Johnson's Law

During Silicon Valley’s boom days, Craig Johnson and the law firm he founded became potent symbols of success. By specializing in early stage, high-tech startups, Venture Law Group became, if not a rainmaker, then a cloud seeder. Venture Law, founded eight years ago, struck it big with early clients like Yahoo. It advised startups like Cerent Corp., which was acquired by Cisco Systems Inc. for $6.9 billion. The firm still has only 110 lawyers, but its influence extends far beyond the nondescript offices on Menlo Park, Calif.’s storied Sand Hill Road. In short order, Venture Law became the legal equivalent of the venture capitalists Johnson so wanted to emulate. But now Silicon Valley is littered with failed startups and venture firms are struggling. Pets.com, a poster kid for dot-com craziness and public company failure, was a Venture Law client. A talking sock puppet occupies a perch in Johnson’s office. The degree of the damage to high-tech firms has Johnson — who has been practicing in Silicon Valley for almost three decades — shaking his head. “Even old-timers like me have never witnessed anything like this sudden deceleration,” he says. He likens the past year to a car going full throttle, then suddenly stopping. Still, Johnson does not voice any second thoughts about what he created. Indeed, the firm is now in the market for new clients, the first time in years, he says. Johnson is a true believer, and his story is oft-told. In 1993, he was a senior partner at Wilson, Sonsini, Goodrich & Rosati. The California native joined the firm in 1974 right out of Stanford University Law School and had been one of those instrumental in making Wilson Sonsini the Valley’s most prestigious firm. He had his own team of lawyers. His pay package was more than $1 million a year. But Johnson also was frustrated about Wilson Sonsini’s direction and growth and a structure he believed was ill-served to represent young tech companies. He had a dream — literally, he has said — about what a law firm that specialized in startups could do. In February 1993, he abruptly quit to strike out on his own. Johnson molded Venture Law into a cross between venture capitalist, business mentor and legal institution. The firm not only specializes in early-stage companies, but eschews the more mundane legal matters that come with maturing companies. It invests in virtually every company it represents, usually taking a 1 percent equity stake at the same terms as venture capitalists. Once their companies get big or go public, they cede legal representation to other firms. Now 54, Johnson has reached the age where he’s easily old enough to be the father of many clients. He’s still advising startups in their infancy, although he now works in tandem with another senior partner. And he has occasionally taken some time off. Last year, he disappeared for two months to bicycle around France. Johnson can afford the break. He almost sheepishly relates that in February 2000, he peered at a chart showing the acceleration in the growth of the Nasdaq index and had an epiphany. “I remember going to my den and getting a ruler and laying it down on top of that line and it was going absolutely straight up,” he says. “By that standard, it would have literally been another three weeks before Nasdaq hit 10,000 and it just didn’t make any sense.” The next morning he began the process of selling his personal portfolio. He liquidated 95 percent of his holdings, including shares in some companies that wouldn’t survive the next 12 months. Johnson sat down in his office recently with The Daily Deal senior writer Matt Miller to discuss today’s business climate in Silicon Valley. Matt Miller: Are you spending all your time these days with panicked companies? Craig Johnson: One piece of business advice that we give the companies we’re working with is to keep a lot of runway in terms of funding and money in the bank. [During boom days] it was almost to the point of seeming ridiculous because in an environment where valuations were constantly increasing, there was a premium placed on just-in-time financing, not raising more than needed because you expected to be able to raise more money later more cheaply. I routinely violated that [precept] by recommending to my companies that they always keep at least 12 months — and sometimes as much as 24 months — worth of money in the bank. I also recommend that once they have it in the bank, they should do everything possible not to spend it. One example, Financial Engines — which I helped to co-found — is a company that has a genetic coding of fear built into it. It had the great good sense and fortune to raise a great deal more money than it needed to spend. Their cash reserves are very strong. They’re supplementing their financing with significant transactions and deals. There’s an example of a company that will likely be a huge winner in the long term because it simply is going to have resources to stay alive and develop its business model. Q: How do you see the current deal environment in the Valley? A: There’s a lot of digestion to be done and frankly, there will be a lot of problems digesting the number of deals that were funded over the last few years. The capital needs of these companies on a cumulative basis will simply be enormous and it is obvious that many of those companies will not be able to attract follow-on financing. Those that can will probably do so at very steep reductions in their valuations from their prior rounds. You still see situations where companies are raising money at two, three, four times the prior round price. The money is there. But you have to do something very special to move into the greed, not fear, category. People expect to see a lot of carnage over the remainder of this year, although much of the carnage will probably be a one-year phenomenon. Once we get through the issue of digesting those companies and shaking out weaker companies that aren’t able to get follow-on financing, then there’s a great deal of optimism that we’ll be back to an environment where value will be able to be created in a systematic way, but over a longer time period. Many venture funds were telling their limited partners in the recent past that the $500 million, $800 million funds would be invested in an 18-to-24 month period. Now we’re seeing VCs telling their limiteds that their most recent funds will be invested over a four- to six-year period. So there’s been a dramatic lengthening of the time over which these funds will be invested. That also means a dramatic slowing in the rate new companies are being funded. Q: How do you see merger environment? A: It’s not likely to be quite the savior it was in other down cycles. One reason is that the companies that have traditionally been most active acquirers — companies like Cisco, Nortel and others — are dealing with a substantially depreciated currency. They have to convince hot, up-and-coming companies in their sector to take much lower valuations than they might have become accustomed to. And when I say “much lower,” I mean like 90 percent or they don’t do the deals. The obvious cast of potential acquirers is relatively inactive at the present time, given their own issues. It’s also true that in this kind of environment, cash tends to be king. Most companies are very reluctant, if they’re not already profitable, to merge with another unprofitable company. It’s like hitching your rock to a rock. Two rocks sink just as fast as one rock, maybe even faster. So you don’t see many struggling companies reaching out to consolidate with their rivals. Q: Does this mean you have to bring a different skill set to your practice? A: It’s not so much a different skill set. What’s clear is that we’re moving back to the way this business has worked for most of my 26-year career, which is a lot less go-go. I’m still very optimistic about the long-term trends in new technology and technology company growth. The markets got way ahead of themselves and we have to digest some very painful retrenchment. It’s very hard for any institution — whether it be Cisco or Wilson Sonsini or Venture Law Group — to adjust to such rapid and dramatic changes in valuations, investment climate, exit mechanisms and the like. Q: Have you changed your approach to your clientele? A: For several years, we could accept almost no new clients. We simply couldn’t keep up with the legal needs of the companies we already had, much less bringing in new companies, and we were very concerned about maintaining high quality of service and our reputation for service. That has changed, not because of any decline in the quality of the companies we work with, but simply because the average company is so much less active than it was before. We have capacity, but not unlimited capacity. We are selectively taking on new companies, but we’re not changing any part of our business model. We are not going to do litigation. We are not going to do other types of legal specialties. We are going to continue to stay focused on high-growth, high-potential technology companies. We are going to continue to focus primarily on the earlier-stage companies, although we may take a few more companies in the middle stages. The biggest challenge we have, given this radical slowdown in the Valley, is simply assimilating the new people we brought on board. We were not in a high-growth mode, like some other law firms, so we’re fortunate. We’ve only grown by about 10 percent a year over the last few years. We’re about 110 attorneys at this time. [That means] fully utilizing an extra 10 attorneys, whereas other firms in the Valley have added hundreds of attorneys. On the other hand, if the environment shows any kind of a pulse again, we’ll be back in the soup. We’ll be totally overwhelmed. We limit the number of companies that each attorney can represent. Even in this environment, if we reach those limits we won’t accept any more clients. But we’re doing a little bit of marketing and a little bit of client prospecting for the first time in a long time. Q: The corollary to the issue of lawyer expansion is the question of lawyers leaving to join startups. Has that dynamic changed? A: Retention for us is key in our service model and it was very painful for us in the last couple years to lose some of the [firm's] people to clients and venture capital funds. We didn’t lose anyone to other law firms. But it was really hard to dissuade a young attorney being offered more money and a big stock option to become a VP for business development of a company that looked like it was going to the moon. We had many people who decided to drop their aprons and run for the gold fields. We had in 2000 a 15 percent attrition rate of attorneys. It’s much lower than other firms, but we publicly advertise on our Web site that we strive for zero voluntary turnover. We jumped through hoops trying to figure out ways to retain people. Q: Had you had lawyers who want to come back? A: We’ve had a number of informal inquiries from people who want to come back, but right now we’re primarily concerned with the people here. Q: Any change in your firm’s approach to taking equity in clients? A: No, we invest in virtually all the companies we represent and we intend to continue to do so. Keep in mind that we do believe the investments made now will probably be better than the investments made in 1999 and the beginning of 2000. Valuations are lower. Companies are more likely to be seriously technology-based. Expectations are reset, so people expect that they will be in the trenches building real companies over five, seven, eight years. We certainly don’t want to make the mistake of pulling back when the best opportunities are surfacing. We obviously will not have the kind of liquidity that we were having, which was very nice and very significant. But we know that our business model is cyclical and we know that there will be years where there won’t be as many public offerings or mergers. Q: What about investments in publicly traded companies whose value declined by the time the lock-up expired? A: One of the benefits we have is that we’re typically working with a company when it’s two individuals. When we invested in Yahoo, I think our investment basis was two cents a share. Now, granted we sold far too early [to Softbank Corp.] and it went up 100 times after we sold. We still made more than 100 times our investment. The bottom line is that even in cases where the stock has dropped very substantially, it still is usually quite profitable to us. Q: Is there a committee approach to when you sell? A: We have a general policy that when it’s possible to distribute the stock, our investment partnership will distribute the stock to the [individual lawyers involved in the company] and the individuals will decide to sell or hold. Only in the case of relatively small returns, where it would be administratively cumbersome to distribute the stock to the number of people involved, will the partnership itself sell the stock. Q: eToys was one of Venture Law’s clients. Did you get stuck holding worthless shares? A: We weren’t there at the bitter end. Part of our business model [is that] when companies have gone public, as eToys had, we will generally stick around for some period of time. Then we will generally exit the relationship in a graceful manner. The main reason for that is that we are not a full-service firm. Most of the needs of public companies are in the areas of litigation and other specialties we don’t do. In some cases, Yahoo being an example, we have stuck around because the team itself was having so much fun. In most cases, when we get a company to a liquidity event, we move back to the beginning and start approaching those two- or three-person teams with our senior resources. Q: Were you able to sell your stake in eToys? A: Ah, yes. That was one of the stocks I was fortunate enough to liquidate. Obviously, there were lots we didn’t. There were, are a number of companies that seemed to me to be very well poised for future growth. The downturn in Nasdaq punished all companies almost indiscriminately. Some I was lucky enough to be able to liquidate. Some I still hold. Some I’m very glad I hold. Q: What about decisions on whether an individual or the group invests in clients? A: Every investment opportunity has to be offered first to the firm. If there is the opportunity to make additional investments on top of that, with the firm’s permission, individuals associated with [representing] the company can invest more. If a company has $100,000 of Series A preferred stock that it’s willing to sell to us, and VLG Investments decides it wants to take $50,000, the remaining $50,000 can be divided among the [legal] team, if they want it. Q: Is VLG Investments a committee of partners? A: We have a four-person committee of partners that administrates that. It’s not really something where there’s a great deal of investment judgment going on. The committee primarily checks the amount of the investment, but in general we have a philosophy that if a company is special enough that it causes us to want to represent it, we should invest in it. Q: Could you explain the decision-making process to take on new clients? A: We leave that to our new business committee, which is a rotating group of attorneys at different levels of seniority. The business committee is primarily there to make sure we don’t over-eat, that when we take on a company, we actually have a full team of attorneys and paralegals at appropriate levels of seniority. We also check to make sure that the attorneys who sign up for the company actually have capacity, and by capacity, I mean the number of companies each attorney can represent. If someone is at his or her limit, it doesn’t make any difference what the company is, someone else has to be recruited to be on the team. We also have limits to the number of unfunded companies directors can take on at any one time. We call it our “three dog night” policy. Any director can have at any one time three companies that have not yet been venture-funded. Copyright (c)2001 TDD, LLC. All rights reserved.