left him.
In 1959, the Shockley refugees opened shop in Palo Alto as Fairchild
Semiconductor, the company that built the first commercial integrated
circuit. This simultaneous birth of venture capital and the semiconduc
tor industry in the Bay Area has had a profound impact on the world
in which we live today.
My first venture investment was in a company called Corbin-Farns-
worth, the first company in the country to commercialize heart defibril
lators. This was a brand-new healthcare device that required regulatory
approval, but it was so useful that the approvals did not take long. We
had a success on our hands, a big one, and eventually sold the company
to Smith, Kline & French.
Of course, a big return by the standards of these early days has no
relation to what people came to consider a big return in later years.
We were not striving for a billion-dollar success at that time. We just
wanted to get a reasonably good piece of a company that was brand
new, take a risk by investing in it, and work to make certain that in
the end the company earned a decent financial return and delivered a
valuable service.
Off on My Own
After three years at my father's firm, I developed an urge to go out
on my own. I had kept in touch with a friend from Inland Steel, an
otheryoung executive named Pitch Johnson, whose father had been the
track coach at Stanford. In 1962, when Johnson visited from Chicago
for "The Big Game"—the annual gridiron clash between Stanford and
U.C. Berkeley—we decided to form our own venture capital company.
Semiconductors were really getting big by this point, and one of our
first investments was in a firm called Electroglas, which made the first
commercially viable gas furnace for manufacturing semiconductors.
When inventing new markets, timing is everything, and Electroglas
had perfecttiming. What it did not have, though, was a chiefexecutive
officer who could handle the company's phenomenal growth. Arthur
Lash, the founder, had come out of Fairchild. He was a good engineer
who knew how to make diffusion furnaces, but he was no manager.
Therefore, we needed a manager.
When a man named Chuck Gravel first approached us during our

search for a new CEO for Electroglas, he seemed like the last person
who might run a company at the cutting edge of semiconductor manu
facturing. He had just left a job as the advertising manager for a boat
manufacturer in Minnesota because, odd as it may sound, he had made
too much money.
The boat company had been suffering from dismal sales, so here is
what Gravel did to remedy the situation: He took the company's entire
$25,000 annual marketing budget and invested it in a single full-page
ad in Life magazine. The ad invited peopleto sign up as distributors for
the company's boats. It was a hugegamble. It also was a huge success.
Prospective distributors from all over the country sent in money to buy
one or more boats, and sales went through the roof. Now Gravel was
rich, so wealthy in fact that he felt uncomfortable living in a small town
in Minnesota. He came out west and introduced himself to me.
Gravel didn't know anything about technology, but he was good at
selling, and sales were what Electroglas desperately needed. Building a
company means a lot morethan justhaving a group of Ph.D.s develop
ing world-class technology and pushing the limits of science. Someone
needs to budget. Someone needs to sell. The role of a venture capitalist
is to try to put those pieces in place and help build a team that works
well together. At the start, the companies are small and people have
to wear many hats. Then, as they grow, there is more differentiation.
As venture capitalists, we have witnessed this growth curve numerous
times, so we can offer some good advice about how to handle the chal
lenges. As it turned out, Chuck Gravel was an executive who could
learn from our experience and turn even a technologically complex
company such as Electroglas into a success.
The sort of informal approach we used in hiring Chuck Gravel and
top managers at some of our other early companies has served us well
over the years. One of the best breaks for me was my introduction to
Wilf Corrigan, the founder of LSI Logic. I found Corrigan and helped
him start LSI in 1981, only because I was in Los Angeles spreading the
word about the venture capital business down there. After a speech I
made to a business group, Corrigan approached me and said he was
getting ready to start a companythat would create customized designs
for large-scale integration computer chips.
Corrigan had served as vice president at Fairchild, but he left after

Schlumberger, the big conglomerate, took over the company. He had
considered going into venture capital but decided he was more suited
to starting his own company than for finding others in which to in
vest. Corrigan figured that it was "better to catch the money than to
pitch it."
Seeing into the Future

I go through a short mental checklist when I am interviewing some
one for a leadership position in a company or considering investing in
someone's novel idea. Technological capability and other traditional
measures play a small role relative to other considerations. I first want
to feel as if I would like to be in business with this person. It's more
than just a warm personality. At some level, I look for some marvel
ous flair, a charisma of some sort, and I look for energy, commitment,
and intelligence. I want them to have done the necessary homework so
that if I ask a question they have the answer or know quickly how to
get it.
This may all seem easy enough, but there is also another dimension
in venture investing: seeinginto the future. After all, a business in which
we invest is going to change dramatically from day one to maturity.
Ideally, we select someone who can take it all that way. When his or
her ideas either succeed or fail, I want to have an idea of how that
entrepreneur might react. It is all about the future, of course, because
we are trying to build something. We are trying to build a company
that wasn't there before, often with technology that has not come into
wide use.
Even if this sounds like a simple formula, it is not. It is the sort of
sense a person develops over many years. It took me that long, anyway.
Experiences become lessons, lessons become practices, and practices
help us succeed or fail. Of course, I had figured out very little of this by
the time Pitch Johnson and I set out on our own in 1962. We had no
idea then that four decades later we would still be looking for the next
new thing. We were not just pioneering technology, we were pioneering
an industry, and we were trying to develop the experiences, lessons, and
practices that would make us successful.
158 o the Masters of Private Equity and Venture Capital
Searching the Orchards

At the start, Pitch and I were just a couple of guys trying to make our
way. We needed to actively pursue potential deals, so we rented a pair
of matching Pontiacs and drove through the orchards around Palo Alto,
looking for signs that indicated someone was tinkering with silicon or
electronics instead of raising flowers or fruit. We would introduce our
selves and explain that we were involved in venture capital. With little
prompting, they would take half a day to tell us all about their business.
We participated in what became standard practices as we went
along. For example, it became common for venture capital firms to
collaborate on deals in pairs or groups of three. It was a way to share
risk, and at the outset it was also a way to spread our relatively small
pools of money into a larger number of deals.
It wasn't long before Pitch and I were talking to Sutter Hill, a real es
tate firmthat was interested in getting involved in venture capital.They
had money. We knew the venture capital business. Together, we had
the makings of a good fit. We jokedthat we could really benefitfrom a
fax machine and a receptionist, which they had. We had a deal.
For some time, Pitch had been talking about leaving the venture
business so that he could learn what it was like to actually operate
a start-up company. When Sutter Hill came along, their investment
marked the right time for us to part ways. Pitch went off on his own,
did some consulting work, and then fairly quickly wound up back in
venture investing, putting his own money to work and making some
great investments.
From Inventor to Manager

By that point I was quite familiar with what sort of person made a
good venture capitalist. I also had developed a sense of how entre
preneurs were able to grow into new roles as they matured as execu
tives and the markets developed around them. William Poduska was
one of those people whom I saw grow into an impressive executive.
When we funded Prime Computer at its outset in 1972, it was impos
sible not to be impressed by Poduska, the technology brains behind the
minicomputer company. Prime was a big success. It came to dominate
the markets for minicomputers and computer-aided design. Nearly a
decade after our first investment in Prime Computer, I was visitingthe

company's headquarters outside Boston when Poduska satbeside me in
the lobby and seemed to have something he wanted to say. Wewent to
the parking lot, andI asked Poduska what was on his mind.
"You know, as a matter of fact, I've been thinking of starting a
company," he said.
"Well, you know, I am inthe VC business," I said with a chuckle.
Poduska was vice president ofengineering at Prime, a position hehad
held since the company's founding, but he felt ready to jump to the next
level. Within a week of our conversation in the Boston parking lot, Po
duska was on an airplane with a proposal for a new company called
Apollo Computer. He wanted to build graphics-intensive workstations.
We agreed to fund Poduska—a $5 million start-up investment—over
lunch at the Palo Alto Club, which Bill Hewlett and David Packard had
started. I called Peter Crisp at theRockefeller Brothers Venture Fund and
told him I needed someone on the East Coast, closer to our new com
puter company, toinvest with me. Ittook little more than that phone call
to bring the Rockefeller money inand, in short order, close the deal.
The company flourished. From 1980 to 1987, it was the leading
manufacturer of network workstations, and we ultimately sold it to
Hewlett-Packard.
The Ones That Got Away

It was a period of big ideas and momentous change. I learned from
experience that it was essential to be quick footed, connected, and on
top of the latest technological changes in order to succeed. In 1981, we
were invited to take a look at an earlyfunding round for Microsoft, for
example. Bill Gates wanted a $2 million investment in the company.
I was ready to back Gates. He was brilliant. He was young. He was
cocky. Steve Ballmer, who had dropped outofStanford Business School
to help Gates start Microsoft, was already with Gates.
There was only one hurdle in our way. At Stanford, Ballmer had
roomed with a man named David Marquardt, who had become a ven
turecapitalist andwho isstill very successful today. We had thefeeling
that Marquardt would have the inside track to fund Microsoft, and we
were right. He became the sole venture investor in Microsoft.
Another big one—Apple Computer—simply got away. I had hired

Len Baker, a brilliant math major out of Yale, and I wanted to give
him a little experience. That's when Peter Crisp, of the Rockefeller
firm, called inearly 1978 to inform me about a company called Apple
Computer down in Cupertino. Peter was in for $2 million. The well-
known venture investor Arthur Rock was in for $1 million, and there
was $1 million open for Sutter Hill.
I sent Baker down to take a look. Baker came back, and he said,
"Well, the guys kept me waiting for 30minutes, they wrote code during
the whole meeting, and they had an arrogant attitude. The valuation
is high, too—around $18 million for the whole company. I think we
ought to turn it down."
I agreed. That decision ended up being my mistake, not Baker's.
First, I should not have sent someone brand new in the business by
himself forsuch a potentially important investment. Second, I knew the
Rockefellers well. Peter Crisp never would have suggested something
that was not of the highest quality.
Recognizing Genius
The face of genius changes allthetime. The nextgreat innovator or the
next great venture opportunitycan bevirtually unrecognizable, particu
larly in new industries orwith new technologies for which nobody has
yet set a pattern for success. Activision became one of our better deals,
but when the founders first came to me with their idea of breaking out
ofAtari and starting the first independent computer game design shop,
I was skeptical.
After hearing their proposal I said, "Fine, butwhat do you see your
selves doing in ten years?"
David Crane, Larry Kaplan, Alan Miller, and Bob Whitehead had
only one thing on their minds. One by one, they essentially said the
same thing. All they wanted to do was design computer games—not
just right then, but for years and years. I couldn't help but admire
their passion, but it was immediately obvious that if we were to back
this group of men they would need a president who could actually run
the business. Eventually we found the right guy: Jim Levy, who had a
background in the musicindustry.
It was difficult for me to visualize how computer-game design could

become a business. Up until that time, the most successful games were
built for arcades, and they were pretty basic. Pong, designed by Atari,
was the best seller. It was simple and black and white, and it had the
most basic graphics imaginable. A small ping-pong-like ball bounced
back and forth across the screen as the players batted at it by manipu
lating Atari joysticks. I told them I wasn't yet certain if this company
would be a good investment, and I asked them for some reassurance.
"Do you play bridge?" Kaplan asked.
"Yes, I do," I responded.
Kaplan then handed me a cassette tape and told me to take it home
and give it a try. At home I putthattape into a Radio Shack computer
my wife had bought me, and the screen lit up. It had black clubs and
spades and red diamonds and hearts, arranged into fan-shaped display,
almost as if I were holding them in my hand. It played a decent game
of bridge, too. I thought, "This is neat." I went back to the office and
made the deal the next day.
An Expensive Missed Exit

Levy and his team envisioned a time in which successful game designers
could become well known for their talents. Just as people might choose
to see a movie by a certain director, they might buy a game because of
its designer. They wanted to give credit and promote their designers.
They began introducing the designers to game players with a one-page
profile in the instruction manuals. One oftheir first big games, Pitfall,
became thefirst game thatwas big enough to have a platform designed
around it, anda few oftheir games became popular enough that stand
alone arcade games were built for them.
Activision went public in 1983. By this point, I was in Washington,
D.C., working as chairman of theExport-Import Bank, yetI was still
on the advisory board at the Stanford Business School. At one of the
Stanford meetings, I was approached by the president of General
Mills. They owned Parker Brothers, which had Monopoly and other
board games, and they were interested in Activision. Soon after,
I had lunch with Jim Levy and told him General Mills was interested
in a deal.
Activision hada market value ofabout $500 million at thetime, but

it was still growing, and Jim thought it would be worth more. "I want
to sell it when we can get $1 billion," he said.
As it turned out, the stock didn't stay at the levels it was at when
General Mills made its approach. We should have done that deal.
Something about Jim's response prompted me tosell my stock, though,
and when the prices started going down, I was glad I did. This was an
important lesson inone ofthe basic tenets ofventure capital: Knowing
when to exit an investment.
From Venture Capital to the Nation's Capital

The job at the Export-Import Bank marked the beginning ofmore than
a decade ofpublic service and also the end ofmy most active period of
venture investing. Given my background, Washington made sense for
me. I was profoundly affected by the important work that my father
had done for the U.S. Government. In the diplomatic and military roles
that he played, the consequences ofhis work were often bigger than the
impact of venture capital might have been. For example, when Presi
dent Harry Truman's Secretary of the Treasury, Henry Morgenthau,
Jr., wanted to convert Germany to an agrarian state after World War
II, his stand was politically popular because of memories of German
industrial might during the war. My father, however, led the fight to
resist the idea. It was the right thing to do, and the push to rebuild
German industry helped create one of the world's most stable and suc
cessful democracies and one of our country's bestallies.
I learned a lot from my father. He always associated himself with
good people, and he believed strongly inthe value ofintegrity and good
ethics. After a family vacation to Canada, we were on our way home
and had driven about 150 miles away from ourhotel when my mother
happened to mention that she had taken an ashtray that she and my
father had admired in their room.
"What do you mean you took it?" he asked.
She explained that it had the hotel's name onit. "This isgood adver
tising. I am sure they wouldn't mind," she said.
My dad turned the car around and drove the 150 miles back to the
hotel. My mother was embarrassed, of course, and also angrier than
I had ever seen her before. It was a great ethical message for me though
and because the hotel ultimately sold us that ashtray, it was one
I remembered every time I saw the ashtray sitting in the living room
of our home.
Dad believed in public service. After his years in Europe and in ven
ture capital, he went on to dedicate himself to population control and
established the Population Crisis Committee. I have always appreciated
the value of public service, too. After graduating from Yale in 1950,
I went to Korea as an infantryman. I was in the 25th Division and
fought in the Iron Triangle. Living in a foxhole that winter was the
coldest I have ever been in my life.
Years later, I was honored when I received word that President Rea
gan wanted me to move from San Francisco to Washington in 1981
to take charge at the Export-Import Bank. When Reagan took office,
he wanted to close down everything that could be handled by private
industry and eliminate subsidies as much as possible. They put me in
charge ofthe Export-Import Bank because they knew that Iwould have
a business point ofview and would do all that I could to make it cost
effective. Therewererumors that I was sent in to shut it down, but that
was never the case.
As I got to know the people and the institution at the Export-Import
Bank, I learned that the place was running pretty well. I could do the
most good, Ithought, by focusing on problems that would benefit from
my business background. For example, prior to my taking office, Brit
ish entrepreneur Freddie Laker had borrowed many millions from the
Export-Import Bank to buy five airplanes to set up Skytrain, the first
low-cost trans-Atlantic airline service. I was skeptical about whether he
would be able to pay us back. Laker was buying his airplanes indollars,
but he was earning halfof his revenue in British pounds.
"Ifthe pound drops in value, you are going to go bankrupt," I told
him on one occasion when he visited my office.
"Bill, you just don't understand the airline business," Laker said. "The
important thing is just to fill those seats with more bloody arses!"
When the dollar appreciated, he did get squeezed. He also faced
increased competition from British Airways, and the combination of
these two factors forced him into bankruptcy. We wound up seizing
and selling the airplanes, but Laker still owed us interest on his loan.
164 o THE MASTERS OF PRIVATE EQUITY ANDVENTURE CAPITAL
At the time, the British government was in the process of privatizing

British Airways, and British Airways was planning topay Freddie Laker
$8 million so he would not sue for unfair competition. About this time,
Colin Marshall, the CEO of British Airways, came to my office and
asked me to sign a statement that released British Airways and Laker's
airline from any claim that the Export-Import Bank might have.
"Wait a minute, Laker has common stock and you are planning to
pay him $8 million?" I said. "Our loan has priority, and so we should
be paid our full interest before he receives any payment."
Marshall refused. Then, about two weeks later, he was back in my
office, offering to split the difference. I refused. Margaret Thatcher,
Britain's Prime Minister, came toWashington and everywhere she went
she complained that the Export-Import Bank was preventing British
Airways from going public.
I began tohear the same thing from people at every department that
she visited: "God, Draper, get that damn thing signed."
Eventually, Marshall did agree to pay the interest in full, and my
holdout seemed to impress the Reagan team.
"You know, I really laughed today," said one ofReagan's aides dur
ing a visit to my office. "One ofthe bureaucrats said that Draper treats
the Export-Import money like it is his own." He thought that was the
greatest compliment that I could receive, and I did, too.
Big Money Comes to the Valley

After spending five years in Washington atthe Export-Import Bank, I
transitioned to a new role as head ofthe United Nations Development
Program inNew York. That work, organizing projects for developing
countries with money contributed by wealthy member countries of
the United Nations, gave me fresh perspective on conditions—and
opportunities—in the developing world. For me, personally, theUNDP
set a stage for the next important chapter inmy venture life: my effort
to start a new investment fund focused exclusively on opportunities
in India.
As I started to look beyond the UNDP, I realized that the world of
venture capital had changed considerably in the 12years that I had been
gone. The funds were much larger, the risks were more treacherous,
PIONEER INVESTING * 165
and, because of that, business practices were considerably different. In

1979, a couple of years before I had left for Washington, I had gotten
aglimpse of the changes ahead when John Weinberg, eventual co-chair
of Goldman Sachs, visited my office.
There I was, sitting in my little office at Sutter Hill, entertaining a
Wall Street big shot. I said to myself, "Something is happening around
here." I certainly had heard of Goldman Sachs. The mystery was how
they had ever heard of us.
The Goldman guys came to visit because they were prospecting, and
they wanted to get acquainted with us venture capitalists so they could
get the lead position for the next big initial public stock offering. We
had taken Apollo Computer public and another firm, Measurex, which
made control equipment for the paper industry. Until the IPOs started,
we did not give much thought to our exit strategy. Our mindset atthe
time was to build great companies. Going public was not anexit; itwas
just another step along the way to building a great company.
There were just a handful of top notch venture firms back then.
Kleiner Perkins was good. Mayfield and NEA were good. IVP was
good, too. We shared deals with all of them. We were in a small
familiar group and cooperated with one another, and life was great
back then.
More than a decade later, in 1994, as I looked into leaving the UN
and returning to San Francisco, I realized the money that had come into
the business had changed the nature ofthe work and the rewards it cre
ated. Many firms kept their eye on the ball, but there were some that
bid up the prices on deals, which inevitably brought returns down for
everybody. Instead of worrying about their carry—in other words, their
share ofprofits—and fretting about the increase in value oftheir port
folio, some venture capitalists were more concerned about their fees,
or the amount of money that they charged based on the funds under
management. The rise ofthe megafunds and the Wall Street transaction
mentality inevitably increased the competitive pressure on everyone.
The advent of the big money era even changed the way venture
capitalists dealt with each other. In his autobiography, Tom Perkins
credited me with bringing Kleiner Perkins its first big success, Qume.
I introduced him to Qume, one of Sutter Hill's investments, which
created a replacement for the IBM "golf-ball" typewriter. It was a
166 • the Masters of Private equity and Venture Capital
daisy-wheel printer, and it was abig hit. Perkins also brought Sutter
Hill anumber of good investments after that. This relationship is an
example of the cooperation between firms that strengthened Silicon
Valley in those days.
Today, some three decades later, the pressures are completely dif
ferent. The big firms are raising giant funds, $1 billion and more, and
with that much to deploy the last thing they want to do is share deals.
I think that is unfortunate because cooperation brings more talent to
the table and often better decisions are made.
Venturing Abroad
During my time at the UN, I traveled to 101 developing countries,
an experience that made me wonder if it might be possible to export
some of our techniques to countries where new investments could
result in astounding change. This would be anew kind of pioneering,
this time with an international dimension and an economic develop
ment purpose.
While I was mulling this idea, a friend named Bill McGlashan in
troduced me to Robin Richards, then a graduate student at Stanford.
Richards had lived abroad and had worked with a vice president of
Coca Cola on some venture capital projects. We decided totry venture
capital abroad. Richards and I looked at China, Indonesia, Vietnam,
and Hong Kong, but ultimately we decided that India made the most
sense. Indian business people spoke English, which was helpful, and
the rule oflaw was well established, ademocracy was in place. Besides,
we liked the food.
To start Draper International, in 1995 Robin and I put together
an India fund, and we knew that we needed local expertise in order
to succeed. The legal work alone that was necessary to found Draper
International told us that. The partnership agreement was inches thick,
and we had to initial every page. Ihad met Manmohan Singh, then the
Finance Minister and now Prime Minister, through my work at the UN,
so we had good connections right from the start. Through referrals, we
heard about a young man named Kiran Nadkarni, who had run the
venture fund of a quasi-government bank, ICICI, and he seemed like
the local talent we might need.
Hiring from the Hospital

We flew Nadkarni to New York, but while attempting to catch a cab
at Kennedy Airport he stepped off ofa curb and broke his ankle. The
bone literally was sticking through his skin, but he came to the Yale
Club anyway to meet me. I called an ambulance and rode to Bellevue
Hospital with him. After we arrived, Nadkarni was shuffled off to
one side, and he was lying on his back on a gurney, waiting for treat
ment. Keeping Nadkarni company inthe hall, I began speaking about
our idea for an Indian venture fund, and we agreed on the details of
his partnership compensation right there, before he was wheeled into
surgery. The poor fellow probably would have agreed to anything at
that point.
Odd as that hiring experience was, it worked out very well. Nad
karni had all the connections that we needed. After setting up shop
in Bangalore, he quickly began generating deals. He introduced us to
Rediff.com, an Internet portal similar to Yahoo; Geometric Software,
a computer-aided design firm; Neta, a firm that manages Internet com
merce; and Yantra, which markets software for value chain manage
ment. We hired another partner, a marketing professional by the name
of Abhay Havaldar, who had worked at HCL HP, a joint venture of
Hewlett-Packard and the Indian technology company HCL. Once
Draper International got started, Robin and I flew to India four times
a year for several weeks at a time. We probably made about 25 trips in
total over six years.
Draper International worked out well over all. We invested in
20 companies and exited most of them through acquisitions by U.S.-
based companies. By the time the Indian technology market collapsed
in 2000, we had exited from most of our investments and returned
16 times our partners' money. It was a fabulous experience.
The Skype Encounter

At this point, the India adventure was behind me, but the world ofven
ture investing was not. I saw a new opportunity coming when I met a
young man named Howard Hartenbaum. His proposed company was
not of particular interest to me, but Howard definitely was. He was
an MIT graduate and had run a company for his brother. He listened
carefully and followed up diligently. I felt that hewould make a natural

venture capital investor. He wanted to travel around Europe looking
for deals, and that sounded good to me. India had worked well for me,
so I thought why not Europe?
Soon after Hartenbaum had moved to Luxembourg, my son Tim,
who has followed me into the venture business, told him to look up a
company called Kazaa. Similar to Napster, Kazaa had developed file
sharing software used to swap music files. Also like Napster, Kazaa
was being hounded and sued by music companies and other copyright
holders.
By the time Hartenbaum caught up with Kazaa, its founders—a
39-year-old Swede named Niklas Zennstrom and a 29-year-old Dane
named Janus Friis—had moved onto something new: Internet tele
phony. Their new company, Skype, was still in the idea phase, but
it promised to be an amazing breakthrough. It would use voice-over-
Internet technology to enable people to talk over the Web for free.
Zennstrom had analmost messianic belief thatbig monopolies, such as
telephone companies, need to be attacked because they are inefficient,
take their customers for granted, and have little incentive to bring new
technology to market. Zennstrom and Friis epitomize what it means to
be a disruptive innovator.
It was 2002, I was 74 years old, and I have to admit that it was
a thrill to be pioneering a new kind of telephony with technology in
Estonia driven by a Dane overseen by a Swede in a company based in
London—and discovering it before my son or any other venture inves
tor, to boot. Zennstrom and Friis had no business plan for Skype, so
Howard offered to give them a hand. They knew the name Draper,
from our reputation in Silicon Valley, I guess, andwanted usto invest.
I put $100,000 of seed money into the company. Later, Tim's firm,
Draper Fisher Jurvetson, invested several million.
Within 18 months, Skype had 40 million users. They started
charging for calls that went to or from standard telephones. By 2005,
with 53 million users and still growing, they were acquired by eBay
for $2.6 billion. This made Skype the biggest hitI ever had, a return of
1,000 times my initial investment. The last time I checked, Skype had
about 450 million users.
Pioneer investing • 169
For-Profit to Nonprofit
This could have been a good time to pack it in and call it a career.
I have to say there was some temptation to do that. Then, again, my
father was into his 70s when he started up the Population Crisis Com
mittee. The fact that, after a long and successful career, he devoted his
time toa nonprofit organization was something that I strongly admired
and wanted to emulate.
Inspired by my dad's example, I decided to diverge slightly from the
path he had set by taking up one ofthe newest forms ofventure invest
ing: social entrepreneurship. Robin Richards and I formed the Draper
Richards Foundation, which provides early-stage grants of $300,000
over three years to entrepreneurs with original ideas that might help
make the world a better place.
Some people say social entrepreneurship is not actually that new.
After all, John D. Rockefeller III coined the term "venture philan
thropy" in the 1960s. But what we are doing is not philanthropy in the
traditional sense. We don't just hand money over to people and hope
that they spend it wisely. We refer to our grantees as "fellows" and
treat them as we do any entrepreneur whom we back.
One grantee, Little Kids Rock, teaches city kids to play instruments
and write music after school. Room to Read builds school libraries
and schools in Africa and Southeast Asia, and Girlsfor a Changehelps
young girls take onproblems intheir communities. They all have com
mon traits: an entrepreneurial-minded founder, a concept that cangrow
to a large scale, and a need for our money.
We have our own objectives; for example, we do not wantto become
just another source of funding for any of these ventures. We want to
be the initial source that helps these entrepreneurs set their ideas into
motion. We want to help them get started with coaching and contacts
just as we do in the venture capital world. After three years, they are
on their own, and they know that from the start.
One of the rewards of this work is the way we can make a differ
ence insociety while still drawing onthe years ofexperience Robin and
I have accumulated. One of my favorites is a nonprofit named Kiva, a
micro-lender that uses the Internet to let individuals make contributions
as smallas $25 to tiny businesses anywhere in the world. Users can go
on the site, literally shop for a business that appeals to them in Kenya
or Ecuador or Tajikistan, and click to make a micro-loan.
With Kiva, Matt Flannery; his wife, Jessica; and Premal Shaw
were quite consciously copying the ideas of Nobel Peace Prize winner
Muhammad Yunus, the founder of Grameen Bank. Grameen was
the first in the world to bring micro lending to huge scale, through
its lending in its home country of Bangladesh. By taking this lending
system to the Internet, though, Kiva has eliminated geography as a
barrier to participation, both for the lenders and for the borrowers. It's
an inspiring story, and one that benefited, I think, from our approach
to social entrepreneurship.
We have treated Kiva, and all our grantees, just as ifthey were start-up
businesses. For the three years that they are grantees we help them orga
nize the board, secure new funding, find business partners, fine-tune their
business strategy, and do whatever else is needed. I hired Jenny Shilling
Stein and Anne Marie Burgoyne to run the foundation, and they have
worked tirelessly to help the founders of Kiva and Room to Read and our
other fellows achieve success. They have selected those fellows very well.
Looking back, I am thankful to have had such a rich and diverse set
of experiences, especially those in venture capital. Society would not
be as advanced, interconnected, and civilized as it is today were it not
for the scores oftalented venture capitalists who provided the platform
for brilliant and passionate entrepreneurs to develop and nurture their
world-changing ideas and innovative technologies. At a time when the
world needs an inventive new form ofinvestment, social entrepreneur-
ship has come along. There is no end to invention, and I am fortunate
to have seen so much of it in a lengthy and rewarding career.
LESSONS FROM BILL DRAPER

<|> Be first. The first to market is where the biggest returns are found.
The view from the front is always the best.
<^|)> Spread the risk. Unfortunately, the majority of investments are

often not successful, but ifonespreads risk over a score of promising
companies then the returns from the one winner can pay for all the
rest. It's almost impossible to pick the big winner right from the start.
4$f> Team over technology. The selection of astellar team trumps the
novelty of the technology, market conditions, and timing. Although
technology is important, the hard work, optimism, vision, and luck
of the entrepreneur—and the team—are the heart and soul of
success.
Feed the winners. Too often, promising companies get starved for
attention and capital because venture investors spend too much
time, money, and energy on futile attempts to save weak ones.
<&$> Think 10 years out. Astart-up will transform as it matures. Pick

people and ideas that can survive through changes in markets,
technology, and economicconditions. Envision the future.
CHANGE FOR THE BETTER:
MANAGING FOR
PROFIT AS MARKETS
AND TECHNOLOGY CHANGE
C. Richard Kramlich
Co-Founder
New Enterprise Associates
AUM: $M billion Years in PE: 35+

Location: Menlo Park, CA Year born: 1935
Grew up: Oshkosh, Appleton, and Milwaukee, Wisconsin
Location born: Green Bay, Wisconsin
Best known deals:i3Com, Juniper Networks, Silicon Graphics
ta^ Semiconductor Manufacturing
International^ Immunex(Amgen), Macromedia (Adobe), Dallas
Semiconductor (Maxim), Ascend Communications (Alcatel-Lucent)
Style: Qpn, constructive
Education: B.S.,Northwestern University, Class of 1957
M.B.A., Harvard GraduateSchool of Business, Class of 1960
Significant experience: General partner of Arthur Rock & Associates,
the firm that funded Intel in 1968
Personal interests: Collector of media art, travel, tennis

The lesson: "There is an 80% chance you can solve a problem."
o 173 *
When C. Richard Kramlich co-founded New Enterprise Associates in

1978, heleft a firm that was founded by Arthur Rock, the person credited
with inventing the term "venture capital." A strong, consistent track
record has enabled Kramlich to build a megafund that takes advantage
of its size to bringoutsizedreturns to investors.
Market conditions and technologies have gone through wrenching
changes, but Kramlich's approach has remained consistent. He identifies
top talent, systematically dissects entire market sectors in a search for
opportunity, and remains open minded about adjusting his approach
as market conditions change. Now spending half his time in China, on
the other side of the planet from his Menlo Park, California home base,
Kramlich is exploring new markets and bringing NEA's methods to one
of the world's most dynamic economies.
In June of 2006, we had invested $13 million in a Chinese company

named Availink that had the opportunity to dominate the Chinese
market for satellite-based, wireless communication. All they needed
was a successful satellite launch.
On the vital day, I learned that satellite launches have three phases.
There was the launch itself, which went great. Getting into orbitwent
great. Finally, solarpanels have to open: did not go great.
One moment, we had a satellite in low-Earth orbit. The next, it was
space junk.
It was immediately clearthat our company's plan to put a Chinese-
made satellite at the heart of a system to run WiFi, broadband, and
other computer communications systems would notwork out. Nobody
panicked, though. Immediately, the company shifted gears. Chip mak
ing and software, two businesses that were much discussed but not
really activated yet, suddenly became the future of Availink.
The longest lasting impact of the satellite mishap was that manage
ment immediately shifted gears, made chip making and software ser
vices the center of the business, and showed a resolve that even more
seasoned professionals might not have mustered. Even as management
refocused strategy, the company continued to push ahead with satel
lites, too, locating an international satellite to receive andtransmit sig
nals. The quick strategic switch, and cool handling of the crisis, earned
CHANGE FOR THE BETTER • 175
the technologist who was serving as interim chief executive a perma

nent appointment to that job. Today, Availink dominates the market
for communications chip sets in China, is moving into developing mar
kets, and is even penetrating Europe.
Change isa constant, but just because wemust deal withchange allthe
time does not make it any easier to handle. Some changes can be antici
pated and planned for. Others areassurprising as a satellite that becomes
space junk. How one manages change can mean the difference between
success and failure. For NEA, our ability to anticipate, manage, respond
to, and capitalize on change has been an essential ingredient of our ability
to grow into a firm that over our 32-year life span has helped 165 com
panies make initial stock sales, invested in 250 that were acquired, and
currently has $11 billion in aggregate cash andcommitments. I personally
have taken eight companies from start-up to $1 billion or more in value.
Just as my own life and career have never stopped changing, the same
goes for the type of companies we have invested in. At NEA, we spend
considerable time managing change. For example, we draw up com
plex diagrams of industries to map where breakthroughs are needed
and how new investment might pay off. This helps us create a key
competitive advantage by seeing, before others do, where high-impact
innovation might take place. This ability to quickly and aggressively
deploy our investors' capital has become particularly essential as our
firm has grown into what some people calla "mega" venturefirm. The
last investment fund we raised topped $2.5 billion—a difficult amount
to invest if you don't start with a clear-cut plan.
Similarly, over the years, I have learned that some people are just
naturally agents of change, as if they are born with a special talent that
makes them that way. They see the opportunities change creates and
embrace the need to shoulder risk. They can infect those around them
with an appetite for invention.Jim Clark comes to mind. A man with a
brilliant and restless mind, Clark is a serial entrepreneur of staggering
success. He has helped form several iconic Silicon Valley companies:
Silicon Graphics International, then Netscape, then Healtheon. Our ex
perience in working with peoplesuch as Jim has shown us that there are
certain unique individuals who create opportunity wherever they go, in
part becausethey learn to make the most of change. Back a person like
that, and change can become a good friend, indeed.
176 o the Masters of Private equity and Venture Capital
A Fortuitous Family Meeting

From the very founding of our firm, the willingness of people to em
brace and even exploit change has been central to our success. We never
suspected at the start, back in 1978, that NEA would become one of
Silicon Valley's most successful firms and wind up funding more than
650 start-up companies. After all, our origins were as humble as can
be. Thefirstmajorfundraising breakthrough came in the most unlikely
and bucolic of places: at the Muncie, Ind. offices of Ball Corporation,
the company that makes the iconic glass jars. At a Sunday morning
meeting there, on the day after Magic Johnson's Michigan State team
beatLarry Bird's Indiana State squad in one ofthe great championship
gamesin college basketballhistory,a man namedJohn Fisher,who was
then chief executive officer of the company, gave up an hour of time
before Sunday church to listen to our investment pitch.
It would have been a memorable trip even if our fundraising efforts
had not immediately paid off. The weather was -15 degrees. There
was a coal strike in Muncie, and the power plant was operating at low
capacity. To save power, the Holiday Inn I stayed at allowed only one
light bulb per room. The television in the bar was the only one that
worked.
My two co-founders and I visited Fisher, his lawyers, accountants,
and members of the Ball family early that Sunday morning. We told
him that the three descendants of founders Frank and Edmund Ball had
expressed an interestin this newinvestment ideacalled venturecapital,
but Fisher was trustee for some of the family money so they needed
his permission to proceed. He said he was skeptical about the risks
involved in venture investing, but he met with us and heard us out. He
warned us, though, that nothing would make him late for the 11 A.M.
church service.
Fisher opened the meeting by addressingthe Ballheirs, accountants,
and lawyersgathered in the room: "You all want to give a million dol
lars to these guys, right?"
I spoke up and told him that was the idea.
He said to the room, "If you have that kind of money to throw
around, you ought to buy some more company stock."
Ball was indeed a good investment, I told Fisher, but so was our
proposal. I began explaining venture capital to him.
CHANGE FOR THE BETTER <» 177
"I read the material. You don't have to tell me anything," Fisher
said. "You are going to form a blind pool, is that right?"
"Yes."
"That means you don't know what you are goingto invest in, is that
correct?"
"Yes," again.
"You are telling me that this may be illiquid for as long as 12 years,
and you are not going to promise any rates of return. Is that correct?"
"Yes, sir. That is correct."
"Well what are you going to do?" he asked.
We didn't have many specifics. "I have had some experience in this,
and my colleagues have some experience," I stammered. "And we are
going to do the best job we can."
Fisher spoketo the room again: "Well, I still don't think you ought to
do this," he told the Ball heirs and advisors. "But if you want to, it's okay
with me. We've got to get going because church starts in 10 minutes."
That was our first limited-partner investment. And now, 30 years and
13 investment funds later, the Ballfamily is still with us. Barbara Good-
body, a Ball heir I had met while ushering at the wedding of a mutual
friend, was at that first meeting, and she remains an investor today.
The Venture Capital Mindset

Fisher's skepticism and, despite that, his willingness to take the risk
represented the essence of the venture capital mindset. Venture inves
tors must be savvy risk takers, able to adapt to changing markets while
helping to nurture creative ideas that might become huge successes.
They know that sometimes they will fail completely. Fortunately for
me, I was coming into my own in the business world at just the time
when economics and tax codes were changing in ways that encouraged
people such as me to take investment risks.
During the Carter administration, tax rates had risen to the point
that taxation was a disincentive to investment. But, beginning in the
late 1970s, a series of favorable changes occurred. The capital gains tax
was cut from 50% to 35%. In early 1979, venture capitalists in Silicon
Valley such as Bill Draper and Pitch Johnson helped persuade the U.S.
Labor Department to change policiesthat had prevented pension funds
from investing in alternative assets such as venture capital. Then, dur

ingthe early 1980s, the chairman of the Federal Reserve, PaulVolcker,
would go to war against interest rates, which had risen to nearly 20%
at one point. The attendantreduction in the cost of capital encouraged
investment throughout the economy.
Mypartners and I formed NEA just as allthese changes were taking
place. Frank Bonsai, Chuck Newhall, and I launched NEA soon after
I had ended a seven-year association with Arthur Rock & Associates,
a firm formed by the man credited with inventing the term "venture
capital." In 1957, Rock had funded Fairchild Semiconductor, a break
through success that really was the cornerstone of the Silicon Valley
tech revolution. Rock made a visionary investment in Scientific Data
Systems, and I had just joined Rock in 1969 when he further burnished
his legend by making a mere 15 phone calls in one afternoon to raise
the $2.5 million needed to get Intel started.
I had graduated from Harvard Graduate School of Business and
worked for a few years in finance at theKroger grocery chain headquar
tersin Cincinnati before moving to Boston to workwithsome fine people
in investment counseling and to learn the rudiments of venture capital.
FromthereI moved to SanFrancisco to joinArthur Rock as a partner. I
waswithRock during some dark days for investments. Thecapital mar
kets were not quite as seized up as they got afterthe collapse of Lehman
Brothers in late 2008, but they were as bad as anyone at that timecould
remember. I learned how to survive when there are no capital markets at
work. You usea great dealof energy and imagination. Even then, we had
to move slowly. Though we raised a $10 millionfund, we never invested
more than $6.25 million of it over the fund's seven-year life span.
On the Move
One time, out of nowhere, during these early years, Rock asked me,
"Dick, have you ever been to Japan?"
I said no.
He said, "Why don't you go over there and raise some money
for us?"
We had 13 companies in our portfolio then, and six were running
out of money at the same time. So I went to Japan and did seven
Change for the Better • 179
deals for six companies. One of them was Xynetics, a company that
made precision cutting equipment that could be used both in cutting
textiles and in positioning systems for electronics. It went from a
start-up to a $50 million company over time. We eventually made
money for ourselves and our Japanese partner on every one of those
six investments.
Rock and I were talking about raising a second fund when Chuck
Newhall swung out to the west coast and looked me up. He was with
T. Rowe Price on the East Coast. Along with Frank Bonsai, who was a
partner at Alex Brown & Sons in Baltimore at the time, Newhall had
decided to start a venture firm. Over a series of dinners the three of us
decided to form our own partnership.
The other two assumed, of course, that I would go back east, but I
wanted to stay in California. Newhall and Bonsai eventually agreed to
this arrangement, so right from the outset we were the first of a kind:
A venture capital firm with offices on both coasts. T. Rowe Price had
committed $1 million, and a firm that was running money for the John
Deere family had committed, too. There was that money from the Ball
family. Eventually, the commitments topped $16 million,which seemed
like good money given the dire circumstances in the markets.
Thanks to the changes in taxes and the change in rules for pension
investing that occurred just as we were opening shop, we went from
having a very bleak outlook to having a rosy one. Even so, we had
plenty of challenges at hand. We had to figure out how to make deci
sions within a small firm when the principals were working in offices
on either coast of the United States. We had no e-mail or teleconferenc
ing in those days, so the 3,000-mile distance felt greater than it would
today. Communication and decision making were both huge hurdles
that we had to overcome.
We decided that, rather than jumping into a batch of start-ups and
other companies we did not know, we would start by investing in sec
ond- and third-round fundings for companies already familiar to us.
We just wanted a mix of companies, not all of which were strangers.
Because some were concentrated heavily in the San Francisco Bay area,
I joined the boards of many of them. Newhall and Bonsai did their
share in the East, also. The strategy worked. We were able to return our
investors' capital within about three years at a substantial profit.
We have come a long way since then. Today, we are investing our
13th fund. We have raised, in aggregate, more than $11 billion. In ad
dition to our offices on the east and west coasts, we also have offices
in China and India. We are trying to elevatebest practices wherever we
go. Change is something we embrace, but we have tried to make sure
that certain principles of our business do not change even as we have
grown. In other words, we have tried to scale the business while keep
ing the art form in it. We have always maintained a democracy among
the partners, wherein we all have the same draw from the firm's fees
and the same participation in the carried interest, or investment profits,
from our funds.
The 100-Year Firm

At the outset, Newhall said he wanted our firm to last 100 years. This
felt at the time like a terrible burden for us to bear, but now we are
more than 30 years into it, and the burden doesn't feel quite as heavy
any more. We have a budget at the firm, from which we pay all our
general partners the same amount. All over Silicon Valley, you hear
about venture capital partners earning extravagant salaries. That does
not happen at NEA.We don't let that happen, because it misaligns our
objectives from those of our investors.
When a firm pays its partners too much, it might take 12 years to
pay back the limited partners, rather than the eight years it takes when
we keep our compensation in line. At NEA,we make money only after
our limited partners make money. We don't spend much, either. Our
firm's expenses eachyearrun at about 1% of funds under management,
and we keep our partners on board by vesting over 12 years, a longer
time period than most other venture capital firms.
The secretto lastingone year, not to mention 100, is to be exception
ally adept at handling change. We have built this capability by split
ting our partners into industry teams, according to different matrices
of expertise. We operate the firm in many different vectors—electron
ics, life sciences, energy technology, and so on—and in each of those
areas we try to have at least one "venture partner" to bring subject-
matter knowledge to our work. The venture partners are our secret
weapon: veteran professionals with deep expertise in their chosen fields.
Change for the Better <> 181
We have a Nobel laureate and the former dean of the Duke University
Medical School who used to run research at Genentech. They can really
make a difference both in making investment decisions and in helping
our portfolio companies through the tough technical challenges that
always arise with new technology.
The 10 p.m. Phone Call

We might not have made it this far without a big hit early on, one in
which our ability to capitalize on technological change was key to our
success. That deal was our investment in 3Com, the computer network
ing company. In the end, we learnedfrom 3Com that changecan be good
or bad, threatening or promising, depending on how you respond to it. In
the face of change, it is important to speak up—to make certain everyone
sees the change comingand has a chanceto respond to it. I am a go-along
person. I don't likeconfrontation. But,despite that, as I learned at 3Com,
there are times when we have to step in and address changing conditions
no matter how much of a personal struggle it might be.
We got involved in 3Com from the time the company started. It was
1981.1 had been an investor in Apple, a company that claimed it gave
individuals "a bicycle for the mind." Apple had become a big hit and
seen positive cash flow almost from day one. Bob Metcalfe, who in
1973 was one of two co-inventors of the Ethernet, a predecessor to the
Internet, was a founder of 3Com. Metcalfe approached me in late 1981
with an idea for a local area network—a group of computers, printers,
and disc drives in close proximity that could be programmed and con
nected to work together.
I had a difficult time telling if this was genius or folly: It did strike
me, however, that this could be another "bicycle." After all, I majored
in history at Northwestern University, a background that gave me
some sense of when historic changes might be happening. Metcalfe and
I talked for a while, even discussing what my investment terms would
be, but I told him to go pitch his idea to other venture capitalists and
return to me if he still wanted me in.
It took about a month before my home telephone rang, about 10 P.M.
one night, with Metcalfe on the line. He had seen about 40 other venture
capitalists, but he was coming back to me.
"I have learned that a deal is not a deal," Metcalfe told me. "I really
want to work with you."
With two other venture capital firms, we invested $1.1 million in
3Com, and I went on the board. Metcalfe set up offices at 3000 Sand
Hill Road—an address that has become famous as the location of the
well-known venture capital firm Sequoia Capital. 3Com, I believe, is
one of only two companies that actually started operations at 3000
Sand Hill. Inside the low-slung office park, we assembled Ethernet
boxes, pouringglue in the backso people couldnot get their hands on
the circuit boards and reverse engineer them. Once we started selling,
the business just grew straight up—$1 million in sales the first year,
$5 million the second, then $17million, then $47million. People called
1981 the "year of the LAN." It was before the Internet came, and
it seemed there was nowhere to go but up. Even so, Metcalfe was a
scientist, not a manager, so we brought in a Hewlett-Packard executive,
Bill Krause, as chief executive.
We had embraced Metcalfe's idea of technological change and,
with Krause managing strategy, helped him build the company. By
1987, though, the market had changed dramatically. IBM had cap
tured a larger market share than 3Com by adding LAN hardware
and software to its computers. Krause had expanded the business
into network software and servers, but this was not enough. With
competition intensifying, Convergent Technologies approached
Krause with a merger offer, and he and Metcalfe both wanted to
do the deal.
The Perils and Promise of Change

Although change can be good, it also can be disastrous, and this offer
seemed the wrong way to address the changes that were coming to the
marketplace. By this point, our firm had distributed nearly 70% of its
stock in the company. While this was a life's work for Metcalfe and
Krause, it was an investment for me. Yet, I could not get over a nag
ging feeling that this deal would do nothing but damage the company.
I thought 3Com should go more in the direction that Cisco Systems
was taking—network equipment—and not toward where Convergent
would take them, into UNIX-based workstations.
Change for the better * 183
Paul Ely, the chief executive of Convergent, came in to make a pre

sentation to the board. Ely, a former Marine and a very confident guy,
drew a picture of the merger as a truly powerful idea. He talked about
the number of customers they had and how 3Corn's products would
line up with Convergent's. I felt skeptical, but just did not have the
technical capability to judge whether Ely was right.
"Paul, you know I am sort of a simple guy," I told him during the
board meeting. "I would appreciate it if you could work up a matrix for
me and just put in each of these boxes who the customer is and what
the product is. I'd like to get some kind of idea of what the growth and
margins are on the products."
When Ely came in a month later, for another presentation, I asked
him about the matrix again, but he brushed me off.
"You know, I am really busy, and I don't have time to do that,"
he said.
I told Ely he needn't worry. I would do the research myself.
When I began calling Convergent's customers, I found the company
had negative gross margins on virtually every product it sold. One cus
tomer of both 3Com and Convergent was AT&T. When I called the
AT&T person in charge of those two vendors, I got a clear look into
what a merger might mean for our company.
"Look, we believe in honoring our contracts," this person said. "But
I want to tell you that I am never going to sign another contract with
Convergent. They are gouging us. We are going to pay our bills, but
this is it."
And you know what? AT&T was the only customer on which Con
vergent was making a profit.
Word got out that I opposed the deal. Even though we held only 3%
of the shares, two big holders gave me their proxies. I now held 15% of
the vote, which because of pooling-of-interests accounting was enough
to block the deal.
As I drove to the board meeting that day, I was working out in my
mind how I would explain my vote. Early on, I had promised my sup
port to Krause and Metcalfe, but now I felt a duty to change course.
Even so, because I do not like confrontation, I did not look forward
to explaining views that conflicted with those of other board members
whose opinions I respected.
I never had to make that speech. When the board meeting opened, a
clean-cut,very educated guy begangiving the fairness opinion on behalf
of the board's investment banking firm. He went on for quite a while,
and I was barelypayingattention because in my mind I was rehearsing
my own remarks.
Then, as he got to the end of his presentation, the banker said,
"Therefore, for the following reasons, we are withdrawing our fairness
opinion."
All hell broke loose. Krause called Ely, who brought his attorney,
Larry Sonsini. They asked if this was a negotiation over price, and
Krause said no. It was more than that. The deal fell apart, but by this
time Krause would not change course. He thought he needed a merger
to keep 3Com growing. Within a year, he had merged with Bridge
Communications, but by that point we had distributed our shares so
the Bridge deal was not my concern.
We didn't give up on the Ethernet business, though. We backed
Grand Junction Networks, which eventually was acquired by Cisco
Systems in a significant acquisition. In fact, we're still involved in
gigabit Ethernet today. Our current Ethernet company, Force10 Net
works, shows how much technological demands have changed and
how we have adjusted to the changes, too. The 3Com systems had less
than a gigabyte of processing power, and Grand Junction Networks
at the time had up to one gigabyte. ForcelO systems, in contrast, start
at 10 gigs. At the time of our investment, the company was on its way
to introducing some really significant technology to bring the systems
to 100 gigs.
This is a big leap in what we call computer "exascale," and with
that growth in processing power ForcelO has grown well. In 2008,
ForcelO sold $57 million in servers to Google alone. One irony of
this success is that one of our other companies that I was a director
of, Juniper Networks, in the late 1990s had a shot at developing this
market. They had systems built specifically to run alongside Cisco
Systems' servers, but with purpose-built technology. Despite that, the
founder and chief technology officer and I could not persuade the rest
of the board to approve the move. The lesson: embrace change, or lose
opportunity, although Juniper continues to do well in its own areas
of expertise.
Change for the better • 185
The Genius Quotient

Now, there are plenty of companies in which the executive teamthinks
they see a big opportunity and wind up running down a blind alley.
At NEA, a partner named Peter Morris and I have developed some
fairly sophisticated tools to avoid the dead ends. When we know an
industry sector well, wewill layout a large ecosystem of all the relevant
technologies. We jumped into Force 10, in fact, after looking at all the
relevant metrics in Ethernet technologies. We got into a company called
UUNet on the east coast that became the backbone of the Internet. Our
managing partner, Peter Barris, went on the board of that company.
Our tools help us address suchquestions as what are the holes where
the incumbents are not playing? As everyone in the world looks for
ways to speed the movement of information, whereshould we position
ourselves? We haveapplied this sort of thinking in a varietyof industries,
such as solar power, a sector where we now have about 15 companies
thanks to others in our firm who have a deep understanding of the
technology.
Most venture capitalists and company managers study reams of
data, analysis, consultants' reports, and the like before committing to
a decision. With upfront work such as that, they can adjust as market
conditions change. A select few have the genius, the forward vision,
to see the future so clearly, so conclusively, that they are ready to act
with seemingly little forethought. In venture capital, we are lucky to
run across such people from time to time. We are luckier still if we
recognize these unique and powerful traits before others catch on and
invest with them first.
Jim Clark is one of the rarest examples of the visionary who oper
ates almost exclusively—and with remarkable consistency—on instinct.
Clark's role as a serial founding genius has been well chronicled. From
pioneering the computer graphics revolution with Silicon Graphics Inc.,
he jumped into Netscape to popularize the Internet. Then he had an
other flash of inspiration and formed Healtheon, a company that was
designed to bring new efficiencies to the $1 trillion healthcare system.
Healtheon fell short of Jim's view that it could completely rebuild the
forms of compensation and communication in the national healthcare
system, but with Healtheon Clark made at least as much progress to
ward a rational healthcare system as anyone else who has tried.
Board Wars
Most people spenda greatdealof energy adjusting to change. Clarkmakes
change and lets everyone else adjust to it. In that sense, Clark is a con
stant force of change. He has a knack for brilliant innovation that seems
remarkablyconstant. It has persisted, seemingly unaltered, since beforehe
left Stanford University's faculty to establish Silicon Graphics, alongside
computer scientist Abbey Silverstone, in 1982. The founders envisioned
Silicon Graphics as a company that could build powerful workstations
and servers capable of creating three-dimensional computergraphics pop
ular with everyone from Hollywood film studios to those working with
complex scientific applications and computer-aided design.
We got involved at Silicon Graphics during a $15 million second-
round financing. I was invited into the investment and went on the SGI
board in 1983. Mayfield had incubated the company from the time
Clark left Stanford University. At my first board meeting, I realized
this company had serious troubles, bubbling into open hostility, in
its boardroom. Entrenched, bickering tribes coalesced around one or
another of the leading personalities in management and were struggling
to create a vision for the company. Soon after that first meeting, a
Mayfield partner, Glenn Mueller, called to say the firm had recruited Ed
McCracken, one of the highest ranking executives at Hewlett-Packard,
to take charge as CEO. What a relief.
McCracken in the early going was the very essence of the sort of top
flight management talent that can transform a company. He got the peo
ple issues ironed out, he rationalized the technology research strategy, he
helpedstructurethe companyto face eachof its marketsappropriately, and
he teamed up with the right strategic partners. Clark, meanwhile, seemed
bent on causing disruption because he is both very intuitive and because
he is never really satisfied. He is on to the next challenge. I know Jim well
and like him enormously. His genius,drive,and engagingpersonality are a
more than acceptable tradeoff for the troubles he sometimes makes.
The Fast-Change Artist

Clark developed a reputation for causing discord at Silicon Graphics.
He had a habit of setting the company's engineers off in odd directions,
diverting attention from tasks that were central to McCracken's strategy.
CHANGE FOR THE BETTER * 187
Clark was absolutely obsessed with the ideaof the "telecomputer," a kind
of hybrid computer and television that hewasconvinced would bethe next
big technology breakthrough. McCracken did not immediately buy into
it—which nearly drove Clark mad—andthe board movedto limit Clark's
influence at the same time we rewarded McCracken for his excellent work
by boosting his compensation above Clark's. This sent Clark into intense
rages with some justification. Clark leftsoonafterward to launch into his
next Silicon Valley breakthrough: Netscape, the search-engine company.
Here's the irony of Clark's departure: McCracken ultimately could
not lead Silicon Graphics through the sharp, fast-paced changes
that were reshaping the business of complex graphics work stations.
At the worst possible time, he took his eye off the job following his
decision to serve on a technology advisory board for President Bill
Clinton. A partnership with Time Warner to experiment with Clark's
telecomputer idea failed. Silicon Graphics, which had a big headstart
on Sun Microsystems—so big, in fact, that the venture capitalist John
Doerr once tried to arrange a merger of the two—quickly lost ground.
Once you lose the magic, you never get it back, and that was the case
with McCracken. We wound up having to replace him, but by then it
was too late. Silicon Graphics ultimately filed for bankruptcy.
By the time Clark left Silicon Graphics in early 1992, he was angry
with me due to his perception that I had favored McCracken over him.
NEA was invited to back the Netscape launch, but we were outbid by
John Doerr of Kleiner Perkins. The verynext year, we backed Healtheon,
Clark's next big venture. That decision came about because by that
point Clark's relationshipwith Doerr had soured. Although Doerr and
Kleiner were very involved at Healtheon, Clark's ever-shifting feelings
toward Doerr and me is testament to the curious mix of friend and foe,
partner and competitor, that typifies life in Silicon Valley. Either that,
or it is just an indication of how mercurial Jim Clark can be. In point
of fact, I believe it may be a combination of both.
Fixing Healthcare
The idea for Healtheon had occurred to Clark when he was in the
hospital in 1995 receivingtreatment for a rare blood condition he has,
hemachromatosis, which requires a hospital visit every few weeks.
188 o the Masters of Private equity and Venture Capital
Once he got so intimately involved in the U.S. healthcare system,

Clark quickly saw how much waste is created, how little actual com
munication occurs regarding patient health, and how the payment
system is horribly outdated. With the use of computer technology,
Clark explained when he came to our offices on Sand Hill Road and
sketched out his plans, a company could squeeze billions in waste
out of the system and improve care for patients along the way. Clark
ultimatelydecided to split the difference in his like/dislike relationship
with Doerr and me by inviting both our firms to invest in the launch
of Healtheon.
I would say my interest in the Healtheon investment, and in several
of our other biological sciences companies, was perhapsspurredin part
by my own deeply personal experience. My first wife, Lynne, died in
1981 from a heart problem that might have been addressed by what
is now a relatively simple procedure, balloon angioplasty. NEA later
funded a company, Advanced Cardiovascular Systems, which helped
lead the development and proliferation of angioplasty methods. Our
firm also developed a relationship with a Stanfordprofessor, Josh Ma-
kower, who has established a number of small companies that make
devices that help fight heart disease, including his current company,
Acclarent, which uses catheter technology to treat sinusitis.
Healtheon had an ambitiousagenda: literallyto squeeze inefficiency
out of the U.S. healthcare system. Clarkdeveloped a decentrelationship
with the company's chief executive, but in serving a seeming need to
be at war with someone he wound up fighting with the NEA partner
who at first was in charge of our investment in Healtheon, Dr. Hugh
Rienhoff. Both men are highly intelligent and both as mercurial as
can be.
Within months of start-up, the relationship between Clark and
Rienhoff was threatening to blow apart, so Clark called to ask me
to step in, which I quickly did. We recruited a capable chief execu
tive, Mike Long, who led the company through its signature acquisi
tion, the purchase of WebMD. That Web-based healthcare company
brought Healtheon into the market for online consumer health infor
mation. Clark, meanwhile, remained the beacon—as he always is—
coming up with insights and visions and leaving it to others to figure
out how to execute them.
CHANGE FOR THE BETTER * 189
The Search for Solar

Healtheon was a company built on an expertise in process innova
tion, backed up by technology. Our firm, though, has its technological
strengths, and we have been big investors in semiconductors over the
years. We have a general partner, Forest Baskett, who, in Jim Clark's
words, is the "deepest and broadest" technologist around. Baskettwas
the Stanford electrical engineering professor who brought Clark to
Stanford. His specialty is semiconductors. Drawing on all the expertise
in our firm around the turn of the century as we searched for places
where we could take advantageof the changes in demand for energy, it
made sense that we should invest in solar energy.
Semiconductors are linked to solar. The key material is silicon, pro
cessing power is essential, efficiency is paramount, and manufacturing
is key. In 2003, we conducted our classic matrix analysis, looking at
all the opportunities, the gaps in the solar marketplace, and the need
for investment. As we looked at the solar value chain, we looked at
feedstock, sand silicon, and the fabrication of wafers into cells. We
considered modules for collecting energy, power systems, and system
installation. Allthat study led us to decide that the celllevel, individual
powercells, is the corevalue proposition. Just as in computing devices
the semiconductor chip is the core value proposition, the cell would
be the key in solar. So, we focused on silicon-based cells because that
is where we could get the most differentiation, the most innovation,
and the most value. In turn, our companies could get compensated for
that value.
We built our portfolio on the basis of multiple technologies. For
generation one, silicon, we have a portfolio company called Suniva,
in Georgia, that is doing really well. We have multiple generations—
organic is one of them—and multiple paths to market. As technology
evolves, companies must take different routes in order to find their
markets. So as to cover all our options, we have seven or eight invest
ments in this area. In essence, we are filling the solar ecosystem with
our companies, flooding the zone, as it were.
As we progress, we are building technology expertise and getting
manufacturing operations to scale. We were one of the very few firms
that invested in silicon from the fundamental materials on up the value
chain, and we are doingthe samewith solar.This appealsto our portfolio
companies, too, because they know they can benefit from their relationship
to other companies in our portfolio. A cell maker might sell products
to an installer, for example. One more point: Differentiation makes for
better investment returns, too. The market assigns a multiplier of two- to
three-times cash flow to, say, a Tier 2 solar provider, but differentiated
technology providers fetch 8to 15 times cash flow. We saw the same thing
happen assilicon technology matured, and the cycle isrepeating itself with
solar. Technologies may change, butwinning strategies persist.
An Evolving Strategy: Venture Growth Equity

Although certain strategies areworth repeating as technologies change,
we must also be open to changing strategies as conditions evolve. For
example, we never would have developed one of our most successful
investment strategies—something we call venture growth equity—had
we not reevaluated our approach as market conditions changed. The
collapse of the dot-com bubble in 2000 had an effect on our firm that
many people probably would not have expected. When we went to
raise our next fund that September, we actually wound up with more
money than we had planned for. Thedot-com busthad created a flight
to quality, and instead of our $1.5 billion target we wound up with
$2.3 billion in commitments.
I'll never forget the daywerealized wewere going to go that big. I was
in a board meetingin our buildingwhen ScottKriens, the chiefexecutive
ofJuniper Networks,caughtmein the halland said, "Dick, $2.3 billion?
This is ridiculous. Youcan't possibly invest that much profitably."
"Scott," I told him, "we have a plan."
The idea actually had come from one of our newest partners, James
Barrett, a Ph.D. who had at one point headed up clinicaltrials at Smith-
Kline Beecham, the big drug company now called GlaxoSmithKline.
Barrett left SmithKline to take over one of our companies that was
struggling. He turned it around. He worked miracles and then went to
another company and then started up one. After that, we brought Bar
rett into our partnership.
This was about the time we were closing on the $2.3 billionfund and
trying to decide how we were going to manage that much money.
Change for the better • 191
Jim offered up a simple observation. "Let's do fewer and more

important things," he said. "The truth of the matter is, we are doing
a lot of small stuff. Sometimes it's because of the experiment. Some
times it's a lack of conviction. We should really commit to where we
put our money."
Investing at Scale
Barrett's idea changed our whole way of doing things. To deploy so
much money, we needed to up the size of our investments. Instead of
an average investment of $6 million, we would put $40 million into
the typical deal. We would go as high as $100 million, and we would
invest in established companies instead of start-ups. If we could get,
say, seven times cash flow on exits, this would have a multiplier effect
on our performance. We also would not use debt. Most of these com
panies could not support debt anyway, so we decided to move in with
total equity investments.
We added one final twist: On the last $250 million of the fund, we
took no management fees. That way, if we never did find somewhere
to put that money, there would not be pressure to invest it for the sole
purpose of earning back our fees.
Tele Atlas is an example of how this worked. The company started
as a division of Bosch, in Germany, doing location-based software for
the automobile industry. In 2003, we jumped at the chance to put $70
million into a $200 million refinancing, along with Oak Investment
Partners, which spun Tele Atlas outofBosch and transformed thecom
pany. There were only two companies in the world doing this work:
NAVTEQ, in Chicago, and Tele Atlas.
Alongside our investment in Tele Atlas, we brought management
expertise to the second largest U.S. company inthe business and let the
Europeans continue running Europe. We got penetration into Japan,
sold stock on the Amsterdam exchange, and at the end of the day sold
the company for $4.3 billon. That made us about seven times our
money. Get results like that from big investments such as we put into
Tele Atlas, and it's possible to really move the needle, even with an
investment fund of $2.3 billion.
Changing from China

In the last few years, probably the latter years of my career, I have
embraced change in what some might consider a surprisingly personal
way. I haddeveloped an opinion, over a number ofyears, that anyven
ture capital firm serious about its business needed to be active in China
and India. Then, a few years back, when we were deciding who from
our headquarters office should staff our China operation, I volunteered
to go, thanks to my wife, Pam.
In 2007, when our China business was getting big enough that we
needed to make this move, it seemed obvious that the partner incharge
ofourChina efforts would be the logical person to go, butScott Sandell
had two young daughters and could not move until the end of 2008.
I volunteered to go, in part because Pam told me it was time to put
some action behind all the talking I had done, and the firm took me up
on myoffer. I hadexpected it to be a short assignment, but2008 turned
into 2009, and even as 2010 is imminent I still am commuting to China.
One reason isthatourfirm has raised a new $2.5 billion fund, andwith
that much money to invest we need Sandell in Silicon Valley.
China is, of course, the Wild East. I've gotten back into the life sci
ences, which has always been one of my great areas of interest. I've
begun developing a view thatintellectual property in China—which is
seen as one of the big drawbacks of investment in that country—will
change over time. The Chinese are doing more research, more costly
and complicated research, and with investment such as that I expect
them to be as aggressive as any country atprotecting intellectual prop
erty sometime in the next 20 years.
Inthe pharmaceutical industry, the Chinese are taking their research
capability beyond the relatively simple task of just creating generic
drugs. One of our companies, Novast Pharmaceuticals, is part of an
industry that has begun taking blockbuster drugs that are about to
come off patent, modifying them, and then obtaining patents on the
new drug. Such drugs are called biosimilars, and the new patents will
last for seven years.
There is plenty of room to make money in biosimilars. After all,
blockbuster drugs worth $110 billion in sales are set tocome off patent
over thenext five years. That's a big, profitable target for biosimilar re
search, and we have invested incompanies capable oftaking advantage
CHANGE FOR THE BETTER ° 193
of that opportunity. We believe this development will lead to better

outcomes at lower cost for the healthcare industry.
China is energizing, really, because so much is happening atonce, and
investment firms such as ours likely will have an ability to exit through
initial stock offerings in China long before the U.S. market bounces back.
The initial public offering market has been all but dead in the United States
since early 2008. Initial offerings in China are still trickling out, and the
market there is likely to rebound more quickly than just about any in
the world. The money and opportunities are both there. Before long, too,
Iexpect to see more Chinese companies start registering stock offerings on
the U.S. NASDAQ market. This is part national pride, part profit motive.
I am on the advisory board of a Chinese company called BioVeda,
a venture capital firm in which we hold an investment interest. The
chairman, Dr. Zhi Yang, is anxious to see the IPO market get going.
"We want to go public with these companies as soon as it is feasible,"
he said. "I think we can see strong earnings multiplied." He looked at
me with a smile and said, "That shouldn't be too big an issue."
Like the CEO of the communications company who performed so
well when the satellite broke down, Dr. Yang is ready to go, regardless
of how big the challenges. He expects to be compensated for his leader
ship and vision—and he will be.
It may be China. It may be 30 years since NEA went into busi
ness. Time passes, technologies and geographies change. But, no matter
where you are in the world, and no matter how old you are or what
technology is hot, 30 times earnings is an attractive return. That much
is a constant because some things, after all, do not change.
LESSONS FROM RICHARD KRAMLICH

<|> Consult the market matrix. Assess the players and gaps between
players when looking for opportunities. Particularly in markets
where new technologies are king, consider which vectors will lead
to success.
Trust your gut, and speak your piece. Do not go along on an

investment idea just because everyone else believes you should.
Bewilling to bust up a deal, or a strategy, if necessary.
<|> Maintain the magic. It is tougher to build momentum than it is

to sustain it. If a strategy, a CEO, or a company is losing its magic,
diagnose the problem and respond.
<§> Technologies change, but strategies persist. Reassess long-term

strategies in light oftechnological change. Some changes merely
reinforce existing strategy, others may force a change.
<|> Do fewer and larger things. When investment resources reach
a certain size, smaller deals just cannot move the needle. To earn
strong returns, take bigger positions in a handful of important
deals. You don't haveto risk too much at the outset, but build
upon milestones.
10
BEYOND THE IVORY TOWER:

TAKING LABORATORY
RESEARCH TO MARKET
Steven Lazarus
Managing DirectorEmeritus
A0Mr$14;biffion Years in VC: 23

Location: Chicago, It Year born: 1931
Grew up: Long Beach, NY Location born: Brooklyn, NY
Best known deals: Illumina, NEON/Sybase, Alnylam/Aviron/
Medlmmune/AstraZeneca
Style: Curious, imaginative

Education: B.S.* Dartmouth College, Class of 1952
M.B.A.; Harvard Graduate School of Business, a Baker Scholar in the
Class of 1965
Significant experience: First director ofthe U.S. Department of

Commerce Bureau of East-West Trade, director of Amgen for 17 years
Personal interests: Skiing, writing. Author ofthe book
Mind into Matter, 2006
The lesson: "Know when to change course."
— (S^X)
195 °
University politics, the uncertainties of basic science, and fundraising

hurdles: Steve Lazarus had to overcome them allin order to make ARCH
Venture Partners a success. After career stops in the U.S. Navy, the
Pentagon, and healthcare giant Baxter Laboratories, Lazarus went to
the University of Chicago to conduct an experiment in venture capital
and discovered it indeed is possible to systematically commercialize the
research from university laboratories.
Overcoming early skepticism from the scientific community, ARCH
gives university scientists a share in the results of their discoveries, an
arrangement that helps create new incentives and rewards for basic
science. ARCH's start-ups have ranged from education company
Everyday Learning Corp. to biotechnology firm Adolor, known for
its pain-management drugs. ARCH manages technology, market,
and financing risks with an eye toward bringing breakthrough new
discoveries into widespread use.
I was too old to qualify as one of Robert McNamara's "whiz kids"

at the Pentagon during the height of the Vietnam War, but I did
work there for him. My job included the task of delivering to him the
"Red Books" that tallied the Vietnam build-up. In the four years I was
at the Pentagon, from 1965 to 1969, the United States sent its first full
fighting forces into Vietnam, suffered the public relations setback of
the Tet offensive, and saw McNamara depart amid escalating protests
against the war. To this day, there are limits to what I can say about
my Pentagon work.
Ifsomeone had told me then that Iwould, late in my career, move on
to something as compelling as the McNamara years, I suspect I might
have been skeptical. But that is exactly what happened with a venture
that began when the University of Chicago asked me to run an experi
ment designed to help commercialize laboratory research. We would
not be the first to do so. Stanley Cohen and Herbert Boyer would earn
that honor with their patent for splicing DNA, but we led the way
in systematically rummaging through university laboratories and aca
demic treatises insearch ofbreakthroughs thatcould become thekernel
of great new businesses. Then we funded them, helped provide manage
ment expertise, and launched them into the marketplace.
BEYOND THE IVORY TOWER • 197
This approach led to the creation ofEveryday Math, anew style of

mathematics education. We helped advance the ability to shop online
with a company called NetBot. We also took a computer processing
technology that was initially designed to help hospitals manage their
data, tweaked it, and helped acompany we called NEON create one of
the fastest, most precise trading tools on Wall Street. Through atech
nique we developed—technology roll-ups—we helped create afamily of
pain-relief medicine that is not addictive and founded Adolor, one of the
most novel biotechnology success stories. Finally, we founded Illumina,
the leading company in genetic diagnosis and analysis, which today has
amarket capitalization in the billions. And there were many others.
We made plenty ofmistakes, too, but along the way we learned alot
about how to work within the university environment. We started by
overcoming the legitimate concerns of some professors and researchers
who at first saw commercialization as a potential threat to the notion
of pure academic research. We brought some of the disciplines of busi
ness to the research setting. We learned to identify potentially powerful
science and to secure the rights to that intellectual property so as to
protect its commercial potential. Above all, we learned the importance
of the intangible human factor: how auniquely talented handful of
star researchers can become repeat performers, turning out great sci
ence again and again, as reliably and bankably as those serial dot-com
entrepreneurs in Silicon Valley.
We did this all through a firm called ARCH Venture Partners, and
I have to admit to taking some satisfaction from the fact that ARCH
began as an offshoot of the University of Chicago, that great bastion of
theoretical, not practical, knowledge. Though renowned as a proving
ground for winners of the Nobel Prize in Economics, the U. of C.
would hardly come to mind as an incubator for the commercialization
of scientific research. With regard to the ever-present tension between
practical and theoretical knowledge, the university when Iarrived on the
scene in 1986 had changed little since the legendary chancellor Robert
Maynard Hutchins in the 1930s introduced the Great Books curriculum
and installed the Socratic method as a primary means of instruction.
As ARCH developed, there were lessons for me to learn personally,
too, about managing and encouraging the process oftechnology trans
fer. AtARCH, I would draw on all the work I had done previously in
198 • the masters of Private equity and Venture Capital
my career, as a Navy officer, as a Commerce Department trade nego

tiator, and as executive vice president of the international division for
the pharmaceutical company Baxter International.
At ARCH, I would learn how to influence and guide uniquely tal
ented scientists, probing and challenging without squelching their cre
ativity. I also would come to admire how big a difference it makes when
we create an investment incentive for a cadre of talented and creative
individuals, thereby amplifying the chances of success and the oppor
tunity for a return on investment. The techniques that have been so
helpful to me might be useful to anyone trying to manage an enterprise
that embraces risk in order to grow companies and turn aprofit.
Profit vs. Research: A False Choice

The ARCH story begins with an energetic debate that was occurring
on the board of trustees at the U. of C. in the early 1980s. In 1970,
Stanford University and the University of California-San Francisco had
patented their technique for gene splicing and were on their way to
ward earning $250 million in royalties from licenses on that patent by
the time it expired in 1997. Asimilar story at the U. of C. was ending
very differently. Around the time Stanford was converting science into
endowment dollars, the U. of C. was letting apromising technology
literally walk out the door. The university failed to legally protect its
rights to a process, first discovered in the U. of C. laboratories, that
eventually became the key to asynthetic hormone produced by Amgen
that helps reduce anemia among people with kidney disease. Business-
minded trustees at Chicago were determined not to let the financial
return that can arise from technology get away from them again.
Pioneers Need Support

The U. of C. may not have the same reputation for innovation as
Stanford, Massachusetts Institute of Technology, and other research-
based universities that have built their names on science breakthroughs,
but it does have a rich, if understated, legacy for advanced scientific
experimentation with profound real-world results. Manhattan Project
scientists during World War II conducted the world's first controlled
nuclear reaction in a squash court under the grandstand ofStagg Field.

The football stadium, incidentally, had been rendered obsolete by
Hutchins himself, who in 1939 abolished the school's football program
en route to withdrawing the university from the Big Ten athletic
conference altogether.
Chicago, however, had aunique asset: Itis the manager of the federal
government's Argonne National Laboratory. Although Argonne is best
known for its research into high-energy physics, the laboratory also is
a leader in biotechnology research. As the University of Chicago began
looking for ways to match Stanford's success in finding profitable patents
in its laboratories, advanced materials seemed a sensible place to start.
With the growth ofHewlett-Packard, Cisco, and others, the new science
of superconductivity seemed to offer the most immediate promise for the
transfer ofArgonne's technological know-how into commercial use.
Conditions were ripe for such a move. Even as science was on the
brink of a new wave of discovery, the nation's legal framework was
changing in important ways, too. In 1980, Congress passed amend
ments to the Bayh-Dole Act, which gives universities the economic
rights to the results of research conducted with government money.
The same year, the U.S. Supreme Court ruled that it is legal to patent a
live, human-made microorganism. The ruling, which granted patents to
General Electric scientist Ananda Mohan Chakrabarty on a petroleum-
eating bacteria he had invented, provided a powerful economic incen
tive for other biotech researchers.
The stage was set for Chicago to bring its research out of the labs
and into the real world. Stanford was making millions by streamlining
the licensing process through its Office ofTechnology Licensing, but
the U. of C. trustees who were looking for a way to commercialize
the university's research saw limits to the licensing approach. Once a
technology was licensed, they felt, the university would lose control
over its ability to ensure that the license holder would maximize the
commercial potential ofthe research. Acompany might buy the license,
locking up the right to use the technology, and simply put iton a shelf.
Perhaps that company might consider the science as potentially com
petitive with its own business. Perhaps the science involved might not
be a priority for the company. The licensing model offered too many
unknowns and too little control.
We Needed a Champion
U. ofC. wanted to take the Stanford and M.I.T. model to a new level,
an innovation in university-funded research. The idea—spearheaded by
Walter Massey, a physicist who had headed Argonne and then was vice
president of research atthe U. of C. —was to actually fund the start-up
ofbusinesses that would focus their efforts almost entirely on the com
mercial potential of the university's scientific breakthroughs. That ap
proach faced a hurdle of its own: U. of C. had neither the know-how
nor the people to do the job.
Massey and the U. of C. trustees needed someone to focus full time
on the commercialization effort. With Massey heading up recruitment,
the university approached John Robson, a protege ofDonald Rumsfeld
who had succeeded Rumsfeld as chief executive of G.D. Searle & Com
pany. Robson declined to be a candidate for the U. of C. job, because
at this point he was weighing a job offer he eventually accepted, to be
come dean ofEmory University's business school. Robson did suggest
an alternative candidate for the job: me.
The timing was just as good for me as it was wrong for Robson.
I had retired from Baxter immediately in the wake of its purchase of
American Hospital Supply. As a middle-aged executive during a time
of consolidation—at 55,1 was the second oldest executive after Baxter
chairmanBill Graham at the time—it seemed bestfor me to take retire
ment and consider the next phase in my career. I was about to begin
commuting to Cambridge, MA, to co-teach a business-school course
on health management, when Robson in the summer of 1986 invited
me to breakfast.
"I've been asked to look at a job at the University ofChicago, which
would be associate dean ofthe business school," Robson said. "They
also want whoever takes the jobto design some kind of mechanism to
transfer technology. The interesting thing is they want to use business
start-ups as one of their techniques."
A Creative Breakthrough
As I thought about and discussed the idea with Massey and others at
the university, it emerged that Chicago's approach was one of those
creative breakthroughs that change the way business is conducted.
Instead ofaccepting 4% or5% ofnet revenue ina conventional licensing

arrangement, the university would have an equity holding. That way,
U. of C. could have a direct effect on how aggressively the technology
was developed, and the arrangement would give the university some
input in selecting the researchers, investors, and business executives
who would help maximize the potential oftheir science. Beyond that,
the university had astutely designated the new position as an academic
appointment, a decision that would prove invaluable as the idea met
with the inevitable resistance from the guardians of Robert Hutchins'
legacy of academic abstraction.
I had no doubt that Chicago had potential as a seed bed for inven
tion. Two years earlier, in an early stab atcommercializing its research,
the university had invited me to its Hyde Park campus for a review
of university-sponsored research projects deemed to have commercial
potential. As Baxter's head of research, I was definitely interested, but
the process seemed off kilter—a parade of half-hour presentations, as
if the science was entered in a beauty contest where the talent portion
involved a remarkably high quotient ofscientific expertise. If anything
had worked for Baxter, it would have been the result ofanalmost incal
culably random match ofthe University's scientific output and Baxter's
commercial needs. In the real world, such coincidences rarely happen,
and none did for us. There had to be a better way.
The university seemed to realize it needed a more expedient
approach. That would not happen, though, until after the dons
of Chicago—faculty members, as well as trustees—could settle
an intramural debate about whether a commercial venture was
appropriate on Chicago's famed academic midway. As the germ of a
quasi-independent commercialization effort began to take shape, it
attracted supporters and opponents in almost equal measure.
Standing Our Ground

What we really needed was an insider, someone who would have cred
ibility with the faculty but enough savvy about the outside world to
see the potential ofthe idea we were trying to pursue. Fortunately for
our so-far fragile efforts, we had such a person in Walter Massey. It
was Massey who masterfully brought peace to Chicago's squabbling
fiefdoms, persuaded opinion leaders from the faculties of physical and

biological sciences to speak out, and applauded the university presi
dent, Hannah Gray, in her vocal and unwavering commitment to the
experiment. Among the trustees, Richard Morrow, then chief executive
of the Chicago-based oil company Amoco Corp., and James Crown,
scion of Chicago's wealthy Crown family, steadfastly rallied support
on the board.
As I learned later about how the debate developed, this event became
an important lesson for me—an extremely useful lesson—about the in
tricacies and dangers of university politics. Atuniversities, fiefdoms and
jealousies, tradition and inertia can threaten even the most positive ideas.
Great ideas at other universities had foundered over just such obstruc
tions, butMassey was determined not to let thathappen at U. of C.
Whatever resistance arose among the faculty oreven trustees, Massey
had a masterful ability to focus debate on what he saw as the ultimate
objectives of the program: To benefit society, to advance science, to
create jobs, and so forth. Massey artfully avoided bringing any discus
sion to a premature conclusion, particularly if the discussion at hand
was one thatmight putour venture at risk. Ultimately, though, trustee
Robert Halperin, a Silicon Valley pioneer, found a way to crystallize
the consensus that had developed among trustees.
"The purpose is to make money, and the only way you are ever
going to be able to measure whether this thing is successful or not is
whether you make money," Halperin said. "Then the other things that
you talk about will occur as derivative consequences." Halperin was
dead on, and after he put his argument that way any of the other pos
sible benefits ofthe project were subordinated tothe chief purpose: the
ability to add funds to the operation ofthe university.
Wenamed the newventure ARCH in recognition of the contributions
expected both from Argonne—the AR in the name—and Chicago—the
CH. Although words such as Halperin's mattered in getting us off the
ground, so did a physical sign I received soon after arriving on campus
in mid-1986. Evidence that the university hadcommitted itself irrevoca
bly tothe project was actual office space, a rare and valuable university
asset for what until then had been only a theoretical venture.
Jack Gould, dean ofthe business school, saw the project as a chance
to give business students practical experience in entrepreneurship.
By allocating office space, Gould was giving us room to operate and

sending animportant signal ofaffirmation to the university's faculty and
students. Making certain the message would be lost on no one, Gould
also put out word among the business school's talented and ambitious
students that ARCH would need volunteers in order to succeed.
Rewinding the Tape

As I settled into my work, I began to realize that I was embarking on a
venture that would draw on my many experiences over the years. The
experiences that unfolded in the months and years ahead were a reminder
of something I first had heard in 1963, while a student at the Harvard
Graduate School of Business. TheNavy had sent meto business school as
part ofmy mid-career development, and itwas atHarvard that I gathered
some particularly useful wisdom from Professor Georges Doriot. Aformer
military man himself, a successful entrepreneur in his own right, and one of
the fathers of venture capital, Doriot had a penchant for memorable and
compelling metaphors that helped him teach lessons that lasted a lifetime.
"The chain of your activities just keeps getting longer and longer,
and it never goes away," Doriot told us. "Our lives form a tape, over
the years, and we carry this tape with us endlessly and become a prod
uct of what we have done over time.
"Youraccomplishments, yourfailures, the wayin which youinteract
with people, they all become part of your own, personal tape," Doriot
concluded.
Doriot's lesson was clear: Build a strong tape, and know that both
your accomplishments and failures will become part of your record.
Treat people fairly andhonestly, and you have a chance at success. It was
common-sense advice, but the metaphor of the tape brought home the
notion that life is an accumulated experience. What we do each day, for
good or ill, builds toward the next, all connected, and always moving.
Lessons from Father

The emphasis Doriot placed on our need to treatpeople well was impor
tant, yet it was hardly news to me. It was something I had learned as a
boy watching my father, an attorney andaccountant, build his accounting
business during the Depression. Jesse Lazarus would drive fromour home
on Long Island to visit gas stations, car dealerships, and tire companies
and offer to do their books and, ultimately, their tax work.
In a business like that,character isimportant. The way you deal with
people, the standards you set—it's a small world, and you can't hide
anything. Atone point during World War II, he got several offers to get
involved in the black-market trade of automotive parts. He turned that
down flat. He was the essence of honesty, and his clients and friends
knew that.
From Dad, I also learned not to underestimate a person merely be
cause of appearances. I had known growing up that my father fought
during World War I in the Argonne as a medic—a traumatic experi
ence, no doubt, but one he never talked about. So far as I knew most of
my life, my dad had led a quiet, competent life, successful but nothing
overly exciting. It was not until years after he was gone that I learned
from a distant relative that my dad as a teenager had sneaked out of the
house at night, ran to an Army recruiting station, and tried to enlist to
fight Pancho Villa on the Mexican border. You just never know what
is written on that tape of a person's life.
Navy Life
As for me, I had not intended to have a military career, but the Korean
War persuaded me to start one. I hadgraduated with an English major
from Dartmouth College in 1952 and was working as an advertising
copywriter when the military draft started setting its sights on people
like me. Rather than get drafted into the Army, I joined the Navy.
A fast moving ship seemed more attractive thantrying to fight my way
up Pork Chop Hill in Korea.
The Navy showed me the world. My wife and I had two memorable
years in Naples. I served on ships, butmuch ofmy work was in logistics
and supply—useful training for a later business career. After Harvard,
sent there by the Navy to round out my management background,
came the Pentagon job and, eventually, a stint as trade negotiator in
the Commerce Department.
At the Pentagon, I had learned to be a good listener and, impor
tantly, how to avoid political pot holes that might destroy a career.
To themilitary staff, I was identified asone ofMcNamara's people, but

my Navy background made me one ofthem, too. I learned to blend in
with whatever group I worked with and focused on helping the some
times conflicting factions to resolve conflicts, setaside differences, and
focus on common aims.
Along the way, I met some interesting, even historic figures and
learned a good bitfrom my dealings with them. I met Don Kendall, the
legendary chief executive ofPepsiCo, while negotiating a trade deal that
helped Pepsi's efforts to forge partnerships in the Soviet Union—one
of the few parts of the world where they did better than Coca-Cola.
I worked with DavidPackard, a co-founder of Hewlett-Packard. People
such as that gave me a view into how business is done at the highest
levels of global commerce and, in Packard's case, the farthest reaches
of innovation. (I also worked with Bill Hewitt, the chief executive of
John Deere, and David Rockefeller.)
The Nixon Crowd and Other Acquaintances

In its odd way, the Watergate scandal was good for me. People at
Commerce kept dropping from sight, almost like victims in an Agatha
Christie novel. Pete Peterson left, an old Washington hand who eventu
ally went on to form Blackstone Group, a major private-equity firm.
As others departed, my responsibilities grew. I set up the Commerce
Department's Bureau of East-West Trade, negotiated deals with the
Soviet Union, and even helped start the Chinese liaison office. At one
point, I was riding in a limousine with Armand Hammer, the Califor
nia industrialist with strong ties to the Soviet Union, when he told me
I would be named Commerce Secretary ifJohn Connolly could win the
presidency. He said it with such confidence, it seemed like something he
could do. Since I was regulating a major deal Hammer was interested
in, I excused myself and fled the limo.
At one point, the Nixon White House offered me a job as one of
four associate directors in the Officeof Management and Budget. With
Watergate getting hotter and hotter, it sounded like a risky move.
I had gotten to knowJebMcGruder and Charles Colson while working
at Commerce, and called on Colson for advice. His carefully phrased
response suggested that this probably was not the right time to be
signing on withPresident Nixon, andI turned down the job. Sometimes,

it's just as important to avoid a potentially devastating "opportunity"
as to jump on a good one.
No one turned down President Nixon and just went about their
business. You were a supporter or you were an enemy, and I feared
that by turning down the budget job I had joined the ranks ofpotential
enemies. Just as I started to look outside government, I got a call about
a job at Baxter Laboratories. Bill Graham, the long-time chief execu
tive liked to collect people like me. I had been written about in Busi
ness Week, I had a modest public profile, and Graham was somewhat
starstruck by such things.
At a dinner meeting on my first visit to Baxter's headquarters in
Chicago's northern suburbs, Graham told me he wanted to expand
Baxter's international business, andwith my profile I would be a good
fit for executive vice president of the company's international division.
I had no background in health care, which made this just the sort of
opportunity I waslooking for: a break withthe past,something outside
of government, heading up a line of business on day one, a chance to
grow existing operations but also to start a lot of things from scratch,
all in an industry that allowed you to do good while doing well. I took
the job.
This was the tape of my career, and life, that I brought with me to
U. of C. when, at age 55,1 signed on as associate dean of the business
school, the person in charge of ARCH. The place had incredible po
tential. The science coming out of Argonne was on the far reaches of
physics and biotechnology. The head of the department of medicine
was Arthur Rubenstein, who now heads the entire healthcare program
at the University of Pennsylvania. There were lesser known but incred
ibly talented starperformers at the bench level inalmost any laboratory
one could find.
Storming the Ivory Tower

The debate over the formation of ARCH had been settled. The univer
sity was committed to moving ahead, but in many respects the larger
challenge ofwinning over thefaculty was still ahead ofme. I developed
the view that there were two key points we needed to address. First, we
needed to alleviate any fears that ourventure was a threatto the purely
academic and theoretical pursuits. And, second, we needed to let the
scientists know—let everyone know—that they might gain personally
from this venture. They might do breakthrough work, for starters, and
they just might get rich.
We addressed the first concern by letting faculty and researchers
know that there would be no limits on publication of scientific
research. Deep down, many star scientists at the nation's universities
go to the lab every day hoping that their work will one day win
them the Nobel Prize. We knew not to trifle with that incentive, and
we made it clear that once the university protected the intellectual
property thattheir work produced, they would be free to publish, just
as they ever were.
In my view, this whole debate about pure academia vs. the com
mercial marketplace had been overblown. The Robert Hutchins legacy
was still very much alive at the university, but there was a flip side to
thatindependent and inquisitive spirit. Dig a couple oflayers down and
there was an independent-mindedness that played to our advantage.
There's a saying oncampus, asold as some ofthe buildings themselves,
that embodies the independent spirit: "You can do anything here, as
long as you don't do it in the street and frighten thehorses." That'sthe
spirit we tried to appeal to while recruiting the faculty and scientists to
work with us.
Times were changing in academia, in any event. At Argonne,
before ARCH came about, the leadership used to celebrate whenever
investigators successfully filed a patent. They would call the scientists
together and present a $100 check to the investigator whose work
had earned the patent, but those little ceremonies were becoming
increasingly outdated. By the time I arrived at Hyde Park, everyone
knew that Stanley Cohen and Herbert Boyer at Stanford personally had
earned a share in the proceeds from their work that led to the patent
for splicing DNA. Compared to the millions that Cohen and Boyer
personally made, those $100 gratuities for university research were not
just outdated; to some at the university, they were almost insulting.
We seized on this change in perspective from the start with the first
big success arising from science developed out of Argonne. At the
time we had our first public offering of stock based on research there,
we printed up some ofthose big, oversized checks—filled out in figures

ranging up toward $20,000—and presented them to the investigators
whose work hadhelped create the company. Thatmade an impression.
Ultimately, we decided to offer 25% ofeither the equity or the royalty
stream to the principal investigator whose research was the core of a
business opportunity. Incentives are powerful tools, and financial in
centives may be the most powerful tools of all.
ARCH in Operation
With the philosophical debates largely behind us, the focus now was on
getting ARCHinto operation. I had the office space I needed from Dean
Gould, and the university and Argonne labs clearly were turning out
intellectual property that would have commercial value. What I needed
now was legwork—enough people who could scour the labs and who
were smartenough to understand thescience and savvy enough to sense
the business prospects of what they saw.
These scouts also needed to be good judges of talent. In any pro
fession, scientific research included, there are a handful of superstars.
Such people have the talent and creativity to make breakthroughs,
not just once in their careers but as a matter of course. Their col
leagues and competitors knowwhothey are,especially in a collabora
tive pursuit such as science where people on different campuses, or
even far-flung continents, might be attacking a particular problem.
It may sound elitist to say it, but it's still true: We needed to identify
the super scientists, the ones capable of serial successes in the labora
tories, people we could do business with as they pushed the frontiers
of discovery.
Fortunately, there are few betterplaces on Earth to find peoplewith
the kind of smarts and savvyI neededthan the U. of C. business school.
Many of these business-school students have returned to school after a
few years out in the working world, so they have a seasoned eye. They
are uniformly intelligent. Many areentrepreneurs in theirownright. As
I would soon learn, besides offering office space, Dean Gould headed
an institutionthat would also provide me with a qualified labor force,
and a volunteer one at that.
Raising Funds—and Volunteers

One day I was sitting in my office, lonely as usual, when a head ap
peared from behind the threshold of the open doorway.
"Are you the ARCH guy?" the person asked. He was a second-year
MBA student named Bob Nelsen, and, although I did not know it when
I first laideyes on him, this was the beginning of whatwould become a
partnership thathas lasted nearly a quarter century. Some ofthe other
earliest recruits are still my partners today: Keith Crandell and Clint
Bybee. Bob was from Seattle and had done some venture investing ear
lier in his career. Keith had an entrepreneurial background, too.
Oncethese first recruits signed on, volunteering with me in addition
to their class work, we split up the territory. Bob took the U. of C.
labs, and Keith took on Argonne. Clint spent time in both places. As
word spread about ourwork, insubsequent years we eventually hadto
sort through maybe 100 applications to fill 20 internship opportuni
ties. Those who were chosen we dubbed the "57th Street Irregulars,"
an homage to our street address and to the mindset of the people who
came there to work. It was also an homage to the troup of brilliant
ragamuffins who assisted Sherlock Holmes, The Baker Street Irregulars.
The name has stuck in my mind, I guess, because venture capitalists
have to be a bit irregular, too, or else they would never take the risks
or recognize the opportunities that most people avoid.
Now all we needed was the money necessary to make the whole
enterprise succeed. In essence, the university was providing the raw
material—the scientific knowledge—and my team was supposed to
provide or hire the know-how to facilitate commercialization. Without
seed capital, though, the science would never come to market, and it
was my job to raise the money.
The Money Hunt

I figured we would need to raise aninitial fund of$10 million to get off
the ground. I talked to university trustees, and received strong support
from the late Kingman Douglas who was chairman of the finance and
investment committee. Arthur Kelley, an old friend of mine who later
became a Chicago trustee, was a risk taker and he led me to several
potential investors. Nevertheless, I was offering little more than smoke,

a lab notebook, and a big idea.
I began what added up to more than 100fundraising trips. Progress
came very slowly. AtMadison Dearborn Partners, JohnCanning toldme
this was too small a venture. John Doerr at KleinerPerkins Caufield &c
Byers, in Silicon Valley, told me he had a gyroscope in his brain that
turned him back west as he approached the Nevada border. We did no
better on the East Coast. To many, the idea of a university-centered
fund was novel but totally unproven, a risk they did not need to take.
"Your track record is all ahead of you," I heard, more than once, from
people who refused to invest with us.
Gradually theeffort started paying off. Through some business contacts,
I got a meeting with Len Batterson at Allstate, and he said the insurance
company would put in $1 million if I could raise the other nine. That was a
start. I got an appointment with Jim Bates,the vicechairman of State Farm
Insurance. One Saturday afternoon in Bloomington, Illinois, Bates took
a break from a tennis game, listened to my pitch for about an hour, and
committed $4million. I hadmy nut, andfrom thatpoint themoney rolled
in.Theuniversity, through Douglas, matched State Farm's $4 million, and
before long I hadmy $9million. By the time I gotback to Allstate, though,
Batterson had left the company, and I never did getthat last $1 million.
It had taken a year to raise the money, and we had been incubating
a few deals by borrowing money without much formal authority from
the university or Argonne. Westarteda dozen companies and had—for
a start-up investor anyway—a fairly remarkable record of success: four
abject failures, four reasonably successful public offerings, and four
firms sold outright, at a profit to our fund.
Everyday Lessons
That first fund helped teach us an important lesson about remaining
open minded in the early days of a business venture. The originating
idea may not ultimately become the germ of the business, but if it is
powerful enough it will survive the adaptations one has to make to
craft an inspiration into a business success. We quickly learned that,
when seeking to launch businesses out of a university environment, an
investor has to be flexible and respond to circumstances. We launched
ARCH as a technology incubator, but the most successful investment

from that first fund turned out to be a company that had nothing to do
with technology: Everyday Learning.
Today, the Everyday Math teaching approach is a core mathemat
ics curriculum in school districts around the country. In 1988, when
ARCH came across the idea, it was the nucleus of a new approach to
mathematics educationdeveloped by a University of Chicago professor
named Max Bell. Prof. Bell believed children would learn mathematics
more easily if lessons were tied more directly to the sort of numbers
problems they see in everyday life.
As a prospective investment, Everyday Learning was a reach. Only
one year of the six-year curriculum was developed, no textbook pub
lisher had committed to the program, and no school district had
committed to launch it. We recruited an able chief executive, a busi
nesswoman named Jo Anne Schiller. We also committed $250,000 up
front, as lead of a syndicate that totaled $1.5 million in support, and
ARCH offered an option for another $150,000.
Everyday Learning never needed that second round of money. In
its first year, with 10 field sites testing the kindergarten curriculum,
they had $100,000 in revenue. Year two, with first-grade curriculum
added, revenues reached $500,000. The business broke even, and rev
enues began doubling every year. Eventually we sold Everyday Learn
ing to Tribune Company,earninga 25% internal rate of return on our
initial investment.
An Optic Adventure
In that first fund we also learned the important lesson that one must
never fall in love with technology. In our early scouting for break
through technology, we ran across research by Roland Winston, a
University of Chicago physicist who had developed a prismatic light
concentrator that increased the sharpness of images on a computer
screen. We called the company NiOptics and got 3M interested in its
commercial potential. There was a catch, though. The technologycost
triple what other, similar technologies cost to produce, and it never
caught on with computermakers. 3M eventually took NiOptics off our
hands, but only for about 85 cents for each dollar we invested.
212 • THE MASTERS OF PRIVATE EQJJITY AND VENTURE CAPITAL
Welearned it was important to have a willing buyer, at the rightprice,

at the right time, in order to turn a promising breakthrough technology
into a successful business. We also learned that at bigcompanies such as
3M it was important to move up the organization chart, to the highest
point we could reach. Our counterpart at 3M was enthusiastic about
the NiOptics technology, but he could not persuade the money people
to invest what it would have taken to make the product succeed. After
that experience, I never hesitated to use whatever contacts I had—on the
U. of C. board or elsewhere—to give us a chance of success.
NiOptics also was an example of something Doriot had tried to
teach me back at Harvard, and it is a lesson I have learned more than
once. In venture capital investing, Doriot said, it is important to under
stand who will buy the technology you're tryingto sell. It is easyto fall
in love with technology and lose sight of the fact that someone at some
point will have to pay for it. An investor can lose a lot of money that
way, and we have not been immune to such temptations.
By 1992, we had cometo the point that ARCH's first fund was fully
invested. If we wanted to continue doing business, it was time to raise
more money. It also was time to take stock of some of what we had
learned along the way. That would help us decide how much money
we should raise, how manycompanies we shouldplan to investin, and
what improvements we should make in the way we operated.
Facing the Three Risks

We had learned that we were, indeed, creating a new style of invest
ment. Thiswas not seed capital, whenearly-stage investors—angels and
the like—help a company get off the ground. In our case, we were iden
tifying science literally at the site of inception, assessing whether it had
commercial potential, and then erecting a commercial entity around it.
It wasn't seed capital; it was virtually from scratch.
Broadly speaking, we faced threekinds of risks: technology risk,market
risk, and financing risk. With the new round of capital we expected to
raise, we knew we would be able to finance investments as needed. We
were becoming experienced enough to make sound judgments about
market risk. Our understanding of the science was growing, as was our
network of knowledgeable experts in the scientific community.
BEYOND THE IVORY TOWER ° 213
I found it helpful to keep in mind something Tom Perkins of

Kleiner Perkins memorably described to me regarding the formation
of Genentech, when I met him during the first round of fund raising.
When Stanford and UC-SF presented Kleiner Perkins with the chance to
buy a license on the gene-splitting technology developed by Cohen and
Boyer, Kleiner Perkins knew it had enough money to buy the license.
The firm also knew that, if the technology was good, the market would
be vast, but the science risk was profound.
Kleiner Perkins' response was to take $250,000 and split it among
three different laboratories, asking each to duplicate the work of Cohen
and Boyer. After all three labs replicated the results, Genentech was
born. At ARCH, we did not have quite the same financial resources as
Kleiner Perkins, but we always aspired to be as diligent in our assess
ment of science.
Invest with a Teaspoon

We also found our own ways to minimize our exposure. We tried al
ways to gather a syndicate of investors to come in with us and sup
port a new technology. This helped spread our financial risk and, over
time, as we gained understanding of the talents and insights of our co-
investors, it helped us better understand the market and science risks
we faced. Beyond that, we tried to move carefully into our investments.
We talked about it as "investing with a teaspoon," particularly with
the first-in money. We offered future funding, often granting options
to our portfolio companies, but made the additional funding available
only if certain milestones were met: the hiring of a chief executive of
ficer, scientific work, proof of market, and the like.
We also were, in a way, talent scouts. We had learned that discovery
is a serial function. If someone discovers something once, chances are
that person will discover something a secondtime long before a person
who has never done one. And we knew, almost without testing the hy
pothesis, that a stellar scientist does not a CEO make. In virtually every
instance, we had moved as quickly as possible to move the founding
scientist out of an administrative role and put an experienced business
manager in place. We intended to repeat this practice in the second
fund and any subsequent fund raisings.
In fact, as our experience grew, we even began moving successful

managers from one successful portfolio company into another. This
proved to be a valuable way to improve our likelihood of success. After
all, we were taking on enoughrisksin tryingto commercialize research.
By sticking with people we knew, and people who knew us, we were
able to minimize another major risk factor: the risk associated with
putting the right management talent in place. Just as we found that
certain scientists were serial successes at finding breakthroughs on the
laboratory bench, we found that certain managers could be serial suc
cesses, almostwithout regard to the specific scientific development they
were working with.
On Our Own
For U. of C, the landmark moment for ARCH—the point at which it
was time for us to begin a new round of financing—brought the uni
versity to its own moment of reckoning. ARCH had succeeded, beyond
expectations really, in its original intent. In fact, in some ways it had
succeeded too well. The university is a not-for-profit institution, and
university lawyers wereconcerned about its active sponsorship of activ
ity that was delivering financial returns of 25% and better on invested
capital. Afterall, I was an administrator of the university, working out
of university space, and employing university students as volunteers in a
profit-making enterprise. I was told that at one meeting a lawyer joked
that the IRS "is after us about our bookstore, no less this."
The time had come for us to go our separate ways. We had ac
complished the mission for U. of C.—creating a path toward com
mercialization. Now, for ARCH, the point of departure opened new
doors for us. We could set our own fundraising goals. We could begin
to expand operations to other campuses and national laboratories.
We could set up our own offices, and working with Bob Nelsen, Keith
Crandell, and Clint Bybee we could professionalize our staff and sup
port operations.
We agreed to continue to work closely with the university. At the
same time, though, we no longer promised U. of C. a first look at in
vestment opportunities. We established ARCH Venture Partners, and I
left the university to become general partner of ARCH.
Beyond the ivory Tower • 215
After consulting with other venture capitalists and Richard Testa, a

Boston-based lawyer who had done path-breaking work in this area,
we decided to set a $30 million target for ARCH Fund II and re
named our firm ARCH Venture Partners. We set the limit based on
our expectation that, among the four of us, we could form at the most
between four and five companies each year. Because we planned to in
vest at such early stages, we expected to spend a considerable amount
of time actually working in each of our portfolio companies, espe
cially at the start when we would be constructing a business around
a scientific invention.
Shifting Gears
Once the fundraising period was behind us, we took ARCH in new
directions. Over time, we would expand to fivemajor bases of operation:
Chicago, where we started, but also New York City, to capitalize on the
research coming out of Columbia University; California; Washington
State; and Albuquerque, NM, where we could tap into developments
from the Los Alamos National Laboratory and the Sandia National
Laboratories. Our first investment out of Seattle—in a company called
NetBot that provides software agents to help online shoppers—we
sold within a year to Internet search company Excite, returning a
$9.9 million profit on ARCH's $1.3 million investment.
In California, we eventually decided to hire a full-time person
just to keep tabs on the technology coming out of the University of
California system. Kristina Burow is a Ph.D. biologist familiar with
the top researchers on all nine campuses, and she provides a sort of
incubation function for bright ideas. The value of this on-the-scene
presence is hard to overstate. After all, we were in business in Illinois
when Marc Andreesen and others at the University of Illinois developed
Mosaic, the search engine that ultimately became Netscape and helped
launch the Internet age. Andreesen, Eric Bina, and others were working
around the clock and in plain view at the National Center for Super-
computing Applications down there. That discovery, had we happened
upon it, would have been worth billions to us. We just never knocked
on the right door. By putting people such as Kristina Burow in place,
we try to make certain we don't miss that door the next time.
Outside the Ivy Walls

The new fund also gave us an opportunity to broaden our focus and
to refine some of our investment strategies. NEON, a company in the
information technology sector, became the first example of ARCH
moving outside the university or government laboratory pipeline for
an investment opportunity. NEON also set up shop in a sector, in
formation technology, in which, to put it mildly, we did not have a
comparative advantage. After all, Silicon Valley and other technology
hot spots are overflowingwith IT expertise and entrepreneurial talent.
Besides, the half-life of an IT investment can be very short. That alone
can create an unacceptable risk for a firm such as ours, which typically
has a longer term investment outlook.
With NEON, our partner Keith Crandell was approachedby someone
he had come to know well as a sort of informal brain trust for ARCH.
Rick Adam was a former Goldman Sachs administrative executive who
had once reported to me at Baxter, and Keith had consulted him about
several of the technologies we had seen at Argonne and U. of C. As it
turned out, Adam had begun developing a tool hospitals could use to
organize and access data and increase transaction speeds. Thetargetmar
ket never developed because hospitals' IT protocols had not reached the
pointwhere they could maximize the potential of NEON's technology.
At this point, NEON was one of our larger investments. Keith and
I were spending considerable time serving on the NEON board, try
ing to salvage ARCH's at-risk capital, and trying to find a market
for technology that had to have a market somewhere. We just hadn't
found it yet.
Eventually NEON did find its market: on Wall Street, where Adam
had had a solid career. Merrill Lynch signed NEON to create a highly
efficient, real-time middleware provider with the capability to guaran
tee the delivery of vital messages. In just five years, beginning in 1997,
NEON grew to $180 million in revenues before it was acquired by
Sybase, a leader in business intelligence software.
Adam is an example of the sort of person this work brings one into
contact with: driven, imaginative, disciplined, and successful. Unfortu
nately, it does not always work that way. A portfolio company, R-2
Technologies, brought home for us the lesson about the vital impor
tance of management talent.
Beyond the ivory tower * 217
R-2 was based on promising technology out of U. of C. and Lock

heed Martin for eliminating false negatives during the reading of
breast scans. Clearly, this looked like it had the potential to become
a big, lucrative business, but the CEO, who had been recommended
by a board member and passed muster with an executive search firm,
failed to provide leadership. He was a misfit for us in any event, with
a background in the imaging industry when what we needed was more
scientific. We registered for an initial public offering, but when the
accountants got in there they could not verify the financial results.
We had to cancel the IPO, bring in a new CEO, and sell the company.
ARCH turned a profit, but lord knows what return we could have
made with a successful IPO.
Rolling Up Success
As we have become more sophisticated about our work we have begun
to focus on moving more aggressively into certain markets. It's a pro
cess we call, somewhat disparagingly, "technology roll-ups." The idea
is to find a winning idea, then look everywhere we can find—in the uni
versity and government laboratories, in corporate research departments
to the extent any are still doing basic science—and obtain the rights
to any potential discoveries we can find. That way, if it's a winner,
we own a part of it, no matter which strand of the research ultimately
proves to be most successful.
We did this successfully with a company called Adolor. Bob Nelsen
was skiingin Vail in 1993 when he received a phone call from Graeme
Bell, a U. of C. biologist known for his work identifying genes involved
in Type2 diabetes. For almost40 years since the discovery of morphine,
scientists had searched in vain for as many as three opioid receptors
that might also be useful in fighting pain, perhaps without the addictive
effects of morphine. We saw great potential for this, and investigative
work by one of our scientific staff, with direction from Bell, led us to a
company in Germany and a scientist at Harvard who were also doing
research that was potentially complementary, or possibly competitive
with, Bell's work.
Immediately we rolled up the technology, shelling out $50,000 for
around five different option licenses—a pittance to spend on science
218 • The Masters of private Equity and venture Capital
that had the potential to become a blockbuster drug. Syndication was

not easy because again the scientific challenge was so widely known
and skepticism easy to find. Despite that, we raised the money and
founded Adolor. The company becameone of the great biotech success
stories, and even went public after the dot-com crash of 2000. Shortly
thereafter we founded Illumina, a genetic testing diagnostics company,
which today has a market capitalization of over $4 billion.
The Tape Rolls On

Over time, ARCH has grown along with its portfolio companies.
Though we run a streamlined organization, we currently operate with
around 25 professionals distributedamong several differentoffices. My
own responsibilities havechanged, as I serve now in an emerituscapac
ity. The title is different, but my input frankly has not changed much.
As ever, I chiefly offer advice and counsel. Challenging assumptions,
raisingquestions, offering a fresh set of eyes—I seekto bring experience
and, at times, even wisdom to my colleagues.
I take pride in some of the products our companies have brought
to market. Aviron, one of our start-ups, now part of Medlmmune/
AstraZeneca, has taken weak, live viruses researched at the University
of Michigan and developed the inhalable flu vaccine called Flumist.
Another, Ahora, pioneered the design of a detector used by homeland
security to detect alien agents. Because of that company, people are
allowed to carry liquids—granted, in small amounts—through security
at airports. One never knows where our technology will go and whom
it will reach.
If Professor Doriot were to review the tape on ARCH's existence,
he would find a firm that relies on strong, trust-based relationships
with scientists, investors, and other partners. He would see a firm with
a systematic approach to identifying the commercial potential of the
scientific work done at key academic and government research centers.
ARCH focuses on four major areas: specialty materials, biotechnology,
medical devices, and software. We emphasize underserved geographies
such as the Midwest, New Mexico, and even Canada. And, finally,
ARCH is a firm that, through its experience and expertise, seeks to
reduce risks for the enterprises it helps create.
BEYOND THE IVORY TOWER ° 219
This is the tape I have created in the quarter century since I left
Baxter to start ARCH and build it into something important. At one
point in my life, I had thought those heady days at the Pentagon might
be the high point of my career. Clearly, those days are an important
part of my tape, but ARCH helped me change gears and movethe tape
onto a different reel—one that drastically altered the ultimate story.
I would like to think it is a tape that others might be able to view, and
use, to build success stories all their own.
LESSONS FROM STEVE LAZARUS
•*3> Manage the "three risks." Technology risk, market risk, and
financing risk all can threaten the success of a potentially lucrative
scientific discovery. Manage each with great care, both at start-up
and as a venture matures.
Invest with a teaspoon. When putting first money into a new

discovery, start with small amounts. Bring co-investors in to spread
the risk. Contribute additional funds only as benchmarks and
objectives are met.
Remember your tape. A person's life and the life of an enterprise

are the sum total of actions and decisions over a period of time—a
tape that never stops rolling, according to legendary Harvard
Graduate School of Business professor Georges Doriot. Pay attention
to that tape.
Control the technology. Take an ownership interest, not a license,

in new technology in order to ensure it is maximized in commercial
application. Use a roll-up strategy, acquiring all available technologies
related to a particularly vital discovery, to dominate a new market.
<^> Avoid potholes. Associate only with quality people. Avoid

unproductive, intramural bickering. Let science lead the way. Learn
to recognize technological failure early, and respond to market
signals—both positive and negative—as events unfold.
11
FOSTERING INNOVATION
PEOPLE, PRACTICES,
AND PRODUCTS MAKE
NEW MARKETS
Founding Partner
>A!»M?^0l5.iftaiion i: Years inVC: 47

\|&&tfeti: Palo Alto, CA Year bom: 1928
Grew up: Des Moines, IA; Palo Alto, CA
Location born: Quincy, IL
Best known deals: Amgen, Boole & Babbage, Coherent Radiation,
Style: Qpen, persistent

Education: B.S., Stanford University, Class of 1950
Significant experience: U.S. Air Force, steel production

Personal interests: Track and field, flying, golf, fishing, opera, education
The lesson: "Stick with things you believe in even when the going
'& difficult."
_____ :—: : c^po
• 221 •
222 • THE MASTERS OF PRIVATE EQUITYAND VENTURE CAPITAL
The term "Silicon Valley" was not yet invented when Pitch Johnson
moved from the steel mills of Indiana to the entrepreneurial breeding
ground of northern California. In more than four decades since then,
usually investing his own money rather than raising a fund from limited
partners, Johnson has been involved in some ofthe venture industry's big
successes in investing suchas Boole & Babbage and Coherent Radiation
in the 1960s, Tandem Computers and SBE in the 1970s, and Amgen
and IDEC in the early 1980s. Hestuck with such companies as both an
investor and director, sometimes for decades.
Johnson's low-key style matches a patient, persistent approach to
the business. Working from Assest Management Company's offices in
Palo Alto, Johnson explores complex technologies and has adapted to
the days of interactive software games with Her Interactive, a company
with products for adolescent girls. An early skeptic about the excesses of
the late 1990s, Johnson has pursued a stick-to-the-basics approach that
never goes out of style.
A steel mill in the Midwest may sound like thelastplace where a per
son might learn how to managethe processof innovation. I worked
in Inland Steel's mill on the south shoreof Lake Michigan, and it was a
hot, smoky place that was anything but high-tech by modernstandards.
But what I learned there—about both people and process—has stuck
with me over the years.
After mytime in the mill, I went on to start a venture capital business
in 1962 with Bill Draper in the Santa Clara Valley south of San Fran
cisco, long before anyone called it "Silicon Valley." I helped recruit the
chiefexecutive who made the biotech firm Amgen a success and funded
a company, Boole & Babbage, that became the first to offer diagnostic
programs for IBM mainframe computers. I also learned the hard way,
through a company called VisiCorp, how a business can go bad when
it doesn't control its key technology. I have helped start venture firms
in many countries, especially in eastern Europe. I currently serve on the
boards of three U.S. companies, and oneeastern European buyout fund.
One makesand markets the NancyDrewcomputergames, another
is working to cure Type 1 diabetes using stem-cell technology, and the
third is working on very sensitive radios using superconductivity.
FOSTERING INNOVATION * 223
I didn't understand it at the time, but I acquired many of the tools

I need to help spur innovative companies as a venture capital investor
during theyears I spent working at the Inland Steel mill in East Chicago,
Indiana. Melting steel in an open-hearth furnace was painstaking, hot
work using the most elemental inputs in industry: scrap steel, iron
ore, oxygen, and fuel oil and ferro-alloys. If the melter supervising the
furnace operators knows his job, each "heat" produces enough molten
metal to make finished sheets, plates, and beams. If not, he winds up
with up to 300 tons of useless material that has to be cut into pieces
and remelted. It requires teamwork andgood, quick decisions on when
to put the heat into the ladle.
Investing as a venture capitalist, trying to ignite innovation, isremark
ably similar, even ifthe sunny, high-tech world ofSilicon Valley is a world
away from the smokestacks ofnorthern Indiana. For starters—and here
is the most striking similarity—the crucial decisions must be made on
the basis of inadequate information. The melter simply cannot measure
everything he needs to know. He dips thermocouples into the furnace to
measure the temperature andsends sample ingots to the labforchemistry
tests, but in the end he has to make judgments based on those changing
measurements and looking into the furnace. He learns,over time, to trust
the process and the men running the furnaces. For example, he learns the
right time to lower a lance into the furnace to blow in oxygen to oxidize
thecarbon and impurities at a faster rate. He determines when to tap the
molten steel into the ladle and where alloys are added to give the steel the
final composition necessary to meet the differing specifications ofan auto
manufacturer, an appliance manufacturer, or a construction company.
In venture capital, weconstantly make decisions based on inadequate
information. We must decide whether or not to back an entrepreneur
without fully knowing if the idea is powerful enough, the market big
enough, or the management strong enough to be a success. But, if we
can't make that call—if we can't, in a sense, tap that heat of steel—we
can't do our business. At some point, we have got to say we are going
to do it or not going to do it. The judgmental quotient of making that
decision is vital to success. Steel isn't made much in open-hearth fur
naces any more because of technology changes, and I am technically
obsolete there, but the decision-making lessons I learned 50 years ago
as I learned to cope with uncertainty are still very much alive.
You have to trust a proven process. I have invested a lot in biotech

companies, Amgen being the most successful, and have found that no
biotech company can succeed if its processes are not sound. It must
control variables, be able to replicate results, learn from mistakes, and
incorporate new information. These are all techniques that were vital
to me at Inland Steel.
Beyond that, there was the human factor. I had grown up in Palo
Alto. My father, who was a former Olympic hurdler, was the track
coach at Stanford. It was a great life, but one that was insulated from
many aspects ofthe working world. Inthe mills I first met large groups
ofeastern European immigrants. I first saw how working people strug
gle and sweat to succeed. Almost all of the workers knew more about
steel making than I did. After all, many had grown up as children of
mill workers. It was my job to lead them and guide them and make
sound decisions, despite my scant experience intheir business. Tothem,
my Stanford engineeringdegree and Harvard MBA would have meant
little, and I never mentioned them to my co-workers. This, too, is part
of the venture capital trade: the ability to read people, to inspire or
manage them, andto help them succeed, even ifthey might know more
about the specifics of success in theirparticular field.
The Process of Innovation

I have a rather small venture capital firm. My friend Bill Draper, with
whom I started in the business in the 1960s, later helped build a big,
well-known firm called Sutter Hill. There are other firms thathave got
ten even bigger, such that they are as much about money management
as innovation. I chose more of a solo route. At my firm, Asset Man
agement Company, I invest almost exclusively myown money and my
family's money, along with that of a few friends. What I am, mainly,
isa co-founder, along with many others, ofthe modern venture capital
business, the one that was so important to the development of Silicon
Valley. In fact, Draper and I had been at work in the valley for nearly
a decade before the writer Don Hoefler of Electronic News coined the
term "Silicon Valley" in 1971.
Oversome four decades ofwork, I have learned a greatdeal about the
process of innovation. I have learned some of the tools and techniques
FOSTERING INNOVATION • 225
needed to turn powerful ideas into great companies. I have learned the
importance of working with the best people, perhaps the single most
vital ingredient ofsuccess. Along the way, I have learned, too, some of
the pitfalls to avoid. A person picks up a lot of lessons over time, and
the person who pays attention, even in places as seemingly dissimilar
as steel mills and biotech labs, has a good chance of backing the right
people, with the right ideas, in the right markets. When all ofthose come
together, you've got a chance of helping to create a great new company.
Nosingle decision is more important inthis equation than the one we
make about whom, among the people we meet, deserves our financial
backing. Virtually all the people a venture capitalist considers investing
in have some elements of merit. They are creative enough to have a big
idea and ambitious enough to put together some kind of business plan.
The art of our business, this part of it anyway, is to select only the very
best people with the strongest ideas. The people with drive, the ones who
can execute, and the ones who can work with people are the ones who
deserve support. They must see the whole market, a path tosuccess, and
the troubles to avoid. Those are the people who get our backing.
Success at Amgen
For me, the one who best symbolizes the model person in all those re
spects is George Rathmann, whom fellow venture capitalist Bill Bowes
and I recruited to run Amgen in its earliest days, when its promise was
great but its success far from certain. Before we found Rathmann to run
it, Amgen had emerged as our possible answer to Genentech, the first
significant biotechnology company. The venture capitalist Tom Perkins
had backed Genentech since its start in 1977. In fact, Perkins had pro
vided space for Robert Swanson and his co-founder Herbert Boyer to
do some of the preliminary research necessary to get Genentech offthe
ground. In 1980, I got my chance. Bowes had come up with the idea
for Amgen andinvited me to invest ina very early round. The company
badly needed a chief executive, though, and we found that Rathmann
was just the person we needed.
Rathmann was an executive at Abbott Laboratories at the time, but
Abbott appeared to have tired ofbiotech. Inthe late 1970s, after Stanley
Cohen and Herbert Boyer developed the ability to splice genes, Abbott
began experimenting with biotechnology but segregated its scientists

within highly secure labs. Abbott also believed thatworking with DNA
would cost too much and take too long before any commercially viable
product could be produced. Rathmann was anexperimenter by nature,
a natural leader who was impatient to get going, so he needed a more
risk-tolerant and innovative atmosphere than Abbott would provide.
Bowes and I learned about Rathmann through Winston Salser, a
University ofCalifornia-Los Angeles professor who had set up a DNA
research laboratory at UCLA and had become the founding scientist of
the newly formed company, Applied Molecular Genetics, or Amgen.
Rathmann was on a sabbatical from Abbott in Salser's UCLA lab. Ac
cording to Rathmann, Abbott had declined to form such a research
unit, sohe was immediately interested when we approached him to talk
about our ideas for Amgen. On the other hand, he was not going to be
a push-over, as we learned during our effort to construct a scientific
advisory board for the company.
We andSalser had built a good scientific advisory board. There was
some talk that this board would report directly tothe company's direc
tors, not to anyof the executives at Amgen. Rathmann wouldhave none
of it. He had some experience with science boards when he worked in
product research at 3M up in Minneapolis. Rathmann succeeded in
helping lead 3Minto the market for x-ray film, buthealso believed the
science board had the effect ofsquelching innovation at 3M, as all sorts
ofpolitical infighting came about over science. There was fingerpoint-
ing when products did not turn out well. In some instances, the corpo
rate board would lobby the company's science board for products that
researchers such asRathmann might never have supported. Rathmann
worried that if we gave Amgen's science board a direct pipeline to the
directors, it would only undermine the chiefexecutive officer.
"It's an interesting idea," he said of our proposal. "But, if the SAB
is going to be around the company, then they will report to the CEO,
or I'm not going to be the CEO." His main hang-up afterthat became
whether his wife, Joy, would bewilling to move to the west coast.
We eventually hired Rathmann. Abbott tried to tempt him byoffer
ing him a research operation of his own, but we worked that out by
offering Abbott a minority stake in Amgen. Rathmann went straight to
work. He recruited top corporate scientists and top university scientists
to work in Amgen's research labs. He was able to attract them and offer
incentives to them in ways that kept them with us even once the com
pany started succeeding and, because of their reputations, other firms
tried to recruit them away.
The Scientist as Industrial Leader

Rathmann was not a scientist in the sense that some university profes
sors are. He was an industrial leader with a strong science pedigree. He
understood business, and he saw how to make money by getting prod
ucts to market. He had the rare combination of understanding where
the science might lead and envisioning what market would be there
once the science arrived. Rathmann also set policy that geared Amgen
toward the Food and Drug Administration approval process, so we
could get drugs through the FDA pipeline more quickly.
Rathmann also got very involved in selecting and suggesting board
members, which was an important part of the company's success.
Working with Rathmann and the board, we figured out a way to get
our business done even though we had a representative on the board
from Abbott, a company that had the potential to become a competitor
on certain of our products. Bowes, Rathmann, and I started meeting
informally. That way we could hammer things out and decide what was
in Amgen's best interests without sharing all that we knew with Abbott.
Abbott knew about this process and felt comfortable with it, because
they realized itwas necessary for Amgen to have the freedom it needed
in order to succeed.
And Amgen did succeed. It took 10 years from its founding before
Amgen could get FDA approval on any ofits products, but those ap
provals ultimately did come. Epogen and Neupogen became the bio
tech industry's first blockbuster products—more than $1 billion in
sales each—and they brought many thousands of patients relief from
anemia due to kidney dialysis and the side effects from cancer treat
ments. By 1981, the company went public, and some of the founding
investors who were running venture funds sold out and did very well.
Because Bowes and I were investing on our own behalf we were able
to stay invested and earned another large multiple as the company
kept growing.
Character Lessons
In a way, the role I played at Amgen, as at many of the companies
I have invested in, was to coach a CEO who was extremely capable in
his own right but who also benefited from my judgment and experi
ence. Coaching is something that I grew up with, because I am the son
of a coach. My dad, Pitch Johnson, Sr., was a track coach. He ran the
high hurdles in the 1924 Olympics—the "Chariots of Fire" team—
and wound up coaching at Drake University in Des Moines, where he
directed the Drake Relays, one of the great track meets in the United
States. In 1940, he got the job at Stanford as track coach and left in
1945 to enter business. My dad fostered in me a desire to win, fairly,
that Iretain to this day, and he helped me relate to the competitive men
and women who start companies. My own years ofbeing a track ath
lete in high school and at Stanford also taught me a lot about working
toward goals and winning and handling loss.
While my dad taught me a great deal about people and character,
much ofwhat I learned about business as a young man actually came
from my father-in-law, Eugene Holman, who was the chief executive
of Standard Oil of New Jersey, which today is called Exxon Mobil.
I actually met his daughter through track and field. While preparing
to attend business school at Harvard, I complained to a guy I knew on
Stanford's track team that I didn't know any women back East, and he
gave me the name ofCathie Holman, a Vassar student, whom I began
dating and eventually persuaded to marry me.
Mr. Holman had worked his way up from the oil fields. He was a
great prospector for oil. He knew that the best way to build a career was
to pay dues and build from the ground up. He believed strongly that,
as an executive at a big public company, he was the custodian of other
peoples' money. And he felt strongly about the value of hard work.
One time when I was working in the mills, some friends of his visited
Cathie and me and saw me return home from work in grimy clothes,
even though I had showered at the mill. I had a Harvard M.B.A., and
this couple wondered why I didn't have a better job.
Mr. Holman had a simple response: "That is what he wants to do," he
said. And for him, as long as the work was interesting and satisfying, that
was good enough. He understood there were jobs from which a person
comes home with dirt on their clothes, since he had held them himself.
The Lure of Capital

For along time, the work in the mill was good enough. Ienjoyed mak
ing steel, and Iwas learning alot about how to manage people, but then
one of those unexpected things happened that can change a person's
life. As I rose in the ranks at Inland Steel, I became eligible for stock
options as part of my compensation. One time, before the annual meet
ing, Iwas reading the prospectus for the meeting and noticed that the
descendants ofthe company's founders each owned hundreds ofthou
sands of shares. It was 1961,1 was 33, and I had worked at the com
pany for seven years. Ihad options for 42 shares—nothing wrong with
that—but the grandchildren ofthe founders had more than 400,000
shares each. I decided then that I needed to do something else. I needed
to stop working for asalary, and I needed to start something so that,
one day, I might be the one who could form capital.
I had two things going for me. I had saved $25,000, and a per
son I had met, a former salesman for Inland, was Bill Draper III. We
had been neighbors in East Chicago, Ind. and colleagues at the Inland
plant, but Draper had left afew years earlier to return to California and
work for his father, William Draper, Jr., at aventure capital firm called
Draper, Gaither &Anderson. Bill's father was one of the pioneers of
California venture capital.
Cathie and I went out that year for the "Big Game," the annual
football clash between Stanford and the University of California-Berke
ley. Draper mentioned he was thinking about leaving his father's firm,
where he was an associate, to set out on his own. I was interested in
forming a firm, too. Over his kitchen table that weekend we drew up
our idea of what our firm might look like. Along with my$25,000, Mr.
Holman agreed to lend me $50,000, and Draper was able to raise a
similar amount. By the middle ofthe next year, we had formed our firm
as a small business investment company licensed by the Small Business
Administration, and we started looking for deals.
Government Help
The Small Business Investment Company program is one of those rare
government initiatives that actually works almost better than anyone
thought it would. Under the SBIC program, which started in 1958,
investment funds that raise a minimum amount privately can raise ad

ditional money as needed by issuing debt securities guaranteed by the
SBA. In those days, the SBA was the direct lender. There were some
abuses after the program first started, when people invested with their
brothers-in-law and the like, but there were many more successful ex
amples, as in our case. At the time we were getting started, we needed
to raise $150,000 in order to get our SBIC license. Once we got that
much, and increased our capital to $300,000 using some government
debentures, the government would lend us three times as much to do
deals. Itwas a great way to leverage our money.
We weren't the only ones in northern California to see this as an
opportunity to kick-start the innovation that would come out of Stan
ford and other universities and the general entrepreneurial climate in
the area. In fact, several of us SBIC investors put together a group
called the Western Association of Small Business Investment Compa
nies. Only half of us were doing what today would be called venture
capital. The rest were doing mainly real estate deals, but we shared
investment ideas, talked about our investment techniques, and gradu
ally developed afairly coherent way of doing business. To this point,
the SBIC program has helped provide more than $50 billion offinanc
ing to more than 100,000 small U.S. companies. Intel, Apple, and
Palm Computing are among the technology companies that started
with SBIC-backed financing.
In 1962, as Draper and I got our SBIC license, we and the other
venture investors in the area all started doing our early deals. We were
innovating out ofnecessity, and we were inventing the business as we
went along. We developed some customs and terminology. We devel
oped the nomenclature of pre-money and post-money valuations and
the idea of organizing rounds offinancing. All of these evolved over
time. The names of them now are called, pretty uniformly, seed financ
ing, rounds A, B, C, and D. We hadn't given them those names yet, but
the practice was becoming pretty standard.
We developed the idea that you put enough money into acompany
toget itto a certain place, and then you agree toputinmore ifthe man
agement team reaches certain milestones. This is standard operating
procedure today, but it was a fairly new approach back then. Another
custom that evolved, because we were all small, was the idea that we
would all do deals together. This, too, was out of necessity. Most of
us did not have enough money to fund many deals on our own, so we
shared the work and shared the future financing commitments, too.
I thought that was an important innovation. The Latin root of innova
tion is novo, which means "to renew." We weren't renewing things.
We were doing one better: We were inventing them and then repeating
the ones that worked.
Before long, the form of doing business evolved from the small pri
vate venture firms using their own capital to the limited partnership
format. Many venture firms had outside investors who were trying to
make a return on their money byproviding capital for start-ups. Even
tually, we began creating preferred stock, so we paid a lot more than
the founders did, but we got our money out first in case of trouble. If
anybody got any money out of a deal at all, the preferred stockholders
came out before the common stock owners did. In a successful deal,
though, the stock all converted at some rate into common stock. That
way, everyone could cash out and get their returns.
On My Own
After about three years in partnership with Bill Draper, I was getting
antsy just advising companies, and Iwanted to operate one. Sutter Hill,
a real estate company, wanted to get into the venture business, so they
bought out our portfolio, and Draper decided to go into business with
them. I had some real capital for the first time in my life. Simply be
cause we had some time and some money to do it, Cathie and I went on
afive-week trip to South America. Before we left I bought some stock in
a public company, Memorex, and by the time we got back I had more
than doubled my money in that investment. It easily could have gone
the opposite way, but it gave me a bit more capital than I had figured
on. I then started to look for a business to buy, but instead of that,
I kept finding deals to do.
I never did wind up managing a single business, but by going out and
setting up my own firm, I was plowing a path that differed from the
ones many of my colleagues from this early period followed. I decided
to invest just my own money, and my family's money, and grow it as
big as I could. While many of my colleagues got into building their
firms, raising fund after fund with dozens of limited partners, I was
growing, albeit more slowly, that one pool ofmoney.
By definition, the approach I took tended to give us different invest
ment time horizons. When you're investing a fund and that fund has a
limited life ofaround 10 years, you have to get the investments mature
and liquid in avery few years and get your investors rewarded. If you're
running a family firm oran "evergreen" firm like Sutter Hill, you have
the luxury ofpatience. That's good, though I have to admit thatthere's
a downside to that, too. If I've made a consistent mistake over the
years, it's the mistake ofstaying in investments longer than I should,
exercising too much patience, I guess.
The Power of a "Pitching Change"

One of the deals in which patience did pay, one of my most important
early deals, was the software company Boole & Babbage. With this
investment, what I learned about the value of patience as an investor
was only part ofthe payoff. I also learned how important it is, when
trying to spur innovation, to change leadership, ifnecessary, when the
management cannot keep pace with changes inthe marketplace. You've
got to have the right people in charge.
I first heard about Boole & Babbage in 1968, when a couple of
venture capitalists named Bill Edwards and John Bryan brought the
deal to me. Actually, the company wasn't called Boole &Babbage just
yet. Thefounders—Dave Katch and Ken Kolence—had named it K&K
Associates, a name thatdidn't have much appeal. I asked them to come
up with a new name, and they delivered: Boole & Babbage, named
after the inventors ofthe mainframe computer and computer software,
respectively. It's hard to say if the company would not have been as
successful with a different name, but this illustrates, I think, that there
aremany important details when a company isgetting launched.
It was a time when IBM mainframe computers ruled the business
world, and one ofthe most successful ofall, the IBM 360 series, was com
ing into common use. Katch and Kolence had an idea to build acompany
thatcould provide software thathelped companies runtheir IBM com
puters better. Until then, most companies just wrote their own computer
code, so our company would simplify their use of IBM's mainframes.
Boole &C Babbage's founders also had the idea of packaging software
that enabled companies to measure the amount of time their comput
ers were running on a program. The software the company developed
helped its clients save the expense and uncertainty of writing the pro
gramming themselves. Another of their major products helped organize
the way printers, disk drives, and other peripherals are organized to
work with the mainframe.
I was alerted to whata good-sized company this could bewhen at a
Harvard Graduate School of Business alumni event I ran into a former
classmate and good friend named Spike Beitzel, who was by then an
executive vice president of marketing at IBM.
"You're competing with us," Beitzel told me.
I told him thatcouldn't possibly be true. We were too small to make
a dent in IBM.
"You're making it so people don't have to buy new computers until
much later," he said. He had a smile onhis face, but he wasn't kidding.
IBM was tough, and, unrelated to my meeting with Beitzel, their
salesmen began telling the customers that they had plans to bundle
some products like ours with their mainframes so they needn't buy our
stuff. IBM had set up a West Coast vice president for industry relations,
to whom we complained, and they stopped the practice.
Despite the hit Boole & Babbage took once IBM started recognizing
us as a competitor, the company kept growing, and as itgrew I learned
that there were limits on how well some founders can adapt as their
company grows. Kolence was the chief executive, but he didn't have the
executive skills to keep up with the company's growth. As chairman,
I decided, with the board's consent, to bring in an executive vice
president with management experience, aperson named Bruce Coleman.
Iguess it's not surprising that Kolence didn't like that. He fought itand
made the arrangement so difficult thatI had to invite him to my house
and tell him I was going to make a "pitching change." He actually
expressed relief after hearing the news.
Still, it's amazing how much difference new management can make
at a company such as Boole & Babbage. Sales and profits took off im
mediately after the change. But nothing is forever, and we had to make
another change in 1991, after one ofColeman's successors had runinto
trouble. He had built the company's sales force so big that sales costs
alone were higher than the revenues on several products. He had put
the company into unrelated businesses and had a compensation plan
that paid out $1 million in bonuses even though the company was los
ing money on $101 million in sales.
In this troubled environment, we named Paul Newton, already a
board member, as the new CEO, and Newton quickly turned around
those problems. By 1998, after sales had risen to $170 million a year,
he sold the company to BMC Software in an $887 million stock swap.
I was in that company 30 years. I made a strong return. Because of the
time involved, it might not have created the internal rate of return that
would satisfy someone who was investing on behalf of limited part
ners, but it was enough for my family. I wish I could have done more
to make that company a lasting leader in the software business, but by
any measure, the investment was a success.
Cloudy Vision
Not every investment turns out as successfully as Boole & Babbage did.
In fact, ithelps to have afailure or two or else you're just not trying. The
key question is what you learn from the investments that go wrong.
For me, the highest profile bust turned outto be VisiCorp. The com
pany started as a sort of partnership, forged out of Harvard Graduate
School of Business, between Daniel Bricklin, a programming genius,
and Dan Fylstra, who had more executive skills and also knew more
about marketing. The seeds of VisiCorp's demise, though, were laid
at the outset, when Fylstra agreed to sign a marketing contract for the
product but obtained no other rights improving it. The programming
was retained by Bricklin, through hiscompany called Software Arts.
VisiCorp had a great run at first. The company had one of the first
computer spreadsheet products, VisiCalc, which helped make the Apple
II a success, because it ran on that computer. It's fair to argue that
without VisiCalc, Apple wouldn't have had the early success it did. By
the same token, the decision by VisiCorp's founders tofocus on Apple,
when it was byno means clear that Apple would become for a time the
dominant personal computer brand, was a good decision.
The key failure with VisiCorp, though, was the company's inability
to control its future because it did not own the software program that
was at the heart of its initial success. VisiCorp tried to compensate for
this shortcoming but could never quite get over it. The lesson from all
this is that, in a market where constant innovation is the lifeblood of
success, it's almost impossible for a company to succeed if it cannot
control the key technology that will determine its future.
In VisiCorp's early days, the lack ofcontrol over new software devel
opment was not an issue. Its big program was selling, and no new prod
ucts were needed yet. By the time VisiCorp was two years old, in 1981,
it was selling more than 30,000 copies of its software each month.
Success like that wouldn't go unanswered, though, and a competitor
soon popped up. Mitch Kapor, a former VisiCalc employee, developed
an integrated spreadsheet, word processor, and graphing program that
essentially ate up the VisiCalc market. Kapor's product, Lotus 1-2-3,
became the standard almost overnight, and it also became a chief tool
by which the IBM PC and other compatible computers worked their
way into the workplace, thanks to their ability to accomplish calcula
tion-intensive office work with ease. Lotus 1-2-3 left VisiCalc in the
dust. Almost overnight, VisiCalc's sales dropped from 20,000 a month
in early 1983 to about one-tenththat amount.
Striking Back
We did all we could to save VisiCalc. Fylstra sued Software Arts for its
failure toupdate and improve VisiCalc. The company's developers moved
ahead ona new product that we eventually called VisiOn. And the board,
with my support, brought in a new chief executive, Terry Opendyk, a
former Intel programmer who had a toughness that no one else in man
agement could muster. Intel was famous for its confrontational culture.
Andy Grove, the chief executive there, liked to pit people against each
other. Hethought it brought outthe best inhis executive team, andthat's
the sort ofmindset Opendyk brought toVisiCorp. My view, too, was that
we needed to just begin developing a program thatcould run on theIBM
and its compatibles, and one that had to matchLotus.
We simply couldn't salvage the situation fast enough. The new prod
uct, VisiOn, pretty much failed. And, eventually, VisiCorp lost its place
in the market. The lesson from all this is that I don't want again to be
partofa company that does notcontrol its own product development.
236 * THE MASTERS OF PRIVATE EQUITY ANDVENTURE CAPITAL
Bob Noyce of Intel, the primary developer of the integrated circuit,

wisely declined to invest in VisiCorp as a startup for this reason.
Another basic revelation from the VisiCorp experience is the im
portance of matching the CEO, and the top management team, to the
challenges facing the company. Though Terry Opendyk at times was
probably rougher on people than he needed to be, he was the right
sort ofperson to go into VisiCalc and do whatever it might take to get
that situation under control. It wasn't his fault that the company just
couldn't getit done. I've been fortunate, really, to work with CEOs over
the years who were well suited to the tasks they faced, and Opendyk
was one of them.
The Tandem Approach

Fortunately, there are different styles to CEO success, and there could
not have been a bigger contrast in style than the one between Terry
Opendyk of VisiCalc and Jim Treybig at Tandem. What's interesting
to me as a venture investor and a student of management, is that both
styles work. The art we try to deploy asventure investors, when we are
called on to put a CEO in place, is in matching the right CEO to the
particulars of the challenges facing the company.
Treybig was founder of Tandem and one of those bigger-than-life
Texas characters. He pulled together a really strong team: a terrific
marketing guy, a strong financial guy, and different sorts of people in
hardware and software design. They worked like hell allweek, and on
Friday nights they would sit down for a few beers. It was a tradition
Treybig maintained even when the company had thousands ofemploy
ees and they needed special insurance in case there were any accidents
as people made their way home after a pop or two after work.
The idea was tohave a flat social structure, with openness toeveryone
in the organization, which Treybig probably brought with him from
Hewlett-Packard, where he had started in the computer business. Bill
Hewlett and David Packard were famous for sitting in the employee
cafeteria and leaving seats open at their table. Those places were
reserved for the rank-and-file workers who might want to sit down
with the bosses for a lunch, the sort of workers who had no other
casual opportunity to rub shoulders with the founders of the business.
Hitting the Plan

It would be a big mistake, though, to think Treybig ran a loose com
pany just because he had this informal style with his employees. The
business plan that he generated worked right from the outset. For five
years he was as close to his plan as I have seen at any company before
or since. He came close on profitability, on sales, on just about any
thing worth measuring. This was a guy who knew business and his
business, very well.
Treybig also was decisive, which is absolutely essential in a leader.
Not every CEO is as decisive as he or she needs to be. With one of
our portfolio companies, I went to a board meeting one time, and
the CEO said, "I've got three courses of action, which one does the
board want?"
That is a turn-off right there. I want to hear him or her say, "Here
is where I want to go. Here's why I want to go there, and here's how
I want to go there."
The board can always reject the proposal because they think the
company should do something else. Offering a choice of options to
the board, without a management recommendation, is not leadership.
Sometimes boards have to be led, too.
The Research Lifeline

Acompletely different sort ofleader, though just aseffective inhis abil
ity to spur innovation, was Alex d'Arbeloff at Teradyne. Along with
Nick DeWolff, a classmate at the Massachusetts Institute of Technol
ogy, d'Arbeloff had started Teradyne in 1960 based on the theory that
the computer industry would need high-precision testing equipment as
it moved toward mass production. D'Arbeloff was a boss, an old-line,
hierarchical type of leader. There was no doubt about that. And he
showed remarkable cool even though Teradyne's sales were, by defini
tion, highly cyclical. Semiconductor makers bought the products when
they were launching a new product line, but very rarely bought when
they were between product introductions or when sales slowed. Reces
sions hit the company particularly hard.
D'Arbeloff's big insight was that it was vital to keep investing in
product development, regardless of downturns in the sales cycle.
That way, when the cycle turned up again, Teradyne would be there
with the best products. It's hard to overstate how gutsy such decisions
can be. As I worked with d'Arbeloff over the years, I developed a deep
appreciation for the way he learned his lesson in the mid-1970s, when
Teradyne lost its leadership position to Fairchild Semiconductor be
cause it failed to anticipate the move to large-scale integrated circuits.
D'Arbeloff wasn't about tolet that happen again. Beginning in1976,
as the industry emerged from a recession, d'Arbeloff more than tripled
research investment, to$17 million. As a new recession set in beginning
in 1980, he bumped investment further, to $20 million a year, even
though earnings fell from $11 million in 1980 to $4 million in 1981.
The company lived for years off ofthe breakthrough research that was
launched during one ofthe darkest periods in Teradyne's history. Itsur
prised nobody thatd'Arbeloff had such a remarkably long-lived tenure.
He retired as Teradyne's chairman in 2000—after 40 years of service
to the company.
Staying Power
That sort ofstaying power is rare. It's a real anomaly. And, in a sense,
the way I have approached the business is out ofpattern, too. The ven
ture capital business has changed over the years, but I haven't really
changed with it.
After the dot-com crash of2000, when the venture market came back,
it came back ina different form than previously. It became a big money
management business. All of a sudden, there were several multibillion-
dollar funds. This has changed the mindset of entrepreneurs, too.
They don't wantto start a company unless they canget$10 million to
$20 million in backing. The venture capitalists, because they're running
so much money, have got to make big deals, too. For them, a bunch
ofsmaller deals just cannot add up compared to the huge fund they've
got. I'm not sure that's healthy.
Myfirm, Asset Management Company, manages just$60 million in
its latest fund. With all our equity holdings, including companies such
as Amgen that I have held for decades, we have about three to four
times that under management. It might sound like a lotto most people,
but it's not. In this business, in Silicon Valley, we are small, and our
family capital is small, but I don't feel small because by any rational
measure we are not. More importantly, though, it's because the nature
of the business is so rewarding.
What I like about the business now is that it has gone back to the
basics. If anything good has come out of the turbulent economic times
that started around 2007, that return to the fundamentals is it. Instead
of focusing on building larger and larger funds, venture investors are
back to starting companies, finding people with breakthrough ideas,
and helping them succeed.
Before the dot-com crash in 2000, something had just gone wrong.
People got short-term greedy. They came into the business for the
quick-hitting part of it. They had no intention of really innovating, of
taking a big idea and building a company out of it. The entrepreneurs
set out to make fast money, they got backers, and they succeeded. Ev
erybody had a share in it: the entrepreneurs, the investment bankers,
the venture capitalists. There were plenty of Porsches rolling around
here that were the result of those deals, and guys built big houses and
got out of the business.
I'm not talking about the Yahoo founders, or Google, or all these
people who built real companies and made great money doing so.
I believe in that. But I think that we paid a price when that bubble
collapsed in 2000. It set the business back, and it had a lot to do with
the quick-hit people. We are in tough times again, and it is difficult to
getliquid even when we build successful companies. We and others are
doing deals in this slow time because by the time these new companies
grow, we think the market for their stock will come back.
Entering New Markets

What such people lose sight of, or what they might never get to know,
is how the process of fostering innovation helps to create new economic
opportunity. I'm a pilot, and I fly my plane four or five times a year to
eastern Europe to help people start businesses. I helped start funds in
Russia, Poland,Romania, and the Czech Republic, but you don't haveto
travel that far to getinvolved in start-ups that still mean a lot because the
people involved are making products they believe in, building marketing
plans, and adjusting to the signals the marketsends.
The market moves fast, and you've gotto be prepared to move with
it.Ifyou don't, you might miss the next big wave. I totally missed the so
cial networking thing. Maybe age was a factor. I don't text people; I still
send e-mails. I've got some younger people who work with me, and they
missed it, too. Maybe we just weren't paying enough attention.
Innovation does not always have to be a world-changing new de
velopment the way Google was, or the way social networks such as
Facebook or Twitter are becoming. Sometimes, it's as simple as just
making changes to a product or listening to market signals, lining up
your company with what the market demands. Sometimes it means
backing a person who is just a really committed, creative chief execu
tive. The reward from venture investing comes inwatching thatperson,
and the business, grow.
One of my favorite recent cases is a company we are invested in
nowcalled HerInteractive. I gotinvolved in thecompany justas it was
starting out, in Albuquerque in the 1980s, and it was called American
Laser Games. They were making training films for cops. These films
presented police with situations where they had to decide to shoot or
not shoot. A cop is in a garage where he sees a guy trying to break
into a trunk. The cop challenges the stranger. The guyreaches into the
trunk, and the cop has to decide whether or notto shoot. Inone ending,
the guy is justchanging a tire. In the other, he's got a gun.
What nobody expected was that a guy in the Middle East ordered
one of these, just to play with at home. Based on that, the then-presi
dent ofthe company, Bob Grebe, thought we could make a product for
the arcade-game market. Grebe got it right. This was at the height of
the arcade boom, and we had manytens of millions in sales. Then the
arcade business died. PC games came along and killed it—and almost
killed the company, too. We had to file Chapter 11.
Somewhere along the line, Grebe had licensed the Nancy Drew
name from Simon &c Schuster, publisher of the books. While we were
in Chapter 11,1raninto some people at Microsoft who hadgreat pro
gramming skills that Microsoft had little interest in developing. We
decided to move Her Interactive to Seattle, but we needed leadership.
Wemet a turn-around guynamedJan Claesson, formerly of Microsoft.
Just to check Jan out, I called Steve Ballmer, Microsoft's president,
whom I knew from when he was a business-school student at Stanford.
Steve said that Claesson was a very strong leader, although "too
tough for us." He said Claesson was just the guy for the job I had
described, "as long as you don't mind how many Marines are left
lying on the hill."
That was the most unusual positive recommendation I ever heard.
It was particularly surprising coming from Ballmer, who's not exactly
a soft touch. Claesson earned the recommendation, though. He turned
the company around and used our Nancy Drew license to get us going
into that market, mostly for girls. He also did it without leaving too
many casualties from the company behind.
Embracing Uncertainty—and the Future

With innovation, you've always got to be prepared for change.
Claessoncompleted his turn-around duties by suggesting we promote
our creative director, Megan Gaiser, to the presidency, and this goes
backto something I mentioned rightat the outsetabout steelmaking—
the need to, once in a while, make a decision based on incomplete
information.
Gaiser had started her career as a documentary filmmaker. She had
gone to Microsoft and worked on its first interactive-only product,
a program called CarPoint. Claesson had brought Gaiser over from
Microsoft, and she was the one who really understood the potential of
theNancy Drew license. Gaiser's idea was to keep Nancy Drew whole
some, as she is in the books created by the writer Millie Benson. The
mothers would buythese games a lot, and theywanted their daughters
to have a wholesome experience. Gaiser understood teenage girls better
than most any adult. She knew that they like cooperative games and
they like sitting in groups and working on puzzles. That cooperative
effort is exciting for many girls.
As Claesson was putting that gender-sensitive stamp on the product,
we all had to keep in mind that we were a company that had just been
through bankruptcy. I was pretty much theonly venture money behind
it. We had to keepcostsdown—spend $100,000 to develop a game, not
a couple million. The trick was having a few people, not a big organi
zation, and just those few dedicated people who love gaming working
hard and efficiently to design these fairly simple games.
Innovation, in the end, really does go back to what I learned at the

steel mill. Her Interactive was notsome great beam that became partof
the structure of the neweconomy. It is a game, a diversion—a decora
tion of sorts. It won't change the world, but it does make customers
happy. It is a good business for a handful of dedicated people to run.
It lets young girls use their brains to solve a mystery in a wholesome
setting. Perhaps the greatest innovation was the hunch that it might
make sense to use technology to introduce thatgreat character, Nancy
Drew, to a newgeneration of young women. That entrepreneur's hunch
is now helping Her Interactive to become a growing, profitable leader
in its field.
Ifinnovation, even on that small a scale, canbe plenty fulfilling, just
imagine how rewarding the big breakthroughs can be.
LESSONS FROM PITCH JOHNSON

<^> Act on incomplete information. Aperson will never have all the
information one would want when making investment decisions.
Get the essential data, and then trust your gut and forge ahead.
<|> Match the people to the challenge. The brightest ideas are nothing
without the right people working in the right waysto bring them
to market.
Control your key technology. A company that does not control its
core technology cannot control its future.
<$> Size is not everything. It does not require a billion-dollar fund for
a person to make a big difference in promoting innovation. In fact,
smaller can be better.
*3> Be patient. Don't be driven by short-term exit strategies. Innovation

can take time before it really pays off.
12
RISK, THEN REWARD:

MANAGING VENTURE
INVESTMENT IN RUSSIA
Chairman and CEO
AUM: $44? inillion Years in VC: 37

Location: Moscow, Russia Year born: 1942
Grew up: PollockPines, CA Location born: San Francisco, CA
Best known deals: DeltaCredit Bank, INTH (Russia Channel 3),
Lomonosov Porcelain, Tessera Technologies, AgouronPharmaceuticals,
Centocor, Biocompatibles International, PPL Therapeutics P.L.C., which
cloned Dolly the sheep
Style: Intellectuallycurious and goal oriented
Education: B.A.,San FranciscoCollege for Women, Class of 1963
M.A., M.I.A., Columbia University, Class of 1968
Significant experience: Peace Corps, Patricof 6c Co. Ventures, which
became Apax Partners, Deputy Administrator, U.S. Small Business
Administration
Personal interests: Former competitivedownhill skier, hiking,

gardening, reading
The lesson: "Never micromanage."
243
Ina career that made her one of the first female partners ofa major venture
firm, Pat Cloherty saved her most audacious first for last: moving toRussia,
where she currently still resides, to run Delta Private Equity Partners9
$449 million portfolio of investments. In Moscow, she has deciphered
opaque balance sheets, jousted with unscrupulous orimperious negotiating
partners, and onceeven hired bodyguards after a dealbroke down.
The move to Moscow, initially necessary to turn around Delta's
troubled first investment fund, now isturning in exemplary results. Delta's
portfolio companies have introduced mortgages and credit cards to Russian
consumers, brought better programming toRussian television, and helped
modernize Russian retailing. Lessons from Cloherty's experience can equip
investors and managers doing business inRussia orany developing market
where the rules are notallwritten and the risks notquite known.
In 1994, when the U.S. government first asked me to help launch

a new venture capital business in Russia, I was at Apax Partners,
doing a good business in mainly early-stage science and technology
companies. I had not been to Russia and didn't speak the language.
While I thought it was a good idea to lay the seeds of actual, free-
market capitalism in Russia, it had never occurred to me that I would
be the person to do it.
I got involved, tentatively at first, by joining the board of the U.S.
RussiaInvestment Fund, whichwas formed pursuant to the Support for
East European Democracy Act of 1989 as part of foreign development
assistance to the former Soviet Union and its former satellites after the
fall of the Berlin Wall. I joined the board as a pro bono director while
still at Apax, from which I retired in2000. Frankly, though, the group's
first dealtaught methat therewas no wayto be tentative about any as
pect of doing business in Russia. The board and staff had committed to
an $8.2 million investment in Dieselprom, a company that waslicensed
to make Daimler-Benz diesel engines in Russia. There was no system
for transferring funds to Russia yet, so the staffsent the first payment,
$850,000 in cash, by courier in a plain black suitcase.
The briefcase was never seen again. Nobody likes to lose an entire
investment, but at least the money usually gets to its intended destina
tion before it disappears.
risk, then reward • 245
I did not take this loss as an omen. Instead, I figured, with a start
like that, there was no way to go but up. Certainly, the economy and
business practices would both take shape.
I have done interestingwork in my career. Together with Alan Patri
cof at Apax Partners, we initiatedthe East Coast branch of the venture
capital industry. Though we eventually would build Apax to $10 bil
lion in assets under management by the time of my retirement in 2000,
at the outset in the early 1970s we were helping to invent the new in
vestment discipline now known as venture capital.Nearly three decades
of such work gave me the tools I would need to succeed in Russia or
anywhere, but so wouldsome of the odderexperiences in my life. There
was the time I got death threats while working at the Small Business
Administration, of all places, because I was investigating alleged im
proprieties in an agency program. I have backed dozens of companies,
ranging from dollar stores in the West to the Scottish company that
cloned Dolly the sheep—proof, I like to think, that I am open to chal
lenge and opportunity, no matter where it comes from.
All of the experiences of a 30-plus-year careerin venturecapital gave
me the technical know-how, appetite for risk, and long-term perspec
tive I would need to navigate as a venture capital investor in Russia.
Yet, in some ways, none of my prior work fully prepared me, either. To
succeed in one of the most unpredictable, laws-in-process, and capital-
hungry countries on Earth, I wouldneed to adapt and improvise or risk
causing Delta Private Equity Partners' two funds to losea lot more than
a suitcase full of cash.
What I have learned so far—and particularly since I moved to
Russia in 2003 to work full time in making Delta Private Equity
Partners a success—offers lessons about the risks and potentials for
investing in foreign markets. Attack the challenges aggressively, but
with due care and thought, and the returns can consistently outper
form those from less risky, more mature markets. But, misplay the
risks of politics, economics, culture, and business, and you can run
into serious trouble.
After all, the Russian private economy is young—less than 20 years
old. It still is influencedby a smallgroup of powerful oligarchs. Although
mobsters and corruption still exist, they are lesscommon problems than
they were in the 1990s. There are signs,in fact, of a developingmaturity.
I have been threatened only once, andafter that particularly unpleasant

meeting I hired bodyguards for a brief period. The rule of law is still a
goal but it isstarting to takeshape. TheVladimir Putin-led government,
more predictable and sensible than one might expect from reading the
Western press, has been a positive influence in nearly every aspect
of business.
Rules for Russian Investment

In Russia, one has to be flexible and yet disciplined, much as one
has to be in the Peace Corps, for which I served in Brazil in the early
1960s. What works in more developed economies may not work in
Russia, and vice versa. In many ways, I have consciously chosen to
modify the rules that have led to success in the United States and other
developed economies. For example, I have certain sectors I almost
always avoid in mature economies: no food, no clothing, no shelter,
no feature films.
So, where have we invested successfully in Russia? Food, clothing,
and shelter, for starters. We like financial services, consumer products
and services, and media and telecommunications, but not technology,
as there is no enforceable intellectual property protection in Russia.
We also steer clear of the 42 areas deemed "strategic" by the govern
ment, for obviousreasons. Onlyfeaturefilms are nonstarters, no matter
where in theworld I do business. Someone somewhere mustbemaking
money by makingmovies, but not me and not many investors, as far as
I can tell. To me, films are frequently vanity projects, not investments
for profit-driven people. And vanity projects are out, no matter where
in the world our investors' money goes.
Russia has other obvious areas to avoid investing in. Early-stage
science and technology is one such area. As in most developing econo
mies, people tend not to understand intellectual property yet, and the
important IP cannot be protected in the absence of an informed judi
ciary. Investments that are dependent on technological innovation are
subject to piracy or other forms of theft in the absence of enforceable
proprietary rights.
While some practices are unique to Russia, other approaches that are
standard in the United States serve us remarkably well in Russia, too.
RISK, THEN REWARD • 247
For example, micromanagement should always be avoided no matter

what the geographiclocation of an investment. Micromanagement leads
you to back weak people, because you think you can always control a
situation. You can't. Get the strongest people possible, and let them
perform or not, as the case may be.
As a rule, we avoid single-product companies, because they can be
put out of business too easily by forces out of their control: a spike
in commodities prices, a new competitor, any sort of major surprise.
We also stay away from husband-and-wife management teams. Busi
ness is hard enough without the marital relationship adding complex
ity. Oh, and one more—never say "Oink." Remember the old adage
that "Pigs get fat, hogs get slaughtered"? It's true. Be satisfied with a
reasonable profit. There is more risk than reward in holding out for
every last penny.
The Call to Moscow

Years of on-the-ground experience give one guidelines for any com
plicated market such as Russia. My own Russian experience started in
1994 with a call from the White House Personnel Office. They were
forming a private board of directors to oversee an economic develop
ment assistance program initiated by congressional statute in 1989 as
the Berlin Wall fell. In an effort to open private markets in formerly
centrally planned economies, the U.S. government was experimenting
with introducing a series of financial tools: equity investment, debt,
insurance, guarantees, technical assistance, and training. This effort at
jump-starting entrepreneurship had started in the former Soviet Block
countries—Romania, Hungary, the Czech Republic, the Baltic States,
and so on—with mixed success.
In 1994, Congress extended the program to include Russia, and the
Clinton Administration needed a private, volunteer board of directors.
The fit sounded farfetched, at best.
"Russia?" I said to the friendly sounding voice on the phone from
the White House Personnel Office. "You have got to be kidding. I have
never been there, and I don't even speak the language."
"They told us you would quibble," said the recruiter.
"Quibble?" I said. "This seems material."
248 ® THE MASTERS OF PRIVATE EQUITY AND VENTURE CAPITAL
But I accepted the seat as a form of unpaid public service while

continuing to make my living at Apax. With other colleagues in
business and finance, I would bring my expertise to bear on
a project that sounded well intentioned, even if the other board
members had no more experience in Russia than I did. There were
no clear guidelines, but the general thrust was clear. An unpaid
board of financiers and business people would start up some sort of
development venture, get it staffed with locals, and, once the market
talked back, form a private successor organization. There was no
formal exit plan, other than the board's listening for the market to
talk back, to tell them what might work, and when it was time for
Uncle Sam to call it quits.
There was room for improvisation and, as experience showed,
a fair chance of failure. In the Czech Republic, the program failed,
and in Central Asia the money disappeared. Mainly, though, there
were successes that gave testimony to the creative spark that a bit
of capital can ignite. In several of the Baltic States, the program
evolved into mortgage lending. In Romania and Albania, the pro
gram midwifed the creation of investment banks. In Hungary, it
led to a fellowship program. In Poland, the U.S. investment had
by far its biggest early success. Starting with $260 million in 1991,
the fund made several successful investments and repaid the initial
capital after about six years.
The U.S. Russia Investment Fund began later, in 1995, with an ini
tial commitment of $440 million from the U.S. government of which
$329 millionwas actually put up beforethe program was "zeroed out,"
in government language. From the start, the board decided that an
important focus would be the financial services sector. Any economy
needs that, of course, and we would work hard to make it happen.
There was another aspect of our work that became a continuous theme
throughout: the introduction of good governance practices and rational
business structures into the Russian economy.
The fund ended up putting $329 million into 44 Russian companies,
and by early 2009 it was almost 50% ahead of value at inception in
1995. The $120 million successor fund formed in 2004 has invested
in 11 more companies, and by early 2009 it had a net internal rate of
return of 209%.
risk then reward • 249
The "Transparency Premium"

One of our first important deals, a television network, came to us
through an American expatriate living in Moscow by the name of Peter
Gerwe. His project illustrates the work we had to do on governance in
most of our deals. In 2005, Peter came across an opportunity to buy
television spectrum. He had a theory that commercial television was
about to take off. The idea sounded promising, but it would take a real
turnaround to make it work. The station had been managed by an old
Sovietapparatchik. He would talk and talk and never take a breath to
listen. He had done nothing to make the programming worth watch
ing, and the studios were dingy—dirty old carpets hanging on the walls
were their less-than-optimal way of improving the acoustics.
The management structure of the stations was just as decrepit as the
physical space. The place was run by a sort of "workers' council" sys
tem that traced back to the Soviet era as surely as the rugs on the walls
did. It had no board of directors and no financial discipline. We created
a board that included seasoned Hollywood types and introduced the
concept of working with other people's money. In other words, there
must be accountability, controls, planning, and execution. Only after
those structures and systems were put in place did Peter's network, or,
really, any of our businesses, have a chance.
Once we got the governance structure in place and put our money
in, Peter and his team went to work making Channel 3 a success. They
began showing soap operas from Mexico and Brazil,pretty torrid stuff
but popular right away. Before long, he was achieving $25 million a
year in net cash flow.
By 2006, we prepared to exit the investment and hired investment
bankers to list the company on the London Stock Exchange. Many
companies in Russia do very little public disclosure, so it is difficult to
determine value. In this case, though, we had very detailed financials—
annual audited financials—of the parent company, INTH. We never got
to market. One of the local pools of capital approached us and offered
a price that was $100 million higher than the high end of the range our
banker had estimated for the initial public offering, with no lock-up, no
market risk, and virtual assurance of antimonopoly approval.
We had a board meeting, and one of the members, a Hollywood
producer, asked, "What are his metrics?"
"Well," I said, "I don't think he's in the back room with his Hewlett-
Packard calculator crunching the numbers, if that's what you mean."
It was clear to me that this pool of Russian investors wanted the
television station, and price was not the issue. This is another revela
tion about how business works in Russia, not to mention an important
consideration for venture capital investors doing business there. For
purposes of exiting the investment,the public markets have been almost
irrelevant in Russia, eventhrough today. In recent years, multinational
companies looking for strategic investments have competed with oli
garchs, the wealthiest families in Russia, to purchase well-conceived
and well-managed companies. Even when a company does register for
an IPO, it often sells to a private investor first.
This liquidity phenomenon has been unique to the Russian market.
Liquidity is the key consideration for venture capital investors any
where—the ability to exit from an investment. Before we put money
into a company, we plan how we may sell it. In the United States, the
public markets are generally part of that planning. In Russia, there is
plenty of capital, but the public markets are virtually irrelevant, with a
dozenmajor players accounting for the bulk of trading. Thus, we placea
premium on working with the local pools of capital and with the multi
nationals and evenpayingcloseattention to our own management teams,
who sometimes have shown an ability to arrange their own exit events.
We sold INTH to ProfMedia, a local media group, for $400 million,
or 14.3 times our cost. I believe a lot of that success was due to the
transparency in the numbers of the company. Many Russian compa
nies are opaque. Either they don't publish meaningful numbers or the
numbers they do publish are not reliable. We have worked hard to de
velop a reputation for transparency, and I believe we get a premium, a
transparency premium, of at least 10% on our deals, sometimes more.
On the INTH deal, it was bigger than that.
Out of the Mattresses, Into the Banks

Even as we were learning through our experiences with Channel 3 to
introduce corporate governance practices into our portfolio companies,
we were hard at work on another other major charge from the U.S. gov
ernment: expanding and deepening the Russian financial services sector.
RISK THEN REWARD • 251
To get our bearings, we hired a consultant from Barclays in the mid-

1990sto assess the country's banking capabilities at that time. He looked
at some 200 of what were called banks but in fact were mainly money-
laundering operations or outfits setup for "tax-optimized" cross-border
trading. These same issues showed up across industry sectors as tax
schemes were the norm, not the exception.
As we dug deeper into the financial services sector, other questions
arose. For starters, there was no history of consumer credit in Rus
sia and little faith in banking at all. Russia was and still mainly is a
cash economy. People kept their wealth—what wealth they had at this
point, anyway—in their mattresses. In most economies, people need
mortgages to buy homes, but Russia was different. After the Soviet
system dissolved in 1991, the citizens of Moscow, 11 million people,
were given the chance to buy their flats for anywhere from $25 to $50
each. People didn't need mortgages because they could just save and
buy their apartments.
The challenge, then, was to demonstrate to Russians that banks
could be safe and that credit, well-used, could make their lives better.
At one point in 1995, I suggested to our staff on the ground in Mos
cow that perhaps we should consider a joint venture with the Russian
Orthodox Church. They own property, they handle money, and, after
all, they're a church.
One of the women there, a mortgage specialist, said to me, "Pat,
I don't think the Russian people will trust the church."
"Let's form some focus groups," I said. "Let's go and find out who
the Russian people will trust with their money."
After a few weeks, our mortgage specialist had her answers. She had
been correct. Russians did not trust the church, but there were two
groups they would trust with their money: intellectuals and foreign
banks. Given that Russian history has produced the likes of Dosto-
evsky, Tchaikovsky, Sakharov, and Sozhenitsyn, I felt we would have
a difficult time persuading the populace that we were intellectuals. The
other option immediately felt more obtainable.
"Well, we're a foreign bank," I said. If we could pilot a bank, we
could measure and adjust to consumer response.
While we worked to start two banks, we also were investing in a
diverse array of other companies. Although we had indeed lost that
$850,000 that disappeared en route to Moscow, we did not let that

stop us. We backed a department store in Moscow, a newsprint
company, and a company that sold bottled springwater, among others.
We were beginning to collecta cohort of Russian entrepreneurs—some
of them old timers from the Soviet era, but others younger and more
entrepreneurial-minded businesspeople. We also found we had to turn
down a fair number of Americans who thought the fund had been
created to back Americans in Russia, irrespective of deal or business
quality.
Peter Gerwe at Channel 3 was an exception among the Americans
who applied for financial backing. After all, he had lived in Russia
much of his career, and he had a very solid business idea. There were
others. We invested chiefly in Russian entrepreneurs, but we felt the
purpose of the fund was to encourage high-quality private entrepre
neurship in Russia, whatever the nationality of the entrepreneur.
The Upside of Economic Crisis

As we were getting deal flow started in these years, the 1998 economic
crisis occurred, triggered by Russia's defaulting on its sovereign debt.
Alongside the dramatic downturn that hit the global economy in late
2008, the economic breakdown that came to a head in Russia in August
of 1998 was the most serious crisis in the country's modern era. Seven
years after the collapse of the Soviet empire, the country's balance of
payments was in shambles. Oil prices, a chief engine of the economy,
were near historic lows. The country was effectively bankrupt, and the
ruble collapsed.
But, in the same way that a forest fire can bring new growth and,
ultimately, a healthier ecosystem, the 1998 crisis had a cleansing effect
on the Russian economy. For starters, as hard as the collapse was on
individual citizens, it wiped out fewer than might have been expected.
In this instance, Russia's cash-in-the-mattress economy protected some
people from complete catastrophe. And, because some people stashed
that cash in U.S. currency, not rubles, the ruble's collapse actually gave
many people more buying power. In the business sector, the crash
wiped out the speculators, carpetbaggers, money launderers, and others
who really were not contributing to the economy. In the real economy,
RISK THEN REWARD * 253
import substitution began on scale, yielding a crop of new companies

that grew into the decade that began in the year 2000.
For the U.S. Russia Investment Fund, this palliative impact was not
immediately evident as the 1998 economic crisis hit. By that point, we
were invested in some 20 companies. Many were weak, and one bit
the dust immediately: Frank's Siberian Ice Cream. The entrepreneur's
main problem was that his inputs were denominated in dollars and his
customers were paying rubles for their ice cream. A company set up
like that cannot overcome the collapse of the revenue currency. It took
about five minutes after the ruble collapsed for Frank's business to go
into the deep freeze.
Dieselprom—the company where the U.S. Russia Investment Fund
lost that initial $850,000—didn't make it, either, nor did a radio paging
company in which we had invested. We learned much, though, from
two pharmaceutical distribution companies that failed. When we did
the postmortem on these pharmaceutical companies, we came across
a pattern that had become all too familiar in Russia: an organization
chart filled with subsidiary companies, offshore entities, and other tools
Russian business people tend to favor when they are trying to avoid
taxes or to take money out of a company. In fairness, sometimes those
structures are built to protect against such financial maelstroms as that
of 1998 and, indeed, 2008. More often than not, though, there are
other reasons.
Baleful Boxes on the Organization Chart

In 2004, we hired Price Waterhouse and Russian customs and tax
experts to develop templates of the illegal structures most commonly
used by Russian businesses. They graphed six basic schemes, most
of which involved corporate entities in obscure jurisdictions—Belize,
the Seychelles Islands, places like that. The operators who run the
Russian-based companies place all their corporate liabilities into these
dummy companies, and then bankrupt them. Other offshore units may
be fronts used to siphon off money or, worse, for businesspeople to
launder their funds.
It would be easy to write this off as a sign of runaway corruption
in Russia, but as I grew to understand Russia better, I also began to
understand why the Russians sometimes set up their businesses this

way. After the Soviet Union collapsed, the economy was in transition,
and no one had a job. There were no banks or other sources of capital
to finance companies. Equity markets were nonexistent. The most ef
ficient way for a business to raise capital, even one that wanted to be
legitimate, wasto keep funds out ofthetax system. Instead of reporting
income and paying taxes, they set up boxes on their corporate orga
nization chart to use the money that would have been paid to Mother
Russia in taxes. The objective was to help their companies grow, in
stead. That's how relatively legitimate operators saw things. The bad
ones? Who knows what they did with their money.
The boxes have another effect. In resource-intensive industries, they
create a temptation for operators to strip off the best assets and leave
just the shell of a company behind. Especially in the 1990s, Russia was
rife with people making money bystripping assets rather than devising
sustainable corporate strategies. We have tried to avoid such compa
nies, mainly by staying away from resource-intensive industries.
This box system of corporate structure, much of it driven by tax
gamesmanship, has an insidious effect on Russian industry. It makes
it impossible for a Western company, certainly for a U.S. company, to
finance a Russian company that has dozens of strange organizational
units in exotic locations. It is a fiduciary risk, for starters, because there
is no way to track cash. It would be an invitation for trouble under the
Foreign Corrupt Practices Act and the Patriot Act, too.
This problem is serious enough that I wrote Dmitry Medvedev when
he became president and suggested that he establish a tax amnesty for
all companies with less than $100 million in sales. This would bring
these companies in from the cold and ultimatelylead to growth because
they suddenly would be eligible for financing by institutions that would
never touch them today.
The 1998 crisis reinforced something we already knew in trying
to grow companies in Russia: the basic tools and understanding of
business still are in utterly short supply. To address this, we created
a Center for Entrepreneurship as a way to introduce best practices.
We in-licensed intellectual property from the Ewing Marion Kauffman
Foundation, which has developedextensivematerials designed to teach
novice businesspeople how to manage cash flow, value their companies,
hire and keep key people, and the like. Along with Ernst &C Young in
Russia, we started an Entrepreneur of the Year Award program, which
has become a major event in the Russian business community and a
way to create positive role models in a place where so many less than
positive ones exist. The program also serves as a key networking and
talent-scouting tool for our fund.
While all these positive effects emerged from the 1998 crisis, one par
ticular result impacted our fund concretely: J.P. Morgan, theU.S.-based
banking giant, fled Russia after the 1998 crisis, along with many oth
ers. It surrendered a clean bank license to the Central Bank of Russia.
We took over that license, and soon were in business with DeltaBank,
our consumer credit bank, and DeltaCredit Bank, our mortgage bank.
Charging to the Future

Opening the banks involved introducing Russians to what, for them,
was a new concept: consumer credit. Russia had not yet been exposed
to the joys and sorrows of credit cards, but they certainly were ready
to learn. With the economy rebounding slowly, showing fundamental
growth for the first time in generations, consumer demand, something
that was nonexistent for 80 years, became real.
The business challenge for DeltaBank was to introduce this concept
and grow it quickly into a business, and the best way to do that was
to partner with an established brand. Ikea, the Swedish retailer, be
came our partner for this strategy. Ikea for years had sourced product
from Russia, and as part of its international expansionit choseto build
stores in Moscow, among other venues. The stores were immediate
hits. I say it somewhat jokingly, but it is actually pretty true that most
Russian citizens would rather choose a sofa than choose a president.
Until recent years, they neverhad beengiven much of a choiceon either
issue. They had never had consumer choice, much less seen affordable
consumer goods such as those at Ikea, and they began trading up, in
cluding with their apartments.
DeltaBank worked a deal with Visa to offer Visa-branded cards in
side of Ikea's megamall on the outskirts of Moscow. I'll never forget
stopping in that store—a beautiful big-box—on my way to the Moscow
airport in September 1999. Signs said: "What is a credit card?" Yellow
256 * THE MASTERS OF PRIVATE EQJJITY AND VENTURE CAPITAL
lines onthe floor led customers to DeltaBank clerks who explained the
concept to them. Visa provided instant credit—$20 credit lines for first-
time borrowers, a decent chunk of money in Russia at the time. The
Russian consumer and the credit card began to take off, but on a very
conservative basis, as appropriate.
A Career of Broken Barriers

Forme, personally, the workin Russia—helping to create newmarkets,
introducing new governance structures, identifying andnurturing man
agement talent—was a challenging and rewarding chapter in my pro
fessional life, especially considering how late in life I happened across
it. I came of age at a time before women were common at the top of
business. I was part of a cohort of other women who sometimes found
ourselves breaking ground with each forward step. I did not see this as
a mission of mine. I was not a "women's libber" in that sense. But I did
find thatI would have to break old patterns and even be a bitpushy ifI
wanted success in business. And I always have supported other women
in their professional development.
I was raised in Pollock Pines, California, a small logging town near
Lake Tahoe. My Irish immigrant father had started his own career at
age 11 as a messenger for the Southern Pacific Railroad in San Fran
cisco. He later worked mainly as a logger and construction worker.
My mother came to the United States from Canada. She sold some
real estate and served on the local school board, all the while being a
wheelchair-bound invalid with serious rheumatoid arthritis. Like many
immigrants, myparents valued education, even thoughtheyhad littleof
it themselves, and had an utter dedication to accomplishment.
Learning always came easily to me. I won scholarships and fellow
ships, skipped a grade, and went to San Francisco College for Women
on a California state scholarship. I loved it. Scholarship holders who
hadinterests in areas not taught at thecollege could have private tutors,
so I had a private tutor in classical Greek.
I joined the Peace Corps soon after President Kennedy launched the
program and quickly found myself hybridizing tomatoes and castrating
pigs in Brazil. Before long, I won a Ford Foundation Fellowship in
International Economic Development and attended Columbia
University's School of International Affairs. I completed two master's

degrees and was heading for a doctorate in 1968 when student protests
shut down the campus. Rather than deal with riots and disruptions on
campus, I went to Cuernavaca, Mexico, and ran seminars for political
exiles from Chile, Brazil, and other Latin American countries. When I
ran out ofmoney, I called home, got my mom towire funds to me, and
returned to New York.
Launching into Venture Capital

By chance in 1969, I met Alan Patricof, a well-established figure in
finance, who was starting something called a venture capital fund.
"Do you want to learn the business from the bottom up?" Patricof
asked me. The answer was "yes." Only later did I learn that particular
turn of phrase was Patricof's code for not paying me much... until
I understood the concept of "carry." My payoff would not come from
salary, I learned; it would come from my share—my carry—of the net
capital gains achieved from the sale of the companies we invested in.
Once I learned that, I was on my way.
The start-up work at Patricof & Co. Ventures was excellent prepa
ration for what I eventually would do in Russia. We started in 1970
with only $2.6 million under management and several clients on re
tainer and one office. When I left in 2000, the firm had $10 billion
under management in five countries. By then, I had done dozens of
deals. More than that, though, we were able to pioneer in the venture
business, shaping the rules and regulations as we went, as I would be
called to do in Russia years later. For example, in the 1970s institu
tions generally did not invest in venture capital as an asset class, so
we raised $2.6 million from nine wealthy families: the Lehman fam
ily, the Motts from General Motors, people such as that. We would
commit our small fund to a deal, and then each individual investor
would decide on the investment, deal by deal. This forced me to truly
understand the investment case for each deal before presenting it to
this group of highly intelligent, sophisticated people.
It was during those early Patricof days, in 1977, that I got a call
from the White House about the DeputyAdministrator position at the
SBA, a political appointment. I took the job out of political interest.
The SBA is one ofthe most political agencies inWashington. Itrepresents

all the small businesses on Main Street, not those on Wall Street, and
every lawmaker on Capitol Hill wants that large constituency served.
I had to focus much time on preferential loans to a range of legally
defined disadvantaged groups—African Americans, Eskimos, Aleuts,
women, Vietnam veterans, and so forth.
I will never forget one SBA experience. We were cleaning up one
of the agency's portfolios, foreclosing on loans that were far past due,
when we took a look at the foreclosure of a defunct pencil company
run by the Blackfeet Indians in Montana. At about the time that the
foreclosure notice on their $350,000 loan arrived, tribe members had
simultaneously received per-capita payments pursuant to agreements
related to subsoil mineral rights from the Bureau of Indian Affairs of
the Interior Department. So, they hired a 747 airplane to fly everyone
to Washington to discuss the matter withme. Everyone came!
The sole-source set-aside program frequently was a magnet for po
litically, not economically, based requests. The 95 field offices of the
SBA bore the brunt oftheburden. Only special cases arrived at my desk
for handling. I left the SBA after two years with great fondness for the
agency, its people, and its mission. At the time, though, the Administra
tion wanted us to put out another $2 billion in sole-sourced contracts
for a program about which I had serious misgivings, so it was the right
time to leave.
Lessons to Invest By
After the SBA, my then-husband and I partnered to form a company
with a scientist from AT&T's Bell Laboratories and his wife. We
secured a license from Bell to the technology to make high-precision
optical fiber connectors. The scientist, Jack Cook, was a waveguide
guru. He initially wanted to invent a passive optical switch, but that
research alone might have cost $100 million and the technology was
not proven. Instead, we chose to make the connectors, which had
immediate commercial potential.
An experience from this company has stuck with me. Jack had a re
search colleague from Bell Labs who joined us, but after a few months
he was questioning his decision.
"Pat," he said, "do I understand this correctly? We are going into

business to make something we already know how to make?"
I told him that's generally the way business is done: You know how
to make something, and you do so. For him, though, his mission was
different. A true scientist, he wanted to advance scientific knowledge,
not refine fiberoptic connectors for commercial use. It was an impor
tant moment of self-knowledge for him and for me. He went back to
the research bench, back to work he enjoyed. Jack, his wife, and I ulti
mately sold the company successfully to 3M. The Cooks went to New
Hampshire to run a charity, and I had real money for the first time in
my life.
I rejoined Patricof Ventures as a partner, a coming home of sorts,
as Alan and his wife, Susan, have been family to me since the early
1970s. The timing of my decision to rejoin Patricof was fortuitous.
A 1979 regulatory decision changed the "prudent man rule" under
the Employee Retirement Income Security Act rules of the Labor
Department to enable pension institutions to invest in venture capital
for the first time, without personal liability for the trustee. Our firm had
begun to expand overseas in 1974, partnering in the United Kingdom
and France and laterin Germany, Israel, andJapan. I resumed my pre-
1977 activities, backing diverse companies. I have always been attracted
to opportunities with heavy intellectual property content, such as life
science and semiconductors. It was in these deals that I developed one
of my favorite rules of thumb: Don't pay more than $40 million post
money, and always sell for at least $1 billion.
Other rules I use today mostly came about as a result of experiences
during this period. One key lesson was to always spread risk. We had
one company fail because of the chaos created when President Nixon
froze wages and prices during the early 1970s. That company provided
low-cost feed supplements for poultry. Prices offinished products were
capped, but input prices were not, creating an immediate negative mar
gin. Three decades before we saw Frank's Ice Cream in Russia collapse,
we saw the same phenomenon in the poultry feed business. Another
company, a thriving steel mini-mill on the Louisiana Gulf Coast, de
pended on the Mississippi River to transport finished product. The Mis
sissippi River ran low one summer, though, and the company couldn't
make it through. Again, we had failed to account for such risks.
260 • THE MASTERS OF PRIVATE EQyiTY ANDVENTURE CAPITAL
Taking Action in Russia

InRussia, the risks are multiple and can threaten the viability ofa busi
ness almost overnight. The economy is vulnerable to volatile oil prices.
Corruption is an issue, although in recent years substantial improve
ments are apparent. Russia still operates on personal connections, with
a small network of powerful people having an inordinate ability to
influence events. I have been around long enough to understand how
this works in this young economy. Over time, we have developed an
ability to do business with these leading financial groups.
Inasmuch as I am officially retired and, fortunately, well off, my
motives in getting involved with the U.S. Russia Investment Fund in
Russia have been largely altruistic. It's a bit like having another Peace
Corps experience stapled onto the end of my career, as it was at the
beginning, but with a wealth of equity investment experience to bring
to the job
I started as pro bono director onthe board from 1994 to 2003, since
I only retired from Apax in 2000. Then, because the Fund was not get
ting the needed investment traction, at the board's request I moved to
Russia in an executive capacity in 2003.
Within five months, we reduced the investment staff from 17 to
seven people and began shaping the portfolio. We sold 30 companies
in five years and made 29 new and follow-on investments. One of the
first sales was of DeltaBank to GE Consumer Finance for 4.3 times its
book value, a good way to start.
Part of the transition involved setting up the funds in a way that
could sustain the investment effort. We formed Delta Private Equity
Partners, a management company, to run the U.S. Russia Investment
Fundand a private successor fund, Delta Russia Fund. We launched the
Delta Russia Fund in June of2004 and ultimately, between two funds,
invested $450 million into 55 Russian companies. With $120 million
in committed capital, the Delta Russia Fund is now 80% invested and
has a net internal rate of return of about 209%.
The lesson from this initial flurry ofactivity was clear. To survive,
we had toact swiftly and aggressively. To sustain progress, though, we
found we would need to meet two key objectives. We needed a coher
ent investment strategy, and we needed professional management of
our portfolio companies. This was the genesis of our list of excluded
investment areas: no real estate, no oil and gas, no commodities, no

greenfields, no pure technology risk, none of the Russian government's
42 strategic areas, and so on.
The governance side would prove in some ways the greater of our
challenges. We discovered we would need a more hands-on approach
than is typical in a U.S. venture fund, butwithout micromanagement.
Portfolio company managements had to learn how to align their inter
est with those of investors and, most important, to see why it was in
their own interest to do so. To that end, we introduced stock options
as part of the compensation.
DeltaCredit Bank was our testcase forstock options, and right from
the start it was obvious the idea would take.In introducing the concept
to DeltaCredit managers, I rattled off an explanation ofstock options:
how they work and how they become valuable if the company's value
increases. When I asked for questions at the introductory session, the
first questioner wanted to know about antidilution protection. The
Russians got it, immediately.
DeltaCredit, the mortgage bank, gave us a window into different
aspects of doing business in Russia: how to handle the power plays and
the importance of top leadership. When I arrived in Moscow, I knew
that the bank was in trouble. I asked Igor Kouzine, a Ukrainian-born
former McKinsey consultant, todo a depth probe on the bank, and his
analysis was superb: overstaffed, underleveraged, and poor processes
in place.
None of that seemed to matter to the then-president of DeltaCredit.
Soon after I arrived inMoscow, he invited me to breakfast andopened
the discussion with a simple, declarative sentence: "I would like to buy
the bank."
I asked him the price, and he offered one that was half ofthe book
value. I asked where he was getting his capital, and he would not say.
I told him that, as chairman of the bank's board, I had a fiduciary
obligation to know how his bid would be funded. Then I asked if there
was anything else for me to know.
"Yes," he said. "If you don't agree, my top ten people and I will
leave."
"Iwish you well then," I told him. "Let's go get security and you all
are out today."
We promptly hired Kouzine, the consultant, as CEO, and the new

management team quickly made a difference. Kouzine reduced staff
from 185 to 95 and increased lending volume to four times previous
levels, profitably. Before Kouzine came on, the bank was closing just
3% of loans. Within a few months, they were closing 85% ofthem.
Before long, we secured a $120 million line of credit at a 6% interest
rate over 15 years. Can't beat that.
We had taken a bank that was underperforming and transformed it
into a winner. We wound up selling it for 2.8 times book value to So-
ciete Generate, but even then the potential was just barely tapped. We
had a40% market share, but with only 3,500 mortgages on the books
in a nation of 143 million people, the potential was vast. And the Rus
sians pay; delinquencies were less than 1%. There was plenty of room
for DeltaCredit to grow.
Although it was important for us to bring in people like Kouzine to
broaden business understanding, it was just as vital that we at Delta
learn to navigate the state of the Russian business community as the
economy privatized. Achief concern is the lack of understanding among
Russian business people about the importance of good corporate gov
ernance. Prior to the wave of privatization that began in the 1990s,
Russian business operated under a very patriarchal system. The rights
of shareholders were little understood and barely respected.
Relationships with boards of directors proved to be particularly vex
ing. Russian business people are not accustomed to taking into account
the views of people who are not part of the day-to-day operation of
the business. Board meetings can become tempestuous, with battles for
control between the management and nonmanagement directors. As
a major investor in these companies, I deal firmly with this issue, but
that does not make it any easier to manage. Many ofthese difficulties
fit under the category ofgrowing pains.
To get some perspective on where the Russians are coming from,
keep in mind that in the early 1990s many young business people
in Russia told me that they learned much of what they knew about
business by watching films such as Wall Street with Michael Doug
las. I found this terrifying. The trading culture and "greed is good"
mentality have nothing to do with running a good business, which is
all about putting capital to work for a reasonable return over time.
risk, Then Reward • 263
The notion that the understanding of business was so low in the early
and mid-1990s that young Russians were using Gordon Gekko as a
role model is one of the revelations that led us to start the Entrepreneur
of the Year program with Ernst &C Young.
A "Roof" for Protection

One of the key elements of success in Russia is the notion of having
what Russians call "roofs" for protection. A roof is any form of safe
guard against disaster. The most effective roof, though, is a well-placed,
honest person onwhom one can rely for straight information, on-the-
ground knowledge, and other help that might advance or guard us
against trouble.
Igot ataste of agood roof in adeal involving the sublicense the fund
had secured for the SPAR supermarket chain in Russia. It opened two
SPAR operations in Russia, one of which, in Middle Volga, we sold
the year I arrived in Moscow for an 86% internal rate of return. The
SPAR Moscow effort was a different matter. The company couldn't
get sufficient retail space in Moscow, a market that was heating up at
the time.
Staff had been working for two years on a deal to sell thecompany,
butthedeal was unattractive. There was nocash, only paper in a highly
leveraged company. Iwas pressured to sign the sale documents, but due
to my doubts I hired a security service to do a background check on
the proposed purchaser. In Russia, such checks can turn up surprising
and unwelcome prior pursuits—money laundering, gun running, mar
ket manipulation, and the like. Fortunately, the capability of security
services are quite impressive, in part because many in the business have
prior KGB experience, so athorough background check typically turns
up just about anything we need to know. In this particular case, the
result was not encouraging and would not have passed the test of the
Foreign Corrupt Practices Act and the Patriot Act, so we called off
the deal and set out to find a better buyer.
This is where my roof came in. Afriend who had connections athigh
levels in the Russian government steered me toward a man I had not
previously known. There was an air of secrecy about our first meeting.
I was told to look for a man in a blue sweater on a Saturday morning
in the downtown Marriott. He had not previously run a business, but

he had led a fascinating life: a guard on the Chinese border as a young
man, an analyst ofthe U.S. defense budget for the Russian government,
and, of great interest to me, a recent stint allocating retail space in
downtown Moscow for the city's mayor.
It took just that one conversation for me to realize I had found the
right person for the SPAR license. I suggested that he buy it, and that
we would back his investment. I rattled off all the numbers I could
remember, he liked what he heard, and after some minor haggling we
shookhands on a deal on the spot. The basic outlines of our deal have
not changed since. For all one hears about the troubles ofdoing busi
ness inRussia, there also are people who are honorable, savvy, driven,
and intelligent business people who are the best hope for better times
in their country.
The story did not end with that handshake atthe Marriott, though.
When the other would-be buyer heard I had struck a different deal,
he was furious. He sent some fairly gruff associates to ask about my
decision.
"What do you want from me?" I asked. "I'm a fiduciary, and this
is a better deal." After two hours of haggling, their offer still was no
good, and the deal in hand was for cash, with our fund still retaining
a 15% stake.
When the visitors left, my colleagues atDelta said they were worried
about my decision. They said I might need bodyguards. The whole situ
ation seemed silly to me, but I acquiesced. The result was that I spent a
marvelous few days with a pair of fit, kind, and polite young men who
carried mybags and opened cardoors for me. If this was whatit meant
tohave bodyguards, then Iwas all for it, but after a few days itfelt like
an extravagance and I resumed my normal program of traveling the
streets of Moscow on my own.
My decision to sell to the new buyer was a winner from the start.
He did everything he promised—came through with the cash, built up
the chain, and expanded regionally. One ofhis stores, anhour outside
Moscow, did $1 million in business on its opening day. We reinvested
with him when we launched our second fund and ultimately sold that
15% stake for a 212% internal rate of return.
RISK, THEN REWARD ° 265
The Sieges of Moscow

One aspect ofdoing business inRussia thatmay change over time is the
tendency Russians have to negotiate, ad nauseum, over the valuation of
companies. Private property is a new concept, so negotiations focus ex
haustively on price with a wholly inadequate emphasis on the strategic
development ofthe company. The two-year squabbling over the initially
proposed SPAR deal was not unusual. Part ofthis reflects the way many
companies are structured tooptimize taxes. Russians are not used tothe
concept of building enterprise value over time, so they are not familiar
with figuring thatinto their negotiating strategy. Mix this with the Rus
sian business person's inordinate fear of getting beaten in negotiations,
and the fascination with various arcane tax dodges, and we find that
Western concepts of profit motive do not always drive negotiations.
Because of the tenacious negotiating style, we have learned to shape
the future of a company even while we are still negotiating to buy it.
It's risky because there is no assurance that we ultimately will get a
deal. On the other hand,it would make no sense to let oneof our target
companies languish, growing weaker during the months and sometimes
years it takes to buy it.
Noviy Disk, a computer games company, is illustrative. An entre
preneur started the company in 1991, selling pirated DVDs to tourists
in Red Square. By the time we came across it some 15 years later, the
company had title to a number of popular computer games and had
begun game development of its own. Italso was moving into producing
computerized training materials for schools. We started negotiations in
June 2007 and proceeded on two tracks. On one track, we restructured
the business. On another track, we pitched in to assist the company in
securing a Nintendo license and a Disney library for localization into
the Russian language. Meanwhile, in negotiations, price was a moving
target—and it and other key issues in our negotiations kept changing,
well beyond the point when both parties would have walked away in
frustration from such talks in the United States.
We finally found a way to bring the discussions to a close. After we
reached agreement on one aspect of the deal, we and the seller would
sign a memorandum that memorialized the terms. "This is a blood
pact," I would say, only half in jest. This methodical approach helped
us winnow down our list of issues one by one and ultimately reach a
comprehensive agreement.
In 2007, the company achieved $95 million in sales and generated
$25 million in cash flow. We ultimately put $12 million into the com
pany, and if the business keeps growing as it should we will do well on
resale, although the financial crisis that began in late 2008, including
especially the ruble devaluation, has provided some challenges for the
company to get through.
Onward!
The learning curve has not flattened in Russia. We continue to adjust
our approach as we move along and as our fund and the financial mar
kets evolve. We have worked to develop a systematic way to share best
practices among our various companies. We emphasize financial results
and challenge the managements ofour portfolio companies to become
more transparent inthe way they report results. We standardize report
ing periods, require analytical information benchmarked tocomparable
companies, and occasionally conduct depth probes on specific issues.
All of this emphasizes how important itis to measure results, while giv
ing us as investors a very clear view into the condition of the business.
I have learned to value highly the Russian people I have done busi
ness with. These are the roofs whohelp protect usfrom mistakes or can
connect us with key contacts. We also could not succeed without the
entrepreneurs who inspire us with their success and character. Some of
our work, I hope, has helped the aspiring young business people think
less about the movie Wall Street and more about the way business is
really done—through shrewd investment, tireless work, creative think
ing, and honorable conduct. The challenges still exist in Russia, but so
do the people and practices that give hope for thefuture.
Venture capital is challenging under any circumstances. Operating in
a formerly centrally planned economy—the antithesis ofcapitalism—is
a learning experience all around. The Russian people have embraced
it. The capitalist genie is out of the bottle, and it promises to raise the
standard ofliving for average Russian citizens. I am pleased to have been
part of introducing the financial tools that, along with many positive
changes on the Russian business scene, can help make that all possible.
LESSONS FROM PAT CLOHERTY

<$> Go local. Rely on local management for their knowledge ofthe
market. Use your street smartsto handle powerful groups and tricky
operators, just as you would elsewhere.
Seek the "transparency premium." In a marketplace where financial

reporting isopaque, transparency can be an advantage. In the
author's experience, it accountsfor a 10% price premium when
a company is sold.
Do not micromanage. Tempting as it may be in a market where

business practices are not fully developed, micromanagement by
outsiders only succeds intraining local managementto be weak.
Export your knowledge, but let others do the work.
<$> Spread risk. Know which industries are potentially hazardous
politically and which are safe for outside investment. Steer clear
of any industry defined bythe state as strategically important.
Companies in basic products and services—foodstuffs, apparel,
financial services, and so forth—are attractive.
Beware of "boxes." Bewary of offshore entities, asset stripping,

money laundering, and other devices used in Russia and other
developing economies in an effort to minimize taxes and divert cash.
APPENDICES
TOOLS OF THE TRADE
In any skilled profession, there are masters, and there are all the rest.
From apprentices to journeymen, to veteran practitioners, all are in
some ways not quite at the same levels of the true masters, and one as
pect that sets the masters apart is the effective use of specialized tools.
The masters of private equity and venture capital have evolved
their own mission-critical set of tools. Spreadsheets and charts help
them measure the risk and performance of their portfolios. Dashboard
software on computers automatically command attention and create
templatesfor a firm's internal communication. Some private-investment
pioneers use specific criteria to select directors and chief executives,
while othersoperate according to rules of practice expressed in colorful
and memorable language.
Just as the management lessons in the preceding chapters lay out
the techniques, strategic thinking, and tactics of these leading private-
equity professionals, the tools are implements of the trade. Most have
not previously been shared outside the firms represented here. All can
contribute to a track record of success.
APPENDIX 1
CHECKLIST FOR EVALUATING

INVESTMENT OPPORTUNITIES
The "old guard" who started in the 1960s had no specific templates or
tools. They used their instincts to gauge what seemed important and
learned by pain and reward. Along with other venture capitalists, Pitch
Johnson of Asset Management Company, quickly decided that he could
succeed only by closely following and helping his portfolio companies.
Then, as now, Johnson and his contemporaries had to make decisions
with inadequate information but enough to move ahead.
Had the earliest pioneers of venture capital drawn up a template for

success, it might have looked like the following:
• People
o Integrity
• First impression:
• From the moment you shake a hand: Is the person open
and honest?
• Guidable? Do they see the potential relationship the same
way as you?
• Is this group to be trusted?
• Arethey able to describe in two to three sentences the idea
of the business?
• 271 •
272 o APPENDIX 1
• Check them out with previous associates.

o Experience
• Very important to have experience in an operating company,
even in failed start-ups
• Understanding of the marketplace
• Needed and complementary skill sets in group
• Attributes of a clear leader
• Marketplace
o Is it big enough to accommodate the aims of the company?
o Diligence note: The Mastersdeveloped a coterieof friends who
were in positions to assist in evaluating a given technology or
market... a trading of favors is the entry into such a group.
• Technology/product
o Vital uses in existingor proposed market
o Protectable/defendable
o Production or reproduction ability at workable cost
• Financial plan
o Planfor future financings as to workability and valuation.
o Make own plan and evaluate that of entrepreneurs.
o Ensure the plausibility of final numbers used for decisions.
• Negotiating the deal
o Estimate value of holding in five years, allowing for dilution of
original percentage.
o Aim fora lOxmultiple on investment infive years, or 58% internal
rate of return (IRR) on the deal; compromise this standard when
risk isless. This level isnecessary to getlimited partners returns for
whole fund in the20% range, after losses and expenses.
o Can start-up to success be achieved in a reasonable time frame?
o Are development costs, burn rate, and projected sales workable?
o Develop a one-year detailed plan and five-year projections.
o Project earnings as to timing and growth rate.
o Be surepriceenables firmto become part of a portfolioof winners/
losers built to show 35% IRR and 18 to 20% net to the LPs.
APPENDIX 2
GUIDELINES FOR
TRANSFORMING RESEARCH
INTO COMMERCE
Steven Lazarus
Converting basic science into commercial ventures is a challenging as-

signment that ARCH Venture Partners has chosen as the centerpiece
of its business. As Steve Lazarus of ARCH explains, to be successful
requires a mixture of political savvy, scientific acuity, and private invest
ment know-how. Lazarus' callfor a flexible and versatile approach has
application inmany walks of business far beyond the university labs.
Harmonize Cultures. Academicians see business people as narrowly

fixated on profit, while executives see researchers as insulated and
naive. Focus on the potentially complementary nature of the two cul
tures, melding the academic's ideas with the businessman's capital and
management skills.
Go Where the Science Is. We have moved investment professionals

from Chicago to science-rich geographies such as Seattle and Austin.
We devote personnel exclusively to major multi-campus educational
systems. But be aware of the risk of a single-institution perspective. To
avoid being blindsided by science from somewhere else, leverage the
firm's geographically diverse partnership against the dispersed scientific
opportunity.
• 273 •
274 • APPENDIX 2
Network Both Discovery and Investment. Compatible and comple

mentary science simultaneously emerges from multiple university
laboratories. Roll up all materially relevant science and defy conven
tional wisdom by making seed and early-stage investments in dis
persed and decentralized organizations. Networking technology aids
in communication.
Find the Stars of Discovery. Only a few investigators at any institution

are true, often serial, discoverers. They are the scientific elite and can be
identified by analysis of publications, citations, memberships in highly
regarded societies, referrals by other elite scientists, and by personal in
terview. There are about two degrees of separation among any of them.
Avoid Building False Hopes. Too many university technology transfer

offices are under pressure to spend time and money with every faculty
member, regardless of the quality or promise of their inventions. This
can lead to disappointment and recrimination that reduce the effective
ness of the transfer mechanism. Be direct and honest with researchers
from the start.
Sidestep University Politics. Some are feudal in nature and have mul
tiple points of approval in the technical transfer process. This raises
transaction costs and delays progress. Deal flow in this space is too
rich, and the speed too fast, to waste time in refractory organizations.
Avoid Specialization. ARCH does not specialize in life sciences,

information technology, or any discipline. Just as universities are
multidisciplinary, so are we. Venture investors need to follow the
academic trend toward interdisciplinary centers involving multiple
complementary scientific pursuits. These convergence opportunities
represent an increasing proportion of our investments.
Avoid ExclusiveArrangements. Do not formally tiein with anyparticular

institution. We do not need a contractual right of first refusal so long as
we respect the academic culture, work with the technology transfer office
APPENDIX 2 • 275
and establish ties with local or regional investors. Weencourage scientific

publication, once the rights to a technology are safely locked up.
Find Good Company. Rely on track record to reduce variables in all

areas. Work with experienced co-investors, serial discoverers, and ex
perienced entrepreneurial management. Be ready to step in and manage
directly. Design the business structure so each participant is treated
equitably and fairly. Keep your word.
Seek Professional Management. Resist the temptation to permit the

discoverer to manage the new enterprise. Few scientists, however bril
liant, have the skill set, patience, or experience to manage a start-up.
Keep the discovery team close to the start-up by naming them as scien
tific advisors or technology chiefs.
Eliminate Risk and Manage Cost. Determine where the deepest risk
resides and devise programs to minimize it at earliest possible points.
Replicate key findings, at multiple locations, to help mitigate science
risks. Keep cost control by investing in carefully designed tranches
aimed at specific endpoints. Begin with an investment syndicate capable
of supporting three investment rounds without new investors
Protect the Intellectual Property. Understand the patent estate in

which you are investing. This is the primary collateral for the earliest
investment. If protection of the intellectual property is weak or
incomplete, the level of risk increases geometrically.
APPENDIX 3
WHAT WE WANT IN A CEO

Joseph L. Rice HI
What could be more imperative to the health and success of a portfolio

company than having the right chiefexecutive officer? At Clayton, Dubi
lier & Rice, Joe Rice andthe firm's other leaders believe the CEO setsthe
tone forall other employees and must therefore have the ability to instill
a performance-driven culture from top to bottom. He orshemust beable
to seamlessly accomplish a wide range of responsibilities and tasks while
overseeing day-to-day operations, supervising the security of employees,
and ensuring the financial health of the company.
Clayton, Dubilier & Rice values proven leaders with successful track
records who have demonstrated execution skills across a broad range of
activities. The successful CEO of a portfolio company will be able to:
• Deliver attractive results while navigating the ups and downs of

the business cycle.
• Identify where operational and financial improvements are needed
and take accountability for follow-through on these initiatives.
• Utilize a disciplined process that ensures accurate and transparent
financial reporting.
• Recognize employee strengthsand weaknesses, promoting talented
individuals who can handle increased responsibilities and parting
with individuals who do not meet expectations.
• 277 •
278 * APPENDIX 3
• Effectively prioritize, knowing how, when, andto whom to delegate

tasks without overloading employees and company resources.
• Pick up the slack or delegate to a person who can when some
one is not able to complete a task or cannot ensure successful
completion.
• Become a present and visible figure among employees, making
oneselfavailable for day-to-day interactions, advice, and problem
solving.
• Lead by example, exhibit team-building skills, demonstrate a tal
ent for implementing a variety of management skills, and, most
importantly, spread enthusiasm.
• Distinguish the delicate balance between confidence and ego;
knowing one's limitations, the CEO must ask for help when a
task is simply too difficult.
• Seek new opportunities whilestillkeeping the strategy focused and
closely aligned to company goals.
The CEO is the nucleus of any company and bears primary respon
sibility for creating a clearstrategic vision for the enterprise, translating
the vision into an action-oriented business plan, and executing against
the business plan.
APPENDIX 4
PORTFOLIO COMPANY
VALUATION TEMPLATE
There are hundreds ofdetailsto track while buildinga successfulbusiness

and measuring the performance of a portfolio of businesses. At Delta
Private Equity Partners, Pat Cloherty and her colleagues have built a tool
that tracks each investment literally from first dollar to anticipated exit.
Budget information, capital investments, major business developments,
and valuation: All materialinformation is available at a glance.
© 279 •
280 • APPENDIX 4
Company Name ["Short company name"]

Contacts: Name of the person who is first on deal
(D- directorboard seat, if any)
Name of the person who is second on deal
Business: [Broad industry description]

Location: [City, country]
Current stage: [Early-stage, expansion, work-out, exit]

Date invested:
Status rating: [A,excellent; B,good; C, focus; D, work out problems]

Other major investors:
Total investment dollars raised to date: $ M
The fund's valuation of the company: $ M

Financial data (000s):
12/31/09 12/31/08 12/31/09 12/31/08
EBITDA
Net income /". \' \..z t /r> ' : „

Net worth
No. of Employees / '>'':': <':;/i"° ,-':i - }"'::~,

Note: Fiscal year ends December 31. EBITDA, earnings before interest,
taxes, depreciation, and amortization.
Business description: [Business description]
Recent developments: [Developments over the recent quarter, plus

small coverage of future plans]
Appendix 4 * 281
Last Current
Purchase Type of No. of Common Quarter's Quarter's
Dates Security Shares Equivalent Cost ($) Valuation Valuation
Current Common
holdings: stock
loan
Valuation method: Valued [at cost, write-up or down basing on the

third party transaction or impairment in value].
APPENDIX 5
"WATERFALL ANALYSIS":
THE STRESS TEST FOR
POTENTIAL PORTFOLIO
COMPANY

In assessing the potential risks and rewards of an investment, Madison

Dearborn Partners seeks to assess all possible material events. Carefully
listing each development—a major restructuring, securing or losing a
major customer, a sharp decline insame-store sales, andso on—the firm
then seeks to project the economic impact of each event. The tool helps
the firm evaluate the financial prospects of each proposed deal. After the
economic events of late 2008, MDP began substantially extending thelife
span of the negative-scenario stress tests.
« 283 o
ro
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Project Light
Waterfall Analysis
MDP Case Based on '06 Mgmt Est.
All Cases Assume $1,494 PP
and 6.4x Total Leverage
r Downside Cases
Slowdown in
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Growth: Reduce Reduction of Growth and Reduction in
Home Specialty 1% Reduction in First Year Sales Labor Growth in Reduction in New Illuminations
to 5% and No Wholesale of New Retail 2007 - 2011 to Retail Store New Store
New Accounts Margins Stores to $500K 0% Openings to 10/yr Openings to 5/yr
A + B + C
MDP Case B
+D+E+F
Sponsor IRR ©
7.00x EBITDA Exit Multiple 17.5% 15.2% 16.4% 16.8% 16.6% 16.5% 16.9% 10.7%
Capital Gain
7.00x EBITDA Exit Multiple $447.0 $371.7 $410.5 $422.2 $416.2 $411.0 $426.1 $ 237.9
7.50x EBITDA Exit Multiple 553.0 473.5 514.7 526.7 520.4 514.0 530.3 330.7
Revenue
2006 $684.7 $684.7 $684.7 $684.7 $684.7 $684.7 $684.7 $684.7
2007 743.5 736.3 743.5 743.2 740.7 740.8 741.4 728.7
2008 791.0 777.3 791.0 789.3 785.5 782.5 784.7 756.2
2009 835.3 817.2 835.3 832.1 827.0 820.9 824.9 782.4
2010 881.4 858.5 881.4 876.7 870.2 860.9 866.7 809.8
2011 931.3 902.1 931.3 925.4 917.3 904.7 912.4 839.6
5YearCAGR 6.3% 5.7% 6.3% 6.2% 6.0% 5.7% 5.9% 4.2%
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Upside Cases
Increase in
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MDP Case H + l+ J + K
Sponsor IRR @
7.00x EBITDA Exit Multiple 17.5% 20.0% 21.4% 18.6% 18.1% 17.9% 23.4%
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APPENDIX 6
MANAGING DIRECTOR
SELECTION CRITERIA
There is no one characteristic that makes a perfect leader. At Madison

Dearborn Partners, John Canning and his colleagues have codified a tool
by which they can assess attributes ofthe firm's managing directors. A
sliding scale, from weaker to stronger, measures the leadership skills and
cultural contributions of these individuals.
• 289 *
290 o APPENDIX 6
Managing Director Selection Criteria

Stronger
Culture f ! • Consistently places • Consistently behaves as • Often places personal
Firm success above a team player. interests above the
individual interests. Firm's.
• Guided by what is best
Embodies what it
for Firm. • Views issues through
means to be a "team
player." • Attitude respectful of prism of "What is best
others, reputation for for me?"
• Treats all individuals,
fair dealing. • Conduct often
whether senior, junior,
Firm or non-Firm, with • Viewed as honest and influenced by hierarchy.
highest level of fairness ethical, without • May treat subordinates
and respect. exception. or non-Firm contacts
• Always exhibits highest inconsistentlyor harshly.

standards of reliability, • May cut comers or shade
honesty, integrity, and the facts to achieve
ethical conduct. desired outcome.
• Any question exists as
to honesty or integrity.
Leadership • Inspires Firm and • Makes leadership • Modest leadership
colleagues to higher contributions to firm and contribution to date.
levels of achievement colleagues.
through dedication and • Infrequently contributes
• Constructive participant substantively to Firm's
personal commitment to
pyppllpnpp
in investment decision investment decision
o Alsdld IOC
making process. making process.
• Consistently contributes Exhibits insight and
with superior insight and • Uneven or infrequent
sound judgment.
originality to investment engagement beyond
• Contributes to Firm team/sector.
decision-making
beyond team/sector
process. • Satisfactory, but not
focus.
• Makes exceptional inspiring, development
• Good mentoring skills. of younger
contribution to Firm
professionals.
beyond team/sector
focus. • Unable to confine
disagreement with
• Known as outstanding
Firm decisions to
coach and mentor to
appropriate forums.
younger professionals.
• Instills Firm culture in
younger professionals,
and maintains the
confidentiality of
matters of difference or
disagreement
among senior Firm
leaders.
Sector • Has developed • Has strong industry • Developing sector

Expertise - recognized industry- sector expertise. expertise, but not yet
leading expertise and Regarded by colleagues considered an "expert."
presence in particular and third parties as
industry sector. being an "expert."
Appendix 6 • 291
Managing Director Selection Criteria (Continued)

Culture * Stronger Weaker • |
• Reputation within sector • Uses industry expertise • Expertise not yet
Sector
consistently leads to to effectively triage sufficient to confer a
Expertise
high-quality opportunities, enhance competitive advantage
differentiated deal-flow. diligence process, and upon Firm.
Opportunities "find" distinguish Firm • Sector focus has led to
him/her. competitively. modest deal-sourcing
•' * : " ;•*:-
• Uses sector expertise to • Infrequently generates opportunities to date.
proactively generate proprietary opportunities,
investment themes and but always on the "short
ideas of a less list" within sector.
competitive nature, or to
differentiate and
advantage Firm in
competitive processes.
• Consistently generates • Has developed good • Modest sources of

Transaction
unique, and often sources of deal-flow. deal-flow.
Execution/
Management proprietary, investment Further improvement • Possesses generally
opportunities. expected over time. satisfactory judgment,
• Demonstrates • Able to effectively lead a but inconsistencies
exceptional transaction team apparent. Requires
creativity, insight, through all stages of a "adult supervision."
discipline, and judgment transaction. • Not yet ready to lead
in forming and • Forms effective transactions.
articulating an partnerships with • Still developing skills to
investment thesis, portfolio managers and work with a manage
transaction maintains productive ment team as the
development, relationships with senior Firm
negotiation, and service providers. Does representative.
execution. not "burn bridges."
• May treat service
• Has demonstrated the • Enjoys complete provider relationships
ability to lead a confidence of roughly. Occasionally
transaction team, with investment staff for burns bridges for Firm.
distinction, through all thorough and unfiltered
phases of a complex • Any question exists
presentation and
transaction regarding objectivity of
discussion of transaction-
(development, diligence, presentation of
related risks and
negotiation, closing, investment
opportunities.
investment thesis considerations.
• Is fully conversant with
execution, and • Desire to do deal can
key issues in
liquidation). color judgment and
transaction-related
• Excels at forming assessment of risks.
documentation and
effective working agreements. Capable of • Needs further
partnerships with leading negotiations. experience negotiating
portfolio company Mastery expected to transaction
management teams, grow in time. documentation.
and maintains and
expands strong
relationships with
service providers and
bankers.
(Continued)
292 * Appendix 6
Managing Director Selection Criteria (Continued)
• Enjoys complete • Generally prioritizes • Time management

confidence of opportunities effectively. skills need further
investment staff for Mayoccasionally refinement. Is frequently
thorough and unfiltered pursue low probability inclined to pursue
presentation and transactions or opportunities that may
discussion of transactions where Firm be marginal or where
transaction-related has little advantage. Firm enjoys little
risks and opportunities. • Usually manages Firm's competitive advantage.
• Has exceptional time resources carefully and »Frequently uses Firm's
management skills. productively. professional and
Readily identifies financial resources
highest impact/highest ineffectively,
probability opportunities unproductively, or in a
where Firm has an manner disproportionate
advantage or edge. to the opportunity.
• Highly effective at using
Firm's professional and
financial resources
efficiently, productively,
and in a manner
proportionate to the
opportunity.
»Has exceptional
command of, and has
successfully led the
negotiation of, all
transaction-related
documents and
agreements.
APPENDIX 7
PERFORMANCE METRICS FOR

MILLENNIUM VILLAGES
Jeffrey Walker
Tracking and measuring performance are, ofcourse, the essence ofgood

management. This principle applies, too, in the operation ofanot-for-
profit enterprise. Jeff Walker and his colleagues at Millennium Promise
use spreadsheet tools such as this to monitor performance across awide
variety of metrics.
. 293 •
294 • APPENDIX 7
Jeffrey Walker
JPMorgan Partners
Millennium
IPromise
D firtrtflx: Poverty finis Hue
Millennium Villages Select Q1 Tracking Indicators bySite
Performance Indicators: Ethiopia Ghana Kenya Kenya Malawi Malawi
Koraro
Gumulira Mwandama
1. Outpatient visits 4,545 6,640 32,926 1,491 2,059 28,334
2. Individuals placed on ARV 37 3 129 0 0 20
treatment
3.TB patients successfully treated 8 14 40 15 0 7

4. Number of babies delivered in a
49 154
health facility 178 24 9 98
5. Pregnantwomen receiving
antenatal care 431 361 1,838 101 36 623
6. Farmers growing high value

0 240 3,200
agricultural commodities introduced 66 0 348
Girls 8,443 3,692

7. Students enrolled in 8,520 289 725 5,277
primary schools Boys
7,403 4,053 9,078 633 813 5,671
Girls
8. Avg. pupil attendance 68% 86% 93% Not Available 91% Not Available
rates in primary schools Boys
65% 88% 93% Not Available 91% Not Available
9. Avg. teacher attendance rates in
69% 87% 78%
primary schools Not Available 98% Not Available
10. Farmers using ISFM practices 1,300 240 Not Available NA 0 1,000
11. Health facilities connected with
1 0
electricity(gridor off-grid)services 2 1 0 0
APPENDIX 7 • 295
Nigeria Rwanda Senegal Tanzania Uganda

Mali Mali Nigeria
Pampaida Mayange Potou Mbola Ruhiira
Tiby Toya Ikaram
9,162 20,696
5,694 1,158 7,512 7,693
2,944
NA 13 29
23 243 214 150

446
122 1,391 1,022 917 1,353

159 230
151 1,700 25
416
2,302 743 Not Available 2,182 3,906

2,933
2,120 859 Not Available 2,353 4,201

3,396 397
94% 97% NA 97% 85%

Not Available 86% 96%
NA 92% 87%
93% 91%
2,000 133
2,960
Not Available
APPENDIX 8
"CARLISMS": KEY PRACTICES

FOR PRIVATE-EQUITY
INVESTORS
Carl D. Thoma
Thoma Bravo, LLC and predecessor firms Golder Thoma & Co.;
Golder Thoma Cressey Rauner, LLC and Thoma Cressey Bravo, Inc.
Carl Thoma, ofThoma Bravo, is aperson offew but memorable words-

plain-spoken expressions that have become familiar to the partners,
entrepreneurs, and advisors with whom he works. These phrases, heard
frequently by anyone who works with Thoma, seem designed to focus
attention and serve asa shorthand ofsuccess ina competitive, fast-moving
private-equity marketplace. Listed here are some ofthe best Carlisms.
Buy and Build. Partner with great management teams to grow com
panies in consolidating industries. Grow cash flow over time via a
three-pronged strategy of (A) operational improvements, often identi
fied during due diligence and completed quickly post-close; (B) add-on
acquisitions; and (C) organic growth.
How Can We Pay More? A private-equity firm should develop a spe

cial, unique angle itsees in the business and leverage the experience and
other resources thatonly it has. Make sure ourreturn is higher than the
next investor's. That way, we can afford to pay more if necessary.
* 297 *
298 o APPENDIX 8
Can We Get Itfor Less? As a value investor, figuring out how to cre
atively pay a lower price is part of adding value. You get what you
negotiate.
Learn More. Never be caught off guard by surprises. When interviewing

management, management candidates, customers, or competitors, gooff
the list of typical questions and points of reference. Track specific perfor
mance at prior stops. Challenge answers. Quality of earnings at close is
important. Send in your best accounting team; look under all stones.
Improve Multiples. Add-on acquisitions, operational improvements,

organic growth, and/or expansion through merger and acquisition
bring size, scale, a better company, and higher exit multiples.
The Game Plan Is Simple; Sticking to It Is the Tough Part. Making

money and building value stem from a relatively simple set of tenets.
The challenge comes in discerning when actions and strategies are be
ginning to divert from plan. Have the wisdom to know and the disci
pline to stay within the guard rails ofstrategy.
When You Can, Stretch It Out. Looking at companies over time and
as long as possible through a cycle can be helpful. Ifa slower pace does
not put the deal at risk, do not go too fast. Press hard on key items.
Don't Make Mistakes. This isn't venture investing, where a few

highly successful investments will offset a large number of failures.
Avoid the mistakes that create the losers, and aim for returns from
every investment.
Inexperience Can Be Very Costly. Try to know what you—and

your team—do not know. Use study and experience to focus on sec
tors you can know as well as any strategic investor. Keep in mind
that younger personnel likely have not been through economic cycles
and volatility. Acknowledge your limits. Recruit people who will do
the same.
APPENDIX 8 • 299
We Can Raise All the Money You Can Spend Responsibly. If a

CEO or founder can develop a strategy that will create a return, an
institutional investor can raise virtually unlimited resources to make
that happen. Show me the returns, and I can show you the money.
This comes as a revelation to CEOs or founders with no prior private-
equity experience.
Doesn't Matter How, Just Get It Done. Process and organization are
not goals unto themselves, just means to the end of making a good
investment. As staffs get larger, the risk rises that people will focus on
process and lose site ofthe real goal. Within the vital limits oflaw and
ethics, it's getting the deal done that counts.
No Deal Is Done Until It Is Done. Have the discipline to divorce any

emotion or sense of obligation from a decision to close, even if you
have signed a letter ofintent. Ifperformance erodes oryou find out that
something is notas represented, be willing to walk. Work due diligence
until pencils are down. Keep challenging the investment case until the
deal is done.
When Are You Moving to Akron? If a deal is notperforming, the deal

professionals may well find themselves living with it—moving to the
headquarters, ifnecessary. This is a form ofinternal threat or gentle re
minder that if management is not fixing the problem then we need to.
Are You Building Personal Equity? I Can Help DwarfWhat You

Make Now. This is the basic case for why a CEO or founder should
accept an infusion of private equity. Ifwe can make them more money
thanthey canmake themselves, thatshould be thebasis of a productive
partnership.
The Only Person Above a CEO Is the Owner. While management's

skill, experience, and dedication are critical, the controlling investor
ultimately is responsible for the business. When necessary, stepin as an
owner to make the tough decisions.
INDEX
Acclarent, 188 Bates, Jim, 210

Acharya, Viral, 21 Batterson, Len, 210
Activision, 160-162 Bayh-Dole Act, 199
Adam, Rick, 216 Beitzel, Spike, 233
Adolor, 197, 217, 218 Bell, Graeme, 217
Ahora, 218 Bell, Max, 211
Airline industry, 83 Benchmarking, 89
Akers, John, 39 Benson, Millie, 241
Albania, 248 "Big Game," 229
Alternative assets, 5 Big money era, 165
American Laser Games, 240 Bigger platforms, 93
American President Lines, 58-59 Bina, Eric, 215
Ames, Chuck, 39 Biological sciences companies, 188
Amgen, 225-227 Biosimilars, 192
Anderson, Fred, 154 Biotech companies, 224
Andreesen, Marc, 215 BioVeda, 193
Angioplasty methods, 188 Bluegrass music, 70
Annan, Kofi, 99 Board attendance, 112
Anticipation, 74 Board size, 112
Apax Partners, 244 Bonsai, Frank, 178, 179
Apollo Computer, 159 Book, overview, 11-13
Apple Computer, 160,165, 234 Boole & Babbage, 222, 232-234
Apprentice business, 9 Boom and bust cycles, 28
ARCH Venture Partners, 197, 202, 208, Boom times, 25
214-215, 218 Both failures and success, 8-10
Ardi, Dana, 103 Bowes, Bill, 225-227
Argonne National Laboratory, 199, 207 Boxes, 253-255, 267
Arthur Rock & Associates, 178 Boyer, Herbert, 196, 207, 225
Asset Management Company, 224, 238 Boyle, Chuck, 91
AT&T, 183 Bricklin, Daniel, 234
Availink, 174-175 Brinson Partners, 64
Aviron, 218 British Airways, 164
Bryan, John, 232
Baker, Len, 160 Bunce, Jack, 56
Ballmer, Steve, 159, 240-241 Burow, Kristina, 215
Balloon angioplasty, 188 Buy and build, 297
Baltic States, 248 Bybee, Clint, 209, 214
Barbarians at the Gate, 39
Barger, Matt, 56, 61, 63 Cahill, Doug, 113
Barrett, James, 190, 191 Canning,John A., Jr., 107, 117, 210,
Barris, Peter, 185 283, 289
Baskett, Forest, 189 Carlisms, 93, 297-299
• 301 «
302 * INDEX
CarPoint, 241 Corbin-Farnsworth, 155

Carry, 145 Corrigan, Wilf, 156, 157
Carson, Russ, 106 Crandell, Keith, 209, 214, 216
Cash flow, 22-23 Crane, David, 160
CCMP, 104 Cressey, Bryan, 120
Central Asia, 248 Crisp, Peter, 159, 160
CEO, 78-79, 277-278 Cross-pollination of ideas, 12
Chakrabarty, Ananda Mohan, 199 Crown, James, 202
Chambers, Ray, 99, 100 Crystal ball myth, 24-26
Chang, Barbara, 109 Culture, 290
Change management, 173-194 Cumming, Douglas, 23
anticipation/surprise, 175 Curlander, Paul, 41
China, 192-193 Czech Republic, 248
Clark, Jim, 186
embrace change or loseopportunity, 184 Dallas Cowboys, 76
lessons learned, 193-194 d'Arbeloff, Alex, 237, 238
perils/promise, 182-184 Dashboard software, 269
scale the business/art form, 180 Dauten, Kent, 123
success/failure, 175 Davis, Steve, 23-24
venture capitalist mindset, 177 Deal frenzy, 133
venture growth equity, 190 Dell, Michael, 149
Chapter authors Delta Private Equity Partners, 260
Canning, John A., Jr., 117, 283, 289 Delta Russia Fund, 260
Cloherty, Patricia M., 243, 279 DeltaBank, 255, 256
Draper, William H., Ill, 151 DeltaCredit Bank, 255, 261
Finkel, Robert A., 1 DeWolff, Nick, 237
Hellman, F. Warren, 47 Dieselprom, 253
Johnson, Franklin "Pitch," Jr., 221, 271 Differentiation, 190
Kaplan, Steven N., 17 Digitas, 69
Kramlich, C. Richard, 173 Doane Pet Care, 98, 112-113
Lazarus, Steven, 195, 273 Doerr,John, 187,210
Rice, Joseph L., Ill, 31,277 Doriot, Georges, 1, 2, 203, 212, 219
Saloner, Garth, 141 Doriot bon mots, 1
Thoma, Carl D., 73, 297 Dot-com bust, 190
Walker,Jeffrey, 95, 293 Doubleclick, 62, 69
Chemical Bank, 97, 104, 106-107 Douglas, Kingman, 209
Chemical Venture Partners, 107 Draper, Tim, 168
Chiefexecutive officer(CEO), 78-79, Draper, William H., Ill, 151, 177, 222,
277-278 224, 229-231
China, 192-193 Draper, William H., Jr., 154, 169
Claesson, Jan, 240, 241 Draper Fisher Jurvetson, 168
Clark, Jim, 175, 185-189 Draper Gaither & Anderson, 154
Clayton, Dubilier & Rice, 32, 38, 45 Draper Richards Foundation, 169
Clayton, Gene, 32, 37 Drew, Nancy, 241, 242
Cloherty, Patricia M., 243, 279 Drivers behind private-equity performance,
Cohen, Stanley, 196, 207, 225 17-29
Coleman, Bruce, 233 cash flow, 22-23
Colson, Charles, 205 crystal ball myth, 24-26
Communications Network, 81, 82 future of private equity,29
Computer "exascale," 184 jobs, 23-24
Confidential compensation, 131 levers of performance, 20-21
Consolidation strategy, 77 negotiation advantage, 26-27
Contributors. See Chapter authors rising tide of private equity, 19-20
Control the technology, 219, 242 some speculations, 27-29
Convergent Technologies, 182, 183 Dubilier, Martin, 32, 37, 40
Cook, Jack, 258, 259 Duplicon, 153
INDEX • 303
Earth Institute, 103 Funeral home business, 84

ECN, 68, 69 Future of private equity, 29
Economic conditions, 137 Fylstra, Dan, 234, 235
Edwards, Bill, 232
Effective worrying, 88 Gaiser, Megan, 241
Ehrman, Fred, 53 Gaither, Rowan, 154
El Polio Loco, 109 Game plan, 298
Electroglas, 155 Gates, Bill, 149, 159
Electronic communications network (ECN), Gems from the experts. See Lessons learned
68,69 Genentech, 225
Elevator assets, 64 Genius, 160-161, 185
Ellison, Larry, 149 Genstar Ltd., 153
Ely, Paul, 183, 184 Genstar Rental Electronics, 61
Embracing uncertainty, 241-242 Geometric Software, 167
Envision the future, 171 Georgescu, Peter, 64, 65-66
Epogen, 227 Gerstner, Lou, 22
Equity participation by management, 20 Gerwe, Peter, 249, 252
Ericsson AB, 103 Girls for a Change, 169
Essential element for success, 75 Gleneagles Summit, 110
Ethernet, 181-184 Global Imaging Systems, 77, 89, 91
Everyday Learning, 211 Gogel, Don, 40
Everyday Math, 197,211 Golder, Stanley, 77, 79, 91, 120
Ewing Marion Kauffmann Foundation, 254 Goldman Sachs, 54
Exclusive arrangements, 274-275 Golf course business, 84
Export-Import Bank, 162-164 Good security fallacy, 71
Google, 69
Fairchild Dornier Corporation, 43 Gould, Dean, 208
Fairchild Semiconductor, 155 Gould, Jack, 202-203
False hopes, 274 Governance engineering, 21
Feed the winners, 171 Government help, 229-231
Ferri, Paul, 55 Graham, Bill, 200, 206
Fewer and larger things, 194 Grameen Bank, 170
57th Street Irregulars, 209 Grand Junction Networks, 184
Financing risk, 212, 219 Gravel, Chuck, 156
Finkel, Robert A., 1 Gray, Hannah, 202
Finnegan, Paul, 136 Great American Management &
First Chicago, 79, 120, 121, 124, 126 Investment, 61
Fisher, John, 176, 177 Grebe, Bob, 240
Fishman, Alan, 106 Greifeld, Bob, 67-69
Flannery, Jessica, 170 Grove, Andy, 235
Flannery, Joe, 38 Growth in scale, 2-4
Flannery, Matt, 170 Guilty until proven innocent, 59
Flat compensation system, 123, 128
Flumist, 218 Haas, Bob, 57, 58
Focal Communications, 130 Hallmarks of success, 7-8
Force 10 Networks, 184 Halperin, Robert, 202
Foreign markets. See Russia Hambrecht & Quist, 107
Fostering innovation, 239 Hammer, Armand, 205
Franks, Bill, 105 Hardly Strictly Bluegrass Festival, 70
Frank's Siberian Ice Cream, 253 Harriman, Edward, 53
French, Bon, 123 Harris Corporation, 33
Friedman, Tully, 56 Harris Graphics, 37
Friis, Janus, 168 Harrison, Bill, 107
Fuente, David, 108 Hartenbaum, Howard, 167, 168
Fundamental principles, 4-6. See also Harvest and grow strategy, 40-42
Lessons learned Havaldar, Abhay, 167
304 • INDEX
Healthcare, 187-188 Katch, Dave, 232

Healtheon, 185, 187, 188 Kazaa, 168
Hedge fund, 5 Kehoe, Conor, 21
Hellman, F. Warren, 47 Kelley, Arthur, 209
Hellman, IsaiasW, 53 Kendall, Don, 205
Hellman, Marco E, 48 Kenya, 101
Hellman & Friedman, 48 Key points. See Lessons learned
Hellman Ferri Investment Associates, 55 Kindle, Fred, 35
Her Interactive, 240-242 Kinko's, 42
Hewitt, Bill, 205 Kiva, 169-170
Hewlett, Bill, 159, 236 Kleiner Perkins, 213
Hoefler, Don, 224 Kohlberg,Jerry, 37,120
Holman, Eugene, 228 Kohlberg, Kravis & Roberts, 26, 37
Hotchkiss, Edie, 23 Kolence, Ken, 232, 233
Hungary, 248 Kouzine, Igor, 261, 262
Hutchins, Robert Maynard, 197 Kramlich, C. Richard, 173
Kramlich, Lynne, 188
IBM, 233 Kramlich, Pam, 192
IBM Selectric, 39 Krause, Bill, 182, 184
Icahn, Carl, 38 Kravis, Henry, 120,128
Ikea, 255 Kriens, Scott, 190
Illumina, 197, 218
Imperial Clevite, 121 Laboratory research, 195-219
Incomplete information, 242 champion, 200
Incumbent management, 24-25 creative breakthrough, 200-201
Industrial leverage, 62 everyday lessons, 210-211
Industry-specific expertise, 93 insider, 201
Inexperience, 298 investing with a teaspoon, 213, 219
Inland Steel, 222, 223, 229 lessons learned, 219, 273-275
Innovation, 240 money hunt, 209-210
Instinet, 69 Nixon administration, 205-206
Intel, 235 optic adventure, 211-212
International partnering, 104 on our own, 214-215
INTH, 249, 250 outside the ivy walls, 215-218
Investing at scale, 191 risks, 212-213, 219
Investing with a teaspoon, 213, 219 tape, 203
Investment discipline, 51 Laird & Company, 36
Laker, Freddie, 163
Jefferson, Thomas, 98, 106 Larger companies, 90-91
Jobs, 23-24 Lash, Arthur, 155
Jobs, Steve, 149 Lazarus, Jesse, 203-204
Johnson, Cathie, 228, 229, 231 Lazarus, Steven, 195, 273
Johnson, Franklin "Pitch," Jr., 155, 157, Leadership, 290
158, 177, 221, 271 Learn more, 298
Johnson, Pitch, Sr., 228 Lehman Brothers, 54-56
Johnson, Tom, 89 Leslie, Mark, 147
Jolie, Angelina, 112 Lessons learned
Jones, Quincy, 112 Canning, John, 136-137
J.P. Morgan, 255 Carlisms, 93, 297-299
JPMorgan Chase, 97, 103 change management, 193-194
Juniper Networks, 184 Draper, Bill, 170-171
Just get it done, 299 foreign investing, 267
Johnson, Pitch, 242
Kaplan, Larry, 160, 161 Lazarus, Steve, 219, 273-275
Kaplan, Steven N., 17 not-for-profit work, 115
Kapor, Mitch, 235 operating perspective, 46
INDEX o 305
partnership paradigm, 93 Metcalfe, Bob, 181, 182

service businesses, 71 Micromanagement, 247, 267
transforming research into commerce, Microsoft, 159, 240
273-275 Millennium Development Goals, 99, 100
Leverage, 21, 136, 297 Millennium Promise, 101-105, 110, 111,
Leverage early successes, 115 114,294-295
Leveraged buildups, 77 Millennium Villages, 101, 103, 293-295
Leveraged-buyout activity, 18 Miller, Alan, 160
Leveraged-buyout firms, 18 Minority ownership, 50-51
Levers of performance, 20-21 Mistakes, 298
Levi Strauss, 56-58 MobileMedia, 51, 63, 64
Levy, Jim, 160-162 Mondrian Investment Partners, 66
Lexmark, 33, 39-42 Morgenthau, Henry, Jr., 162
Liddy, Ed, 35 Morris, Peter, 185
Little Kids Rock, 169 Morrow, Richard, 202
Local area network, 181 Mueller, Glenn, 186
Long, Mike, 188 Multiples, 298
Long-term strategies, 194
Lotus 1-2-3, 235 Nadkarni, Kiran, 166, 167
Nancy Drew license, 240, 241
Madison Dearborn Partners, 117-137 NASDAQ, 67, 68
Maintain the magic, 194 NEA, 173-194
Makower, Josh, 188 Negotiation advantage, 26-27
Malawi, 101, 111 Nelsen, Bob, 209, 214, 217
Management. See Partnership paradigm NEON, 197, 216
Management by inquisition, 102-104 Neta, 167
Management lessons. See Lessons learned NetBot, 197, 215
Management metrics, 11-13 Network both discovery and investment, 274
Management's equity, 20 Networking effect, 109-110
Managing director selection criteria, Neupogen, 227
289-292 New Enterprise Associates (NEA), 173-194
Manatron, 91 New markets, 239-241
Manhattan Project scientists, 198-199 New York Yankees, 76
Mann, Marvin, 41 Newhall, Chuck, 178, 179
Mark-to-market accounting, 124 Newton, Paul, 234
Market matrix, 193 Nextel, 121
Market risk, 212, 219 NiOptics,211, 212
Marquardt, David, 159 Nixon, Richard, 259
Marshall, Colin, 164 No deal is done until it is done, 299
Masalawala, Rustom, 114 Norris Industries, 121
Massey, Walter, 200, 201, 202 Not-for-profit work, 95-115
Match the people to the challenge, 242 Board of directors, 111-112
Matrix analysis, 189 building to scale, 107-108
McAuley, Brian, 121 call to service, 99-100
McCann,Jim, 112, 113 chief executive officer factor, 113
McCracken, Ed, 186, 187 Draper, Bill, 169-170
McGlashan, Bill, 166 from field research to startup, 100-102
McGruder, Jeb, 205 lessons learned, 115
McNamara, Robert, 196 management by inquisition, 102-104
McNaughton, Angus, 153 management leadership, 112-113
Measurex, 165 networking effect, 109-110
Medvedev, Dmitry, 254 from private equity to not-for-profit,
Melting steel, 223 97-98
Memorex, 231 putting pieces in place, 110-111
Mencoff, Sam, 136 roots, 105-107
Meridian Mortuary, 84 from small to huge, 108-109
306 * INDEX
Not-for-profit work, (Cont.) lessons learned, 242

turning philanthropyinto profit, 114 new markets, 239-241
two-way benefit, 104-105 staying power, 238-239
Novast Pharmaceuticals, 192 steelmaking, 223
Noviy Disk, 265 Tandem, 236-237
Noyce, Bob, 236 Teradyne, 237-238
NPower, 98, 109 VisiCorp, 234-236
Perkins,Tom, 165, 166, 213, 225
O'Brien, Morgan, 121 Perrin, George, 81, 82, 87
Ofek, Elie, 25 Perry, Jim, 121
Office Depot, 98, 108-109 Personal equity, 299
OmniPoint, 128 Petco, 109
Opendyk, Terry, 235, 236 Peterson, Pete, 54, 205
Operating partners, 34 Pitfall, 161
Operating perspective, 31-46 Platform investing, 77
Operational engineering, 21 Poduska, William, 158, 159
Overview of book, 11-13 Poland, 248
Owner, 76, 299 Pong, 161
Oxxford Suits, 57 Portfolio company valuation template,
279-281
Packard, David, 159, 205, 236 Potholes, 219
PageNet, 63, 64, 80, 83, 87 Prime Computer, 158
Paging industry, 63-64, 83 Prime Succession, 84
Paragon Family Services, 84 Private equity
Parker Pen, 104, 105, 112 drivers. See Drivers behind private-
Partnering approach, 102 equity performance
"Partners with Management," 86 future of, 29
Partnership paradigm, 73-93 Madison Dearborn Partners, 117-137
CEO factor, 78-79 not-for-profit work. See Not-for-profit
changingrelationship, 86-87 work
focus on management, 85-86 operating perspective, 31-46
larger companies, 90-91 partnership paradigm. See Partnership
lessons learned, 93 paradigm
making management an asset, 75-76 rising tide of, 19-20
platforms of success, 76-78 service businesses. See Service businesses
profiling for success, 80-82 Private-equity firms, 18
refining the strategy, 84-85 Private-equity portfolio company boards, 21
starting up, 91-92 Professional management, 275
tactical execution, 83 Profiling for success, 80-82
target industries, 80 Protection of intellectual property, 275
team, 82-83 Protective measures, 134-135
time mangement, 79, 88-90 PT Components, 121
worry, 87-88 Public service, 162-164
Pasquesi, John, 56
Passion, 46 Qume, 165
Patent, 275
Patience, 232, 242 R-2 Technologies, 216, 217
Patient capital, 6-7 Raben, John, 36
Patricof, Alan, 245, 257 Rathmann, George, 225-227
Patricof & Co. Ventures, 257, 259 Reagan, Ronald, 163
Paulson, Henry, 35, 57 Rediff.com, 167
Pay disparities, 137 Research. See Laboratory research
People, practices, and products, 221-242 Resistol, 57
Amgen, 225-227 Return on tangible capital, 50, 62
Boole & Babbage, 232-234 Rice, Joe, 125
embracing uncertainty, 241-242 Rice, Joseph L., Ill, 31,277
government help, 229-231 Richards, Robin, 166, 167, 169
INDEX • 307
Rienhoff, Hugh, 188 staying in the race, 70-71

RJR Nabisco, 26 transition period, 69
Roberts, George, 120 wireless sector, 63
Robin Hood Foundation, 98 working capital, 65-66
Robson, John, 200 Service Employees International Union, 23
Rock, Arthur, 68, 160, 178 Shared effort, 102
Rockefeller, David, 205 Shared risk, 102
Rockefeller, John D., Ill, 169 Shaw, Premal, 170
Rogers, Kevin, 77 Sher, F. Patrick, 108
Romania, 248 Shipley, Walter, 106
Roof, 263-264 Shoar, Antoinette, 27
Room to Read, 169 Shockley, William, 154
Rubenstein, Arthur, 206 Siegel, Don, 23
Rubin, Bob, 54 Silicon Graphics, 186, 187
Running, 70, 71 Silverstone, Abbey, 186
Russia, 243-267 Simon, William, 99
boxes, 253-255 Singh, Manmohan, 166
call to Moscow, 247-248 Single-product companies, 247
Center for Entrepreneurship, 254 Size, 242
consumer credit, 255-256 Skype, 168
early years, 260-263 Skytrain, 163
economic crisis, 252-253 Small Business Investment Company
Entrepreneur of the Year award, 255 (SBIC), 229-230
financial services sector, 250-252 Smith, Frederick, 79, 120
lessons learned, 267 Social entrepreneurship, 169. See also
liquidity, 250 Not-for-profit work
negotiation, 265 Social impact of private capital, 13-14
risks, 260 Solar energy, 189
roof, 263-264 Sole-source set-aside program, 258
rules, 246-247 Sonsini, Larry, 184
transparency premium, 249-250 Soros, George, 111
valuation of companies, 265 SPAR supermarket chain, 263
Specialization, 274
Sachs, Jeffrey, 99, 101, 113 Spread the risk, 170, 259, 267
Saloner, Garth, 141 Stanton, John, 63
Salser, Winston, 226 Staying power, 238-239
Sandell, Scott, 192 Steelmaking, 223
Satellite launch, 174 Stein, Jenny Shilling, 170
SBA, 258 Steinbrenner, George, 76
SBIC, 229-230 Stereotype of private-equity investor, 18
Scale the firm, 149 Stress testing, 134, 135
Schiller, Jo Anne, 211 Stretch it out, 298
Sector expertise, 290-291 Stromberg, Per, 20
Self-satisfaction, 70 Style drift, 132, 133
Semiconductors, 189 Suniva, 189
Service businesses, 47-71 Sutter Hill Ventures, 153, 158
American President Lines, 58-59 Swanson, Robert, 225
basics, 49-50
Greifeld effect, 67-69 Tamke, George, 35, 42
guilty until proven innocent, 59 Tandem, 236-237
industrial leverage, 62 Tangible cash flow calculation, 50, 62
learning from mistakes, 51-52 Target industries, 80
Lehman Brothers, 54-56 Team, 82-83, 171
lessons learned, 71 Technology risk, 212, 219
Levi Strauss, 56-58 Technology roll-ups, 197, 217
minority ownership, 50-51 Tele Atlas, 191
paging industry, 63-64 Telecom boom and bust, 130, 131
308 • INDEX
Telecomputer, 187 liquidity, 250

Teradyne, 237-238 mindset, 177-178
Testa, Richard, 215 people, practices and products. See
Thatcher, Margaret, 164 People, practices and products
Thoma, Carl D., 73, 120, 297 required return, 145
Thomas, Richard, 124, 125 Saloner, Garth, 141-150
Thomas H. Lee Partners, 109 sharing deals, 166
Thomas Jefferson Foundation, 98 statistics, 142
Time management, 79, 88-90 venture growth equity, 190
Tools of the trade, 269-299 Venture capital mindset, 177
Carlisms, 297-299 Venture growth equity, 190
CEO, 277-278 Vintage risk, 133
managing director selection criteria, VisiCalc, 234, 235
289-292 VisiCorp, 222, 234-236
Millenium Villages, 293-295 VisiOn, 235
portfolio company valuation template, VoiceStream, 63
279-281 Volcker, Paul, 178
transforming research into commerce,
273-275 Wal-Mart, 113
waterfall analysis, 283-287 Walker, Jeffrey, 95, 293
Transaction execution/management, Wall Street, 262
291-292 Waterfall analysis, 134, 283-287
Transition period, 69 Watergate, 205
Transparency premium, 249-250, 267 WebMD, 188
Treybig, Jim, 236, 237 Weinberg, John, 165
Twain, Mark, 29 Welch, Bill, 32, 37
Tyson Foods, 103 Welch, Jack, 22, 33, 34, 44, 98
Welsh, Patrick, 106
Ultra marathon running, 70-71 Western Association of Small Business
UN Development Program, 103 Investment Companies, 230
Uncommon success, 9 Western States 100 race, 70
UNDP, 164 Western Wireless, 63
Uniroyal Tire, 33, 38 Whitehead, Bob, 160
United Nations Development Program Winkels, Richard, 112
(UNDP), 164 Winston, Roland, 211
University environment. See Laboratory Wireless sector, 63
research Working capital, 65-66
U.S. Office Products, 43 Worry, 87-88
U.S. Russia Investment Fund, 244, 248, 253 Wright, Mike, 23
UUNet, 185
Xynetics, 179
"VC Confidential," 10
Venture capital Yang, Zhi, 193
change management. SeeChange Yantra, 167
management Yiddish joke, 9
Draper, Bill, 151-171 Young & Rubicam, 64-65
entrepreneur, and, 147-150 Yunus, Muhammed, 170
laboratoryresearch. SeeLaboratory
research Zennstrom, Niklas, 168
ABOUT THE AUTHORS
For the past twenty years, Robert Finkel has been investing as part
of the Chicago private-equity community. As founder and presi
dent of Prism Capital, Mr. Finkel has overseen fund deployment into
a total of 40 portfolio companiesthrough both the PrismOpportunity
Fund and the Prism Mezzanine Fund.
Mr. Finkel is a co-founder and former chairman of the Illinois Ven
ture Capital Association which represents Illinois' $100 billionof ven
ture capital and private equity funds, and he received its prestigious
Fellows Award. He also received on Prism's behalf the Private Equity
Fund Manager of the Year Award for both 2007 and 2008 from
Opal Financial. Mr. Finkel was selected to serve on the Illinois State
Treasurer's Fund of Fund Review Board and serves on the board of
Chicago Junior Achievement and the Governing Board of the Bulletin
of the Atomic Scientists.
Prism is an active supporter of small businesses across the coun
try; Mr. Finkel was selected to testify before the House Small Business
Committee in support of the SBIC program's reauthorization.
Previously, Mr. Finkel was an investment manager at Wind Point
Partners where he invested in both growth and later stage companies.
Before entering the world of private equity, he was an investment
banker specializing in mergers and acquisitions with PaineWebber. He
received an M.B.A. from Harvard Graduate School of Business and a
B.A. from Johns Hopkins University. Quoted in BusinessWeek and fea
tured on MSNBC's Last Call talking about private equity, Mr. Finkel
frequently appears as a speaker at trade conferences and seminars.
David Greising is business columnist andchief business correspon
dent for the Chicago Tribune. In September 2008, he resumed
writing a column that first ran in the Tribune from 1998 to 2003. As
chief business correspondent, Greising isthe newspaper's lead writer on
globalization and the intersection of politics, business, and economics.
Greising's opinion column features analysis of business and eco
nomic news and their impact on readers. Re-launched as the 2008
financial crisis was first exploding, his columnhas offeredincisive and
timely analysis of events. As chief business correspondent, Greising
has traveled around the world, from the rainforests of South America
to the industrial boom towns of China, to report about globalization
and its impact on Chicago.
Greising previously worked for BusinessWeek, both as its Atlanta
bureau chief and in the Chicago bureau. He was a business reporter
and columnist for the Chicago Sun-Times. He is the author of two
business books: Vd Like the World to Buy a Coke: The Life and
Leadership of Robert Goizueta and Brokers, Bagmen and Moles:
Fraud and Corruption in the Chicago Futures Market, co-authored
by Laurie Morse.
Born in Chicago, Greising is a graduate of DePauw University. He
and his wife, Cynthia Hedges Greising, are co-authors of the children's
book Toys Everywhere!
(continuedfromfrontflap)
• C. Richard Kramlich (New Enterprise

Associates)—who describes how
investment and management strategies
must adjust as technology and economic
conditions abruptly change
• William H. Draper III (Draper Richards

L.R)—who details how investors and
managers must adjust their style as they
seek out new markets around the world
• F. Warren Hellman (Hellman 8c Friedman

LLC)—who describes investing in the
minority stakes of service businesses and
the discipline necessary to be successful
in driving returns
The Masters of Private Equity and Venture

Capital also explores the strong influence of
private capital in the global economy—how
companies are run, what strategies they pursue,
and how they maximize assets. For manage
ment and investing lessons from the best pri
vate investors in the business, there is no better
source than this book.
Robert A. Finkel is president and founder

of Prism Capital, a private equity firm that
manages $200 million in assets across two
funds. Prism invests in growing companies
and provides equity and mezzanine financing
to smaller companies.
David Greising is chief business correspon

dent for the Chicago Tribune. He is the author
of two prior business books.
The McGraw-Hill Companies

INVESTING
THE ICONS OF PRIVATE

INVESTING SHARE THEIR SECRET:
TO MAXIMIZE PROFITABILITY
In The Masters ofPrivate Equity and Venture Capital, ten leading pioneers in the industr}
tell, in their own words, how they created wealth, transformed their portfolio companies,
and helpedbuild two of the most influential business sectors today.
This unique collection ofpersonal and practical interviews is packed with a wealth of revealing
stories and useful guidance on the subjects that mattermost to high-level investors, such as:
SELECTING AND WORKING with Management

Pioneering NEW MARKETS
Screening POTENTIAL INVESTMENTS
ADDING VALUE through Operational Improvements
Applying PRIVATE EQUITY PRINCIPLES to Nonprofits
Much of the valuable lessons and wisdom contained in The Masters of PrivateEquityand
Venture Capital is shared here for the first time—in print or anywhere else. And, this
everyday resource features practical tools of the trade used by the most successful inves
tors and advisors of our time, including risk analyses, personnel evaluations, portfolio
appraisals, and other useful tools.
"This book contains wisdom and insights from distinguished people in an

importantindustry. Venturecapitalists like Bill Draper, Dick Kramlich and Pitch
Johnson helped create an industry that has nurtured some of our best companies.
Private equityinvestors likeJeflfWalker andWarren Hellman know as much
about improving corporate performancethrough activegovernanceas anyone
in the business. We have much to learn from these reflective practitioners."
—William A. Sahlman, d'Arbeloff Professor of Business Administration
and Senior Associate Dean, Harvard Business School
USD $34.95
ISBN 978-0-07-162460-2
MHID 0-07-162460-0
53495>
Learn more. llnJB Do more.

9 780071H624602
MHPROFESSIONAL.COM

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The

.ith DAVID GREISIN6 c^fb„siness Correspondent,Chicago Tribune

The Masters ofPrivate Equity andVenture

Each chapter in The Masters ofPrivate Equity

•John A. Canning,Jr. (Madison Dearborn

•Jeffery Walker (JPMorgan Partners/

New York • Chicago • San Francisco • Lisbon • London

34567890 WFR/WFR 016543210

—From a Declarationof PrinciplesJointlyAdopted by a Committee of the

This book is printed on acid-free paper.

PART I: PRIVATE EQUITY

1 METHOD OVER MAGIC: THE DRIVERS

2 Operating Profits: using an Operating

3 Skin in the Game: investing

4 The Partnership paradigm: working with

5 beyond the balance sheet:

6 the inside game: managing a firm through

PART II: VENTURE CAPITAL

7 The Entrepreneur and

8 Pioneer Investing: taking venture

9 Change for the Better: Managing for profit

10 Beyond the ivory tower:

11 FOSTERING INNOVATION: PEOPLE, PRACTICES,

12 RISK, THEN REWARD: MANAGING VENTURE

APPENDICES: TOOLS OF THE TRADE

1 checklist for evaluating investment

2 Guidelines for Transforming research

3 WHAT WE WANT IN A CEO 277

4 Portfolio Company valuation template 279

5 "WATERFALL ANALYSIS": THE STRESS TEST

6 MANAGING DIRECTOR SELECTION CRITERIA 289

7 PERFORMANCE METRICS FOR MILLENNIUM

8 "CARLISMS": KEY PRACTICES FOR PRIVATE-EQUITY

Ineed to acknowledge a group ofpeople who made it possible for me

It isone thing to come up with a good idea andquite another to exert

During dinner when I was young, the conversation frequently

But, as I reviewed Doriot's writings recently, I found a passage that

What Prof. Doriot described, in his misleadingly simple phrase as "the

and venture capital investment has continued to grow in scale and im

people who want to understand how businesses succeed or fail. Choosing

shells of outmoded companies, stripping out what is valuable, and then

on informal networks of advisors, people who can add additional

Both Failures and Success

and co-investors, management, and vendors. When itdoes go well, the

Gems from the Pros

existing companies—from corporate orphans to carve-outs to merged

The Social Impact of Private Capital

create opportunities and allocate capital in ways that benefit society.

More than two decades of research and writing have established

The investment firms that we once called "leveraged-buyout firms"

While leveraged buyouts of public companies were relatively scarce

The Rising Tide of Private Equity

The Levers of Performance

operating expertise that they apply to add value to their investments,

Impact on Cash Flow

subsequent research that examined data through 2005, found similar

The Crystal Ball Myth

inside information. To some extent, supporters of private equity im

The Negotiation Advantage

Investment returns to the limited partner investors in private-equity