Jörg Rheinboldt (APX): We don’t look at industries, we look at the market horizontally. We invest in everything that’s digital as long as we understand it.
27 Nov, 2020
David Blivin is Founder and Managing Director of Cottonwood Technology Fund I, II and their Euro Fund. He was also previously the Founder and Managing Director of Southeast Interactive, the first and largest information technology-focused fund based in the Southeast of the US.
It happened over time. I was initially working at Montrose Capital, a merchant bank based in North Carolina’s Research Triangle Park. Merchant banking is more like leveraged buyouts, later stage, cashflow-positive companies. But because we’re based in Research Triangle Park, we were surrounded by a lot of innovation. It was back in the early 90s, with lots of entrepreneurs looking for capital and there were very few sources based in that region. So, even though we were a merchant bank, most of them did not understand the difference; they just knew we were investors and approached us periodically for capital. I would refer them to others because it wasn’t really what we did. Then, eventually, I met another entrepreneur, and he started taking me to meetings. We decided that, maybe, we should raise a venture capital fund to help provide more sources of capital to entrepreneurs in that region at that time. My boss agreed with me, and we raised our first fund in 1995, raised the second fund about 1.5-2 years later. At that time I went from part-time running the fund while still working full-time for the merchant bank to a full-time commitment with the fund. I built the team, and the rest is history as I say. We raised 3 funds eventually about $180M in total. Then I sold that to one of my partners when the market turned on in 2001-2002. He wanted to raise a later stage fund because the market was difficult for the early stage, and I wanted to stay focused on early-stage investments, which was what I enjoy doing and what I’m still doing. Ultimately, as my wife is from Santa Fe, we moved to New Mexico in 2008, and that’s where I started Cottonwood. We’ve made 20 Investments, about $50M altogether so far, and we just had an initial close on our Fund III. We just made our first investment in Fund III and are targeting raising $50-75M.
Probably the most unusual one was in a company that had a 3D interface to the web. And this was back in the late 90s. When you navigated the web, you essentially flew through space, like in a computer game, and you saw billboards, created cities around different communities, e.q. the financial, or retail, or healthcare community. And if you want to get to Amazon.com, for example, you would fly past the Nike store and other small retailers. You would pay for using this technology based on whether you were a net recruiter of traffic or a user of traffic. It was a pretty interesting concept, but at the time the bandwidth wasn’t fast enough to support their 3D experience. That was one that was interesting and would still be interesting I think but never made it into the mainstream.
We’re probably getting on average 1 prospect a day, so it is 300-400 a year. A lot of them don’t fit our criteria, so we get many business plans from companies that just know we’re a venture capital firm. Our focus is the early founding stage of hard science-related companies – Materials, Robotics, Photonics, Energy, etc., but before they have a product or a customer, and we help them to finance that first product. If we get 400 plans, a lot of them will be software, a lot of later stages, a lot outside of our region. If we get down to the ones that would be relevant, it is more like 1 a week that really fit our criteria potentially. We end up on phone call with, maybe, half of that – after an initial review of the deck and understanding the business opportunity. Ultimately we make 1 or 2 new investments a year.
A little bit of both. We go to conferences, we visit the research universities that are based in our region. We have an office in the Netherlands and visit the innovation centers in the Netherlands, Germany, Belgium, France. In the US, we go to the universities, the national labs, other centers of innovation in the region, which we define as New Mexico and the surrounding states – Texas, Arizona, Colorado, Utah, etc. We do need to proactively source innovation because we’re getting started so early. It is usually not a company that has raised money and already is in national databases looking for capital. We’ve got to find those ideas in many cases. Once we make investments, and a company has press releases that they’ve raised the funding with Cottonwood as a lead investor, that word gets out also and brings us some deal flow. People get to know us and we get into databases as active investors.
We’re looking for hard science, for things that are very unique and different from what is already in the market, highly patentable or patented. If you look at innovation in general, so much of it is incremental to what’s already in the market – a little bit faster, a little bit cheaper, whatever. We’re usually looking for something that’s never been done before, and, quite honestly, even looking like it can’t be done at all. Still out of the 20 Investments that we’ve done, all have been able to do what they promised and develop their products. We look for these kinds of unique disruptive ideas that can become new industry standards in their relevant markets. In today’s environment, most of the venture community focuses on software and services, so it is also unique to be focusing on hardware and hard science. So most of our next round capital comes from the corporate venture community, which is quite active today and bigger than it’s ever been. If you’re a real company that needs real products, you need to identify new innovation to incorporate it into a roadmap of the next-generation capabilities. Having said that, most big corporations have reduced their internal investment in internal research and development, so a lot of corporations source innovation today by partnering with universities, national labs, etc.. We become a good partner for corporations by finding unique innovation early, funding the initial prototype development and then they can get engaged once there is something for them to test and validate.
I’d say, even founding stage sometimes – there are several companies in our portfolio that we essentially co-founded with the founders. At earlier stages, there are really few sources of capital for hard science related types of companies. Some of the Angel networks do a little bit of investing in that space, but they quite often don’t have the capacity to put in more than $250-500K. For the hard science that’s just not enough, typically, to get a working prototype, demonstrate it to potential customers and give them a chance to evaluate it. The other thing that, I think, is underappreciated, is that the hard science companies are generally started by scientists, by the people who know how to build a product that works; but what they don’t necessarily know is how to build a company and sell this product. And almost always you need a business person added to the team to develop these business relationships with the corporate customers and even with the next round investors. If you don’t do that at the beginning, it is hard to do that when you’re running out of money and need to raise the next round. One of the things we do is put $1-2M at the beginning – even though it’s the founding stage – to get the business person on the team, so we can start talking about market entry strategy, business models, and have someone on the team that can
Yes. In the initial round.
Depends on whether we are syndicating or doing it ourselves. The minimum investment would be $1M. So, somewhere between $1M and $2M, and we do, usually, at least half of that.
Every company is a little bit different. In some cases it may be too early for us, so we may give them coaching and help them to meet some of the folks they might need to meet. In these cases, we may get involved once they are ready when they develop their products and can deliver them to the customers. But, in general, it takes us somewhere between 3 and 6 months from the initial meeting to the investment. Our due diligence is more on the market opportunity and the technology side. As I already mentioned, one of our primary value additions is our corporate network, so even before we invest, we introduce these companies to corporate partners that we have across different Industries. Primary due diligence for us is getting feedback from the corporations that we have these relationships with on both how big is the market opportunity and how unique is this technology – if it works! Many times they say, “Oh, you know, we see things like this all the time, but no one’s ever got it to work.” We’re looking for this unique opportunity and a chance to be a new industry standard, to grab 10-25% of the market, not 1% or 2%. Our corporate partners usually don’t really want to invest at a too early-stage company, before there is a working product their engineers can evaluate. But they do want to know about these kinds of technology, and by getting their feedback early, by keeping them updated on the progress, getting them a prototype when it’s ready we line them up for the next round of raising capital.
We’re looking for disruptive ideas that can gain 10-35% market share. Every company we invest in we believe could go public or could be acquired for multiple hundreds of millions if they get the product or the technology working and reach their customers. Since we’re,usually,the first ones in, with our initial investment we typically get 30-40% of the company, and then we’re diluted down as they raise additional rounds of capital. But once the company is successful, we’re thinking about 25 to 100 times of our money, and we have one company in a process of exit consistent with that. Obviously, not 100% of our companies are going to do that, but even if one or two reach that goal, it really drives the returns of the fund.
Looking at rounds of funding, at the earliest stages it is around 40% of the ownership, the next round it’s about ⅓ of the company, next round around 20-25%. It becomes less as you become more mature, and even if you’re raising more money. The valuation, in theory, is going up, and the risk is going down, so you’re giving up a smaller percentage of the company with each round. In our round, we’re,usually,taking somewhere between 30% and 40%.
As I said, most of these technology-related companies are started by technology people. They do not, typically, have a business person on the team. Because we’re so early, we don’t have much of a team to evaluate. We help them to recruit and build the team over time, bringing in that business person, etc. The primary thing that we’re looking for in the founding team is some understanding that their strength is the technology, and we’re going to have to build the team over time, and that they may not be running the company eventually, that we may need to bring in a business person that really is driving your market entry, building the team, recruiting capital, etc. More than anything else we look for technology founders that understand that, if they are going to be successful, the team is going to grow and different skill sets are going to have to be recruited to the company, and their skill sets may or may not be on the business side – in many cases. If they’re not open to essentially losing some control of the company over time, then it’s going to be hard to be successful, because there’s no way you can be successful as a one or two-person company, especially without business people in the team. That’s the main thing we’re looking for in the founding team – a desire to be successful and understanding that they have a company or technology that could represent a big market opportunity, and any big companies are going to have to raise tens of millions of dollars, build a team of tens and hundreds and thousands of people over time. And we want to make sure that we share a common vision of the potential of what we’re trying to build together. And not that they want to own and control the company forever, because it’s not practical in conjunction with what I’ve just talked about in terms of scaling of the company, team,and capital.
I would say, with Steve Jobs. It’s an easy answer because he was so successful. There is one thing about Steve Jobs – he was totally driven to win. We start with these very small companies that have one or two people, in some cases with a prototype, and it’s not going to be an easy road to success. If you’re not committed and you’re going to give up easily in the face of difficulties, or getting negative feedback from initial customers or investors – none of it is going to be easy and the path is not going to be straight-forward. You need people who are not going to accept failure. That’s not everybody. A lot of people feel, that, if things get hard, they can always may look for another job. We’re not going to run the company, so we need people there who don’t sleep at night worrying about how they’re going to win. And we can help them win, but we really need someone as committed as we are on the other side of the table.
It always comes down to people. I constantly remind myself that it’s easy to fall in love with the technology and the market opportunity, because we see so many interesting technologies, as you might imagine. And it’s easy to lose sight that you’re not going to be successful if there are not right people, there no matter how interesting the technology is. I’ve had investments in the past, where I thought,we and the founders had a common vision on how the company can be successful. And then when they’d get the money, these people may decide that they can do what they think, not what was agreed to do. I try to listen, to make sure there’s really a commitment, a common vision. When people are trying to raise money, they, in many cases, have a sense of what I want to hear and tend to agree with everything I say. They want me to say “Yes.” That’s not always the best thing: they should know more about the opportunity than I do, they should push back in some cases and say, “You might think that, but here’s why that might not be the best path forward, etc. I look for people who are listening to both sides. The same thing happens on the other side: they think they know more than I do – and they really do on the technology, no doubt! But they don’t know more than I do, necessarily, on the business models, and market opportunities, and how to enter the market. Talking about red flags: I don’t want people who are too agreeable with me – they should know more than I do and should be able to correct some of my assumptions. And I don’t want people who don’t want to listen. Now and then we have meetings with entrepreneurs saying, “I just need the money, I don’t really need that much help.” That’s a red flag. Maybe they don’t think they need my help, but they still need to be open to new ideas, be ready to learn and you should at least be open to ideas, to research, to relevance and accuracy of some of the feedback, not just blindly accept it. And everybody should be open to criticism, to ideas that are different from the imaginary path to success they made in their minds. I don’t want them blindly accept everything, just listen and, maybe, come back with some research done, with the arguments, not just an initial reaction and refusal. So, my primary red flags are really about the people, how easy are they going to be to work with, how well they’re going to listen, and how well.
Not so much, to be honest, and part of the reason is that we are involved so early. In most cases, if we don’t invest, there are not that many other options for them to raise money and be successful going down a different path. The markets that we’re focused on are outside of Silicon Valley, there are limited sources of capital here, and almost in every case, we end up being one of their only options for capital to get to the next stage. I’m not aware personally of any companies that we passed on and that then became very successful, so I have had little chance to regret my decisions. In North Carolina, though, that happened in a few cases, because the ecosystem there was more developed and had a more robust funding environment in the late 90s before things turn down. A lot of companies there, when we said “No,” still could easily get money from other people, and some of those companies did end up being relatively successful. So, it does happen and, probably, will happen with Cottonwood as well.
We never invest in software. So, any of the software related things, like AI, Blockchain, SaaS, Mobile apps – we don’t invest in any of those areas intentionally, because we focus on patents, and it’s hard to get patents in the software-centric industries. You’re very dependent not on the patents, but on your ability to raise capital and build the team pretty quickly, because anybody can compete with you if they think it’s a good idea and they have access to more money and better management. I like a lot of companies that I see, relevant to those areas, especially in the AI space, SaaS, which are quite interesting and quite compelling. But we choose not to play at that space, just because we don’t have a big enough fund to get them into the mainstream, especially when you’re based outside of the big money centers, like California, Boston, or New York.
Well, not really for us. Certainly, COVID-19 has had impact on most of our companies and their ability to raise additional capital. Some corporations, that were pretty aggressive at the beginning of the year (and the last few years), sponsoring innovation, now have been taking a step back to see how big of the impact will be on their company and making sure their core business is back on track first. Our companies, in general, because they are so early, not yet depending on revenues, so the capital they are raising is intended to last for a certain amount of time in the absence of revenue. And COVID doesn’t really impact them from that standpoint. Fortunately, in almost every case our portfolio companies raised capital before the COVID hit and have enough capital that allows them to last for a while and get to the next stage on their technical milestones and, hopefully, raise the next round. For new investments, we’re probably being a little more cautious in terms of diligence and getting a better sense of the commitment from the corporate community, as we go into some of these companies.
Obviously, Apple, since they’re worth over 2 trillion dollars today. Facebook is obviously on the list. I think Twitter is interesting regarding how much of the dialogue nationally is supported by Twitter – 24/7. I was surprised how that platform became, for a lot of people, corporations, and celebrities, a way to get their voice out. I’m really missing a lot of breakthrough ideas, but these 3 just come to mind quickly.
I love what I’m doing. For me, it is something I would almost do for free because I enjoy it so much. It’s nice to get paid to do it if you’re successful. But almost like a professional athlete, I enjoy meeting and seeing these innovators and new ideas on a daily basis, working with founders who have a vision for their company and helping them to get started, helping them execute on their plan, getting them in front of the right customers and investors, helping to build a team. No, there’s nothing that I would do rather than what I’m doing right now. I feel very fortunate to be able to do it.
I think it’s definitely more chess than checkers. Sometimes I use this analogy with the portfolio companies. I tell them, “You’re trying to raise the next round, but you have to be thinking 2 or 3 steps ahead. You don’t just hire this person, but you need to think about who you will need next. Same with the customers.” For me it’s a little bit more like chess: it’s strategic, you need to understand what your competition is, where the opportunities are on the market, your positioning to take advantage of those opportunities. You have to be thinking about multiple things simultaneously.
One of the biggest things I try to teach founders is this: Expect that you’re going to lose control of the company at some point and not be afraid of that. Because you’re trying to build a company, not a small single proprietorship. Understanding where your strengths are, understanding what skill sets are needed to fill in if you’re not skilled in some areas – this is Number 1. It is about building a team and getting yourself into the best position in the company over time. Building a team, being ready to lose the control – those skills are very important. Number 2: When you’re raising capital quite often, you may be ready to take it from almost anybody. But you should think about it – it is almost a marriage. You should take money from people you’ll be comfortable to work with, who are willing to be a partner with you. So, taking money from the right people is very important. And Number 3: You have to listen to the market, because, as I mention, we go to corporate folks to get feedback on the market opportunity and technology. Technical people often feel like they know more than anybody about the problem they are solving and the technology they are developing, but almost every company pivots in terms of where the initial market is, what the initial business model is, what the application of the technology they have is, etc. Quite often they have feedback from the market but they don’t listen to it and just continue to knock on new doors with the same story, wasting a lot of time and money. Listen to the feedback – from customers, investors, your market. You need people who are open to hearing, not just talking.
My first is Santa Fe, where I live, and my second is New York City. In Europe, probably Rome is my first and my second is Amsterdam.