Clear just closed down.

Here’s how it worked while it was in business. You paid $200 for a one-year membership. You underwent a big, complicated background check to prove that you were extra-super-trustworthy.

In exchange, in a few big airports, you got to skip to the front of the TSA line for screening.

Now, you didn’t skip the screening itself. You still went through the X-ray machine and had to remove your shoes, belt, pocket contents, laptops, and plastic quart ziplock bag of toiletries.

You just got to cut to the front of the line.

A few people signed up. In certain airports, it was, indeed, worth actual money to cut to the front of the line.

This wasn’t Clear’s actual business plan. The actual business plan was that Clear would do detailed background checks on travellers, who would then be trusted to bypass security completely because they were extra-super-trustworthy.

Now, the TSA doesn’t even trust pilots, who go through the same screening as the rest of us to make sure they’re not bringing something extraordinarily dangerous onto a plane like a 3.5 oz bottle of shampoo. Because, of course, with a little bottle of shampoo, they could make a bomb, which they could use to fly the plane they are piloting into a building, something that is impossible for mere pilots sitting at the controls of the jet.

So as it turns out, the TSA never actually agreed to go along with this skipping-the-screening thing, and ultimately, all Clear was allowed to do was get you to the front of the line.

At this point, and here’s the interesting part, at this point, a rational businessperson would say, “Well, does the Clear idea still make sense if we can’t actually let you skip the screening?”

OK, maybe it still makes sense to charge to skip to the front of the line. Maybe there’s a business model in that.

In that case, though, why did they still do background checks? It doesn’t make any sense.

The environment changed. It turns out that Clear’s business model of prescreening wasn’t going to be possible. But they kept doing it anyway. What kind of organizational dysfunction does it take to completely ignore the changed circumstances and keep at a money-losing business?

What’s even funnier is that Clear could probably have been profitable if they had just skipped the one unnecessarily stupid part of their business model: the detailed background checks on all their customers.

Nobody at Clear did any thinking. They had a business model, the business model wasn’t actually possible, everybody knew it, and they still plugged away at it. Thoughtless optimism. I don’t know whether to salute ‘em or laugh.

It was seven years ago today when everybody was getting excited about Microsoft’s bombastic announcement of Hailstorm, promising that “Hailstorm makes the technology in your life work together on your behalf and under your control.”

What was it, really? The idea that the future operating system was on the net, on Microsoft’s cloud, and you would log onto everything with Windows Passport and all your stuff would be up there. It turns out: nobody needed this place for all their stuff. And nobody trusted Microsoft with all their stuff. And Hailstorm went away.

I tried to coin a term for the kind of people who invented Hailstorm: architecture astronauts. “That’s one sure tip-off to the fact that you’re being assaulted by an Architecture Astronaut: the incredible amount of bombast; the heroic, utopian grandiloquence; the boastfulness; the complete lack of reality. And people buy it! The business press goes wild!”

The hallmark of an architecture astronaut is that they don’t solve an actual problem… they solve something that appears to be the template of a lot of problems. Or at least, they try. Since 1988 many prominent architecture astronauts have been convinced that the biggest problem to solve is synchronization.

Follow the story, here. I started picking on one company that appeared to be particularly astronautish: Groove, which was trying to rebuild Lotus Notes (a giant synchronization machine) in a peer-to-peer fashion.

Groove had some early success selling secure networks to the military-industrial complex, but didn’t make much of a ripple outside that niche. Their real success was in getting bought by Microsoft, which brought Groove’s designer and chief architecture-astronaut Ray Ozzie to the role of “Chief Software Architect” at Microsoft, supposedly the technical guy that would keep inventing the future after BillG left so that Steve Ballmer would have some new territory on which to build his next illegal monopoly.

And now Ray Ozzie’s big achievement arrives and what is it? (drumroll…) Microsoft Live Mesh. The future of everything. Microsoft is “moving into the cloud.”

What’s Microsoft Live Mesh?

Hmm, let’s see.

“Imagine all your devices—PCs, and soon Macs and mobile phones—working together to give you anywhere access to the information you care about.”

Wait a minute. Something smells fishy here. Isn’t that exactly what Hailstorm was supposed to be? I smell an architecture astronaut.

And what is this Windows Live Mesh?

It’s a way to synchronize files.

Jeez, we’ve had that forever. When did the first sync web sites start coming out? 1999? There were a million versions. xdrive, mydrive, idrive, youdrive, wealldrive for ice cream. Nobody cared then and nobody cares now, because synchronizing files is just not a killer application. I’m sorry. It seems like it should be. But it’s not.

But Windows Live Mesh is not just a way to synchronize files. That’s just the sample app. It’s a whole goddamned architecture, with an API and developer tools and in insane diagram showing all the nifty layers of acronyms, and it seems like the chief astronauts at Microsoft literally expect this to be their gigantic platform in the sky which will take over when Windows becomes irrelevant on the desktop. And synchronizing files is supposed to be, like, the equivalent of Microsoft Write on Windows 1.0.

It’s Groove, rewritten from scratch, one more time. Ray Ozzie just can’t stop rewriting this damn app, again and again and again, and taking 5-7 years each time.

And the fact that customers never asked for this feature and none of the earlier versions really took off as huge platforms doesn’t stop him.

How on earth does Microsoft continue to pour massive resources into building the same frigging synchronization platforms again and again? Damn, they just finished building something called Windows Live FolderShare and I haven’t exactly noticed a stampede to that. I’ll bet you’ve never even heard of it. The 3,398th web site that lets you upload and download files to a place on the Internet. I’m so excited I might just die.

I shouldn’t really care. What Microsoft’s shareholders want to waste their money building, instead of earning nice dividends from two or three fabulous monopolies, is no business of mine. I’m not a shareholder. It sort of bothers me, intellectually, that there are these people running around acting like they’re building the next great thing who keep serving us the same exact TV dinner that I didn’t want on Sunday night, and I didn’t want it when you tried to serve it again Monday night, and you crunched it up and mixed in some cheese and I didn’t eat that Tuesday night, and here it is Wednesday and you’ve rebuilt the whole goddamn TV dinner industry from the ground up and you’re giving me 1955 salisbury steak that I just DON’T WANT. What is it going to take for you to get the message that customers don’t want the things that architecture astronauts just love to build. The people? They love twitter. And flickr and delicious and picasa and tripit and ebay and a million other fun things, which they do want, and this so called synchronization problem is just not an actual problem, it’s a fun programming exercise that you’re doing because it’s just hard enough to be interesting but not so hard that you can’t figure it out.

Why I really care is that Microsoft is vacuuming up way too many programmers. Between Microsoft, with their shady recruiters making unethical exploding offers to unsuspecting college students, and Google (you’re on my radar) paying untenable salaries to kids with more ultimate frisbee experience than Python, whose main job will be to play foosball in the googleplex and walk around trying to get someone…anyone…to come see the demo code they’ve just written with their “20% time,” doing some kind of, let me guess, cloud-based synchronization… between Microsoft and Google the starting salary for a smart CS grad is inching dangerously close to six figures and these smart kids, the cream of our universities, are working on hopeless and useless architecture astronomy because these companies are like cancers, driven to grow at all cost, even though they can’t think of a single useful thing to build for us, but they need another 3000-4000 comp sci grads next week. And dammit foosball doesn’t play itself.

In the olden days, Excel had a very awkward programming language without a name. “Excel Macros,” we called it. It was a severely dysfunctional programming language without variables (you had to store values in cells on a worksheet), without locals, without subroutine calls: in short it was almost completely unmaintainable. It had advanced features like “Goto” but the labels were actually physically invisible.

The only thing that made it look reasonable was that it looked great compared to Lotus macros, which were nothing more than a sequence of keystrokes entered as a long string into a worksheet cell.

On June 17, 1991, I started working for Microsoft on the Excel team. My title was “Program Manager.” I was supposed to come up with a solution to this problem. The implication was that the solution would have something to do with the Basic programming language.

Basic? Yech!

I spend some time negotiating with various development groups. Visual Basic 1.0 had just come out, and it was pretty friggin’ cool. There was a misguided effort underway with the code name MacroMan, and another effort to make Object-Oriented Basic code-named “Silver.” The Silver team was told that they had one client for their product: Excel. The marketing manager for Silver, Bob Wyman, yes that Bob Wyman, had only one person he had to sell his technology to: me.

MacroMan was, as I said, misguided, and it took some persuading, but it was eventually shut down. The Excel team convinced the Basic team that what we really needed was some kind of Visual Basic for Excel. I managed to get four pet features added to Basic. I got them to add Variants, a union data type that could hold any other type, because otherwise you couldn’t store the contents of  a spreadsheet cell in a variable without a switch statement. I got them to add late binding, which became known as IDispatch, a.k.a. COM Automation, because the original design for Silver required a deep understanding of type systems that the kinds of people who program macros don’t care about. And I got two pet syntactic features into the language: For Each, stolen from csh, and With, stolen from Pascal.

Then I sat down to write the Excel Basic spec, a huge document that grew to hundreds of pages. I think it was 500 pages by the time it was done. (“Waterfall,” you snicker; yeah yeah shut up.)

In those days we used to have these things called BillG reviews. Basically every major important feature got reviewed by Bill Gates. I was told to send a copy of my spec to his office in preparation for the review. It was basically one ream of laser-printed paper.

I rushed to get the spec printed and sent it over to his office.

Later that day, I had some time, so I started working on figuring out if Basic had enough date and time functions to do all the things you could do in Excel.

In most modern programming environments, dates are stored as real numbers. The integer part of the number is the number of days since some agreed-upon date in the past, called the epoch. In Excel, today’s date, June 16, 2006, is stored as 38884, counting days where January 1st, 1900 is 1.

I started working through the various date and time functions in Basic and the date and time functions in Excel, trying things out, when I noticed something strange in the Visual Basic documentation: Basic uses December 31, 1899 as the epoch instead of January 1, 1900, but for some reason, today’s date was the same in Excel as it was in Basic.

Huh?

I went to find an Excel developer who was old enough to remember why. Ed Fries seemed to know the answer.

“Oh,” he told me. “Check out February 28th, 1900.”

“It’s 59,” I said.

“Now try March 1st.”

“It’s 61!”

“What happened to 60?” Ed asked.

“February 29th. 1900 was a leap year! It’s divisible by 4!”

“Good guess, but no cigar,” Ed said, and left me wondering for a while.

Oops. I did some research. Years that are divisible by 100 are not leap years, unless they’re also divisible by 400.

1900 wasn’t a leap year.

“It’s a bug in Excel!” I exclaimed.

“Well, not really,” said Ed. “We had to do it that way because we need to be able to import Lotus 123 worksheets.”

“So, it’s a bug in Lotus 123?”

“Yeah, but probably an intentional one. Lotus had to fit in 640K. That’s not a lot of memory. If you ignore 1900, you can figure out if a given year is a leap year just by looking to see if the rightmost two bits are zero. That’s really fast and easy. The Lotus guys probably figured it didn’t matter to be wrong for those two months way in the past. It looks like the Basic guys wanted to be anal about those two months, so they moved the epoch one day back.”

“Aargh!” I said, and went off to study why there was a checkbox in the options dialog called 1904 Date System.

The next day was the big BillG review.

June 30, 1992.

In those days, Microsoft was a lot less bureaucratic. Instead of the 11 or 12 layers of management they have today, I reported to Mike Conte who reported to Chris Graham who reported to Pete Higgins, who reported to Mike Maples, who reported to Bill. About 6 layers from top to bottom. We made fun of companies like General Motors with their eight layers of management or whatever it was.

In my BillG review meeting, the whole reporting hierarchy was there, along with their cousins, sisters, and aunts, and a person who came along from my team whose whole job during the meeting was to keep an accurate count of how many times Bill said the F word. The lower the f***-count, the better.

Bill came in.

I thought about how strange it was that he had two legs, two arms, one head, etc., almost exactly like a regular human being.

He had my spec in his hand.

He had my spec in his hand!

He sat down and exchanged witty banter with an executive I did not know that made no sense to me. A few people laughed.

Bill turned to me.

I noticed that there were comments in the margins of my spec. He had read the first page!

He had read the first page of my spec and written little notes in the margin!

Considering that we only got him the spec about 24 hours earlier, he must have read it the night before.

He was asking questions. I was answering them. They were pretty easy, but I can’t for the life of me remember what they were, because I couldn’t stop noticing that he was flipping through the spec…

He was flipping through the spec! [Calm down, what are you a little girl?]

… and THERE WERE NOTES IN ALL THE MARGINS. ON EVERY PAGE OF THE SPEC. HE HAD READ THE WHOLE GODDAMNED THING AND WRITTEN NOTES IN THE MARGINS.

He Read The Whole Thing! [OMG SQUEEE!]

The questions got harder and more detailed.

They seemed a little bit random. By now I was used to thinking of Bill as my buddy. He’s a nice guy! He read my spec! He probably just wants to ask me a few questions about the comments in the margins! I’ll open a bug in the bug tracker for each of his comments and makes sure it gets addressed, pronto!

Finally the killer question.

“I don’t know, you guys,” Bill said, “Is anyone really looking into all the details of how to do this? Like, all those date and time functions. Excel has so many date and time functions. Is Basic going to have the same functions? Will they all work the same way?”

“Yes,” I said, “except for January and February, 1900.”

Silence.

The f*** counter and my boss exchanged astonished glances. How did I know that? January and February WHAT?

“OK. Well, good work,” said Bill. He took his marked up copy of the spec

…wait! I wanted that…

and left.

“Four,” announced the f*** counter, and everyone said, “wow, that’s the lowest I can remember. Bill is getting mellow in his old age.” He was, you know, 36.

Later I had it explained to me. “Bill doesn’t really want to review your spec, he just wants to make sure you’ve got it under control. His standard M.O. is to ask harder and harder questions until you admit that you don’t know, and then he can yell at you for being unprepared. Nobody was really sure what happens if you answer the hardest question he can come up with because it’s never happened before.”

“Can you imagine if Jim Manzi had been in that meeting?” someone asked. “‘What’s a date function?’ Manzi would have asked.”

Jim Manzi was the MBA-type running Lotus into the ground.

It was a good point. Bill Gates was amazingly technical. He understood Variants, and COM objects, and IDispatch and why Automation is different than vtables and why this might lead to dual interfaces. He worried about date functions. He didn’t meddle in software if he trusted the people who were working on it, but you couldn’t bullshit him for a minute because he was a programmer. A real, actual, programmer.

Watching non-programmers trying to run software companies is like watching someone who doesn’t know how to surf trying to surf.

“It’s ok! I have great advisors standing on the shore telling me what to do!” they say, and then fall off the board, again and again. The standard cry of the MBA who believes that management is a generic function. Is Ballmer going to be another John Sculley, who nearly drove Apple into extinction because the board of directors thought that selling Pepsi was good preparation for running a computer company? The cult of the MBA likes to believe that you can run organizations that do things that you don’t understand.

Over the years, Microsoft got big, Bill got overextended, and some shady ethical decisions made it necessary to devote way too much management attention to fighting the US government. Steve took over the CEO role on the theory that this would allow Bill to spend more time doing what he does best, running the software development organization, but that didn’t seem to fix endemic problems caused by those 11 layers of management, a culture of perpetual, permanent meetings, a stubborn insistance on creating every possible product no matter what, (how many billions of dollars has Microsoft lost, in R&D, legal fees, and damage to reputation, because they decided that not only do they have to make a web browser, but they have to give it away free?), and a couple of decades of sloppy, rapid hiring has ensured that the brainpower of the median Microsoft employee has gone way down (Douglas Coupland, in Microserfs: “They hired 3,100 people in 1992 alone, and you know not all of them were gems.”)

Oh well. The party has moved elsewhere. Excel Basic became Microsoft Visual Basic for Applications for Microsoft Excel, with so many (TM)’s and (R)’s I don’t know where to put them all. I left the company in 1994, assuming Bill had completely forgotten me, until I noticed a short interview with Bill Gates in the Wall Street Journal, in which he mentioned, almost in passing, something along the lines of how hard it was to recruit, say, a good program manager for Excel. They don’t just grow on trees, or something.

Could he have been talking about me? Naw, it was probably someone else.

Still.

Eric Sink has been hanging around Joel on Software since the early days. He was one of the creators of the Spyglass web browser, he created the AbiWord open-source word processor, and now he’s a developer at SourceGear, which produces source code control software.

But most of us around here know him from his contributions as host of The Business of Software, a discussion group that has become the hub for the software startup crowd. He coined the term micro-ISV, he’s been writing about the business of software on his blog for several years, and he wrote an influential series of articles for MSDN. He just published a full-fledged, dead-trees paper book called Eric Sink on the Business of Software, and he asked me to write the foreword, which appears here.

Did I ever tell you the story of my first business?

Let me see if I can remember the whole thing. I was fourteen, I think. They were running some kind of a TESOL summer institute at the University of New Mexico, and I was hired to sit behind a desk and make copies of articles from journals if anybody wanted them.

There was a big urn full of coffee next to the desk, and if you wanted coffee, you helped yourself and left a quarter in a little cup. I didn’t drink coffee, myself, but I did like donuts and thought some nice donuts would go well with the coffee.

There were no donut stores within walking distance of my little world, so, being too young to drive, I was pretty much cut off from donuts in Albuquerque. Somehow, I persuaded a graduate student to buy a couple of dozen every day and bring them in. I put up a handwritten sign that said “Donuts: 25¢ (Cheap!)” and watched the money flow in.

Every day, people walked by, saw the little sign, dropped some money in the cup, and took a donut. We started to get regulars. The daily donut consumption was going up and up. People who didn’t even need to be in the institute lounge veered off of their daily routes to get one of our donuts.

I was, of course, entitled to free samples, but that barely made a dent in the profits. Donuts cost, maybe, a dollar a dozen. Some people would even pay a dollar for a donut just because they couldn’t be bothered to fish around in the money cup for change. I couldn’t believe it!

By the end of the summer, I was selling two big trays a day… maybe 100 donuts. Quite a lot of money had piled up… I don’t remember the exact amount, but it was hundreds of dollars. This is 1979, you know. In those days, that was enough money to buy, like, every donut in the world, although by then I was sick of donuts and starting to prefer really, really spicy cheese enchiladas.

So, what did I do with the money? Nothing. The chairman of the linguistics department took it all. He decided that the money should be used to hold a really big party for all the institute staff. I wasn’t allowed to come to the party because I was too young.

The moral of the story?

Um, there is no moral.

But there is something incredibly exciting about watching a new business grow. It’s the joy of watching the organic growth that every healthy business goes through. By “organic,” I mean, literally, “of or designating carbon compounds.” No, wait, that’s not what I mean. I mean plant-like, gradual growth. Last week you made $24. This week you made $26. By this time next year you might be making $100.

People love growing businesses for the same reason they love gardening. It’s really fun to plant a little seed in the ground, water it every day, remove the weeds, and watch a tiny sprout grow into a big bushy plant full of gorgeous hardy mums (if you’re lucky) or stinging nettles (if you got confused about what was a weed, but don’t lose hope, you can make tea out of the nettles, just be careful not to touch ‘em).

As you look at the revenues from your business, you’ll say, “gosh, it’s only 3:00, and we’ve already had nine customers! This is going to be the best day ever!” And the next year nine customers will seem like a joke, and a couple of years later you’ll realize that that intranet report listing all the sales from the last week is unmanageably large.

One day, you’ll turn off the feature that emails you every time someone buys your software. That’s a huge milestone.

Eventually, you’ll notice that one of the summer interns you hired is bringing in donuts on Friday morning and selling them for a buck. And I can only hope that you won’t take his profits and use it for a party he’s not invited to.

Many software companies these days are built using some form of venture capital. But the VC industry has been hurting lately. A lot of investments in dotcoms turned out to be spectacular flameouts. As a result, VCs are becoming ever more selective about where to put their money. To get funded these days, it’s not enough to be a pet shop on the web. Nope! You have to be a pet shop on the web with 802.11b wireless hotspots, or your business plan is going right in the dumpster.

The formerly secretive world of VC has become a bit more transparent, of late. VCs like Joi Ito, Andrew Anker, David Hornik, and Naval Ravikant have created weblogs which are a great source of insight into their thought process. That dotcom thing resulted in three great books by company founders that look deep inside the process of early stage financing (see footnote). But as I read this stuff, as a founder of a company, I can’t help but think that there’s something wrong with the VC model as it exists today. Almost every page of these books makes me say, “yep, that’s why Fog Creek doesn’t want venture capital.” There are certain fundamental assumptions about doing business in the VC world that make venture capital a bad fit with entrepreneurship. And since it’s the entrepreneurs who create the businesses that the VCs fund, this is a major problem. Here’s my perspective on that, from a company founder’s point of view.

When people ask me if they should seek venture capital for their software startups, I usually say no. At Fog Creek Software, we have never looked for venture capital. Here’s why.

The fundamental reason is that VCs do not have goals that are aligned with the goals of the company founders. This creates a built-in source of stress in the relationship. Specifically, founders would prefer reasonable success with high probability, while VCs are looking for fantastic hit-it-out-of-the-ballpark success with low probability. A VC fund will invest in a lot of startups. They expect about seven of them to fail, two of them to trudge along, and one of them to be The Next Netscape (“TNN”). It’s OK if seven fail, because the terms of the deal will be structured so that TNN makes them enough money to make up for all the losers.

Although the real spreadsheets are many megabytes long and quite detailed, this is the VC’s calculation:

But founders are much more conservative than that. They are not going to start ten companies in their lifetime, they’re going to start, maybe, two. A founder might prefer the following model:

Even though the second model has a lower expected return, it is vastly preferable to most founders, who can’t diversify away the risk, while VCs who invest in dozens of businesses would prefer the first model because it has a greater return. This is just Econ 101; it’s the same reason you buy car insurance and Hertz doesn’t.

The difference in goals means that VCs are always going to want their companies to do risky things. Oh, sure, they’ll deny it, but if they were really looking to do conservative risk-free things, they’d be investing in U.S. Treasuries, not optical networking companies. But as an entrepreneur, you’re going to be forced at gunpoint to bet on three cherries again and again and again. You know you’re going to lose, but the gunman doesn’t care, he’s got bets on all the slot machines and one of them is going to pay off big time.

There’s nothing controversial here. A VC would say, “that’s what VC is for: investing in risky ideas.” Fair enough. As long as the entrepreneur wants to take a 10% chance, VC may be the way to go. The trouble here is that the VC is now doing a perverse kind of selection. They are looking for the founders with business ideas where the founders themselves think the idea probably won’t work. The end result is that VC money ends up being used in bet-the-farm kind of ways. This kind of recklessness causes companies like WebVan to blow $800,000,000 in a rather desperate attempt to buy a profitable business model. The trouble is that they were going so fast that they didn’t have time to learn how to spend money in a way that has a positive return, which is, by definition, what you have to do to be profitable.

Here’s my philosophy of company growth. A growing company looks like this:

Oh, wait, I forgot to define the Y axis. Let’s assume this curve is my revenues:

There are some other things which grow at roughly the same speed. For example, the number of employees:

And the number of people who have heard of your product, which we’ll call “PR”:

There’s also the “quality of your code” curve, based on the theory that good software takes ten years .

I’ve drawn these curves moving up at roughly an equal rate. That’s not a coincidence. In a small company, you regulate each of these curves so they stay roughly in sync. Why? Because if any two of those curves get out of whack, you have a big problem on your hand—one that can kill your company. For example:

1. Revenues grow faster than you can hire employees. Result: customer service is inadequate. Let’s tune in to Alex Edelstein over at Cloudmark: “[Cloudmark Sales are] pretty swamped, so they’re not getting back properly to everyone…. What’s happening here now at Cloudmark is a little like the early days at Netscape when we just had too few people to properly respond to the customer interest.”
2. Revenues grow slower than you hire employees. Result: you burn cash at a ridiculous rate and go out of business. That’s an easy one.
3. PR grows faster than the quality of your code. Result: everybody checks out your code, and it’s not good yet. These people will be permanently convinced that your code is simple and inadequate, even if you improve it drastically later. I call this the Marimba phenomenon . Or, you get PR before there’s a product people can buy, then when the product really comes out the news outlets don’t want to do the story again. We’ll call this the Segway phenomenon.
4. Employees grows faster than code: Result: too many cooks working on code in the early days causes bad architecture. Software development works best when a single person creates the overall architecture and only later parcels out modules to different developers. And if you add developers too fast, development screeches to a halt, a phenomenon well understood since 1975 .

And so on, and so on… A small company growing at a natural pace has a reasonable chance of keeping these things in balance. But VCs don’t like the flat part of the curve at the beginning, because they need an exit strategy in which the hockey-stick part of the curve occurs before their fund needs to cash out, about six years according to VC Joi Ito . This is in direct conflict with the fact that good software can’t really accomplish this kind of growth. Hockey stick, there will be, but it will take longer than most VCs are willing to wait. Remember my chart of Lotus Notes? Good heavens, I am repeating myself.

VCs try to speed things up by spending more money. They spend it on PR, and then you get problem 3 (“PR grows faster than code”). They spend it on employees, and then you get problem 4 (“too many cooks”) and problem 2 (“high burn rate”). They hire HR people, marketing people, business development people. They spend money on advertising. And the problem is, they spend all this money before anyone has had a chance to learn what the best way to spend money is. So the business development guy wanders around aimlessly and accomplishes zilch. You advertise in magazines that VCs read, not magazines that your customers read. And so on.

OK, that’s the first part of the VC crisis.

The second part is the fact that VCs hear too many business plans, and they need to reject 999 out of 1000. There appear to be an infinite number of business plans looking for funding. A VC’s biggest problem is filtering the incoming heap to find what they consider to be that needle in the haystack that’s worth funding. So they get pretty good at saying “no,” but they’re not so good at saying no to the bad plans and yes to the good plans.

When you have to say “no” 999 times for every time you say “yes,” your method becomes whack-a-mole. Find the flaw, say no. Find the flaw, say no. The faster you find flaws, the more business plans you can ding. Over at VentureBlog you can amuse yourself for an hour with some of the trivial reasons VCs will ding you. PowerPoint too complicated? Ding! Won’t tell us your magic sauce? Ding! You didn’t research the VC before you came in? Ding! It’s not their fault; they are just trying to say no 999 times in as efficient a way as possible. All of this reminds me too much of the old-school manager who hires programmers based on what school they went to or whether they look good in a suit.

Naval Ravikant, a VC at August Capital, reveals the classic VC myopia of feeling like they just don’t have time to get to know entrepreneurs that aren’t ready to pitch yet. “Most VCs are too busy to ‘dance,’” he wrote. They are too busy vetting serious proposals to shmooze with interesting companies that might not need cash right now.

This is, roughly, the equivalent of the old joke about the guy searching for his car keys under a streetlamp. “Did you lose them here?” asks the cop. “No, I lost them over there, but the light’s better here.”

But the great companies are often not the ones that spend all their time begging for investments. They may already be profitable. They may be too busy to look for VC, something which is a full time job for many entrepreneurs. Many excellent entrepreneurs feel that their time is better spent pitching products to customers rather than pitching stock to investors. It’s bizarre that so many VCs are willing to ignore these companies simply because they aren’t playing the traditional get-funded game. Get out there and pursue them!

Here’s another funny thing that’s happening. VCs are reacting to the crash by demanding ever stricter conditions for investments. It’s now considered standard that the VC gets all their money back before anyone else sees a dime, no matter what percent of the company they actually own. VCs feel like this protects their interests. What they’re forgetting is that it reduces the quality of startups that are willing to make deals. Here’s one of VC Joi Ito‘s suggestion for VCs : “Sign a ‘no shop’ and get a letter of intent (LOI) signed quickly so an auction doesn’t start jacking up the price.” A no shop is sometimes called an exploding term sheet. It means that the company must either accept the deal on the spot or it won’t get funded at all. The theory is, we don’t want you going around to other VCs trying to get a better deal. It’s common among the second-tier VCs, but the best VCs are usually willing to stand on their own merits.

It seems to me that a company that accepts an exploding offer is demonstrating a remarkable lack of basic business aptitude. Every building contractor in New York knows you request bids from five or ten plumbers before you award the contract. If a plumber said, “I’ll do it for $x, but if you shop around, deal’s off,” the contractor would laugh his head off and throw the plumber out on the street. Nothing sends a stronger message that an offer is uncompetitive than refusing to expose it to competition. And that’s for a $6000 kitchen installation. Getting $10 million in funding for a business is the biggest and most important deal in the life of a company. You’re going to be stuck with this VC forever, they’re going to want to control your board of directors, they’re going to push the founders out and bring in some polished CEO as quickly as they can, someone who will take the picture of the cat off your homepage and replace it with the usual MBA jargon.

And now they want you to agree to all this in a matter of fifteen minutes without talking to anyone else? Yeah, right.

VCs who make exploding offers are pretty much automatically eliminating all the people with good business sense from their potential universe of companies. Again, it does make it easier to say no 999 times, but you’re pretty much guaranteed to say no to all the companies with a modicum of negotiating skills. This is not the correlation you’re looking for. In fact, just about everything the VCs do to make their deals “tougher,” like demanding more control, more shares, more preferential shares, lower valuations, death spiral convertible stock, etc., is pretty much guaranteed to be at the expense of the founders in a very zero-sum kind of way. And this means that smart founders, especially the ones with businesses that can survive a lack of funding, are going to walk away. VCs must realize that if the business flops, no matter how much control you have, the investor is going to lose everything. Look at the story of arsDigita. A nasty fight over control gives Phil Greenspun enough money to buy an airplane, and the VCs still lost every penny when the company went down the tubes. So all these tough deals are not really protecting the VCs, they’re just restricting the VCs’ world of possible investments to dumb companies and desperate companies. Sam Bhaumik, VC, says “VCs are being aggressive, but most requests are legitimate.” The capital belongs to public pension funds and university endowments, he notes, using the standard widows-and-orphans sob story.  Boo hoo . Come on , public pension funds and university endowments are the savviest investors out there; don’t tell me they need coddling and protecting. They’re investing in risky venture funds for a reason: they want to get paid for taking risk. If they wanted protection, they’d invest in US Treasuries.

There are probably hundreds of software companies started every day. Of that universe, there is a small number that are actively looking for early stage investors. Of that small number, an even smaller portion is willing to go along with the current harsh deals that VCs are offering. Now slice away the founders who are afraid of being arsDigita’d. The population shrinks even more as VCs reject companies that don’t match their—quite reasonable—criteria for spotting a successful company. You wind up with a tiny number of investment opportunities which, quite frankly, is vanishingly unlikely to contain The Next Netscape.

More Reading

Considering VC? First read this article on the web:

An Engineer’s View of Venture Capitalists , by Nick Tredennick

Don’t miss these three books by company founders:

• High St@kes, No Prisoners: A Winner’s Tale of Greed and Glory in the Internet Wars by Charles Ferguson.
• The Leap: A Memoir of Love and Madness in the Internet Gold Rush by Tom Ashbrook
• Burn Rate: How I Survived the Gold Rush Years on the Internet by Michael Wolff
• Startup: A Silicon Valley Adventure by Jerry Kaplan

A movie about the process:

• Startup.com

And don’t forget:

• Eboys: The First Inside Account of Venture Capitalists at Work by Randall E. Stross

Weblogs by VCs:

• VentureBlog
• Joi Ito