NYC 2.0 (continued)

I never made it to the Web 2.0 conference yesterday, and you know how I feel about that label :-).  Anyway, I happened to be in San Francisco for a portfolio company board meeting and some other events.  After a Nokia boat cruise with many of the team that launched the awesome Nokia Internet 810 tablet (I will get myself one of those), I had the opportunity to go to a MySpace party to celebrate the opening of their San Francisco office.  I had a great time and while I ran into many friends from the Bay Area, what I enjoyed most was bumping into many of the original New York entrepreneurs that I have known over the last 10 years.  In a scary way, it felt like it was 1997 all over again, and we were at a networking event in New York talking about their first startups.  The only difference is that it is 10 years later, and we have greyer hair.  Jeff Stewart who was part of the Proxicom rollup and founded Mimeo and now Monitor110, said that everywhere he turned he ran into another New York entrepreneur.  Standing next to me was Andrew Erlichson founder of Flashbase (sold to Doubleclick) who I funded years ago and now CEO of Phanfare, across the room was Andrew Weinreich of sixdegrees and now meetmoi, and on the other side of the room was Jason Calacanis of the Silicon Alley Reporter and Weblogs and now Mahalo.  While he is in LA now, I still count him as an original New York entrepreneur.  Jeff and i tried to organize a group picture but just could not make it happen.

You may be thinking to yourself who cares or why is Ed namedropping?  There is a simple answer – I have known many of these guys for the last dozen or so years since the first Internet wave, and it is simply awesome to see everyone still plugging away, following their passions, getting smarter and better, and continuing to build the New York entrepreneurial ecosystem.  I know we are no Silicon Valley, but it is great to see these entrepreneurs all working on their second and third companies.  It was also great to hear their stories of raising their first or second or third rounds of capital for their most recent companies.  When I started as a VC in 1996 and first met many of these entrepreneurs, it was clear that we were all starting from scratch.  We didn’t know what we didn’t know.  We didn’t have entrepreneurs working on their second and third startups back then.  What we had was energy and passion.  And yes I agree that the whole Silicon Alley movement was pure hype and ridiculous but for those of us who have stuck around we have learned a lot and we are on the cusp of doing some great things.  We now have energy, passion, and grey hair which is a great combination.  I said it before in my NYC 2.0 pitch a couple years ago, but I believe that everyday our world here is getting more and more important as the media companies and advertisers try to make sense of this new era of communications.  As companies like Google and AOL and others continue to build a bigger and stronger presence here, it will continue to make us better.  True to form, I have already seen my first couple of spinouts from the Google New York office, and I expect to see many more.  But it is many of these guys that I hung out with above who were some of the original pioneers in New York that have helped blaze a path for many of the new entrepreneurs we are seeing today.  When the bubble popped, they didn’t quit and go home.  They continued to fight and continued to build new companies and for that we should all be thankful because today the New York ecosystem is building and getting stronger.  The funny part is that it took me being 3000 miles from home to have this revelation again.

Are there enough ad dollars for the thousands of small startups?

as i have said before the big keep getting bigger and the low barriers to entry mean more and more small guys are fighting for crumbs. the only way to sustain is if dollars continue to flow from old media to new media and the pie continues to get larger. if it does not, watch out!

clipped from

The catch, according to some, is that much of the money flowing toward the Internet is concentrated on a few dozen of the most popular sites. That has left smaller, less well-known sites at a severe disadvantage when it comes to attracting advertising money and surviving.

In the United States, the top 50 Web sites accounted for more than 90 percent of the revenue from online ads in the first half of 2007, according to the Interactive Advertising Bureau and PricewaterhouseCoopers. The top 10 sites accounted for 70 percent of the revenue.

  blog it

Should I flip or should I build?

It seems that everyday there is a new annoucement of a tiny startup being bought by a large company.  Two days ago it was Jaiku being bought by Google and this morning CBS announced that it is buying Dotspotter, a 10 month old gossip blog.  Put yourself in these entrepreneurs’ shoes – you launch a great product or service today, usage is growing, revenue is nil or minimal, and cocktail party chatter and buzz are at its highest.  You then have the opportunity to sell today at a pretty good number but you forego your chance of building that huge business.  What do you do and how should you think about it?  As i started thinking deeper about this question, I was reminded of the old Gartner Hype Cycle chart.  If we use this as a backdrop, perhaps I could show a framework from which to think about this important decison.

According to Gartner, "A Hype Cycle is a graphical representation of the maturity, adoption and business application of specific technologies."  Similarly, I have graphically represented the choices an entrepreneur has to make in the continuing saga of build or flip.  Let’s call this the "BeyondVC Startup Cycle."Beyondvc_startup_cycle_1 According to Gartner, there are 5 phases in a Hype Cycle (my comments in parentheses): Technology Trigger (product launch), Peak of Inflated Expectations (height of buzz), Trough of Disillusionment (this is harder than I thought), Slope of Enlightenment (the broad market is finally ready), and Plateau of Productivity (better have my next product ready).  I believe the descriptions speak for themselves as what usually happens with the adoption of new technology is that the hype builds quickly but it actually takes a lot longer to reach critical mass.  Similarly, one can superimpose a startup lifecycle on the graph.  If you look at the build or flip question in this context, it is obvious that an easier, less risky choice to make is best done at the Peak of Inflated Expectations or height of the cocktail circuit chatter.  Usually at this point in time, an entrepreneur can maximize short-term value as acquirers will buy more on vision and technology than on business fundamentals.  If you decide to build for the long haul and go for the home run, it will take you a fair amount of effort and time to create the same value that acquirers will pay today at the buzz cycle as they will expect more mature companies to have more established products or services and more milestones hit.  Companies that sell at the early stages should understand that while they may forego going big, if they do not sell today for strategic value then they would have to live up to their hype and be bought in the future for real revenue. In other words, as companies mature the valuation of a startup turns from pure strategic value to one where it is based more on actual revenue multiples and market comparable data.   

At this inflection point, an entrepreneur needs to think about whether they want to and can build for the long haul (taking into account the risk and time to do so) or sell today (net present value of your potential expected outcomes in the future). This is the point where you have built a nice service or product, gotten a number of users, but have not really monetized it or created a scalable business model that can drive profits.  Can you really build a company or is this just a feature for a bigger player?  If you choose to go for it and raise VC funding, you have to really believe that the capital you raise will help you create a much larger pie in the end.  Do you want a larger percentage of a smaller pie or a smaller percentage of a much larger one?  Once you take in the money, it requires a ton of hard work to build a team, continue to innovate, and refine your business model.  There are no guarantees and given the amount of time and energy you expend you could just as easily go out of business after 5 years of effort.  One other factor for entrepreneurs to look at is the opportunity cost or the time you spend on one venture. 

Since I never like to make decisions in a vacuum, if I had an offer, I would test the market to get a read from VCs to see what their interest level is in funding my business and also poke around and speak to a couple of other strategics to see if I could extract more value.  In the end, these valuable data points will help you make a more confident decision – if no VCs bite, then it is an easy decision for you.  If some VCs have an interest, try to understand how much capital and at what price they would be willing to invest.  If you really believe in your business then you should either take the money from the VC or get a significant premium from the strategic investor to sell today versus building your business for the longer term. 

At the end of the day, it comes down to two things.  First, what is your appetite for calculated risk – in finance there is a direct correlation to risk and reward.  If you want the big payday, you are not going to get it investing in risk-free bonds.  Secondly, it comes down to your passion.  Building a company is about more than just the money as money can be fleeting – remember the bubble, it sent a lot of carpetbaggers home.  The ones who have made the big payday have focused on a broader and bigger goal, building an insanely great product or service for their customers and keeping them incredibly happy. As you do the right thing for your customers, you will do right for your investors, your employees, and ultimately yourself.

On performance based earnouts

I am sure you remember the ebay-Skype deal where ebay coughed up $2.6b upfront for Skype and offered an earnout of up to another $1.7b for hitting performance numbers.  Besides the value of the deal, what struck me most was that 40% of the total potential deal size was based on performance-based milestones.  Fast forward 2 years later and in the day of reckoning it seems that eBay is only going to pay $530mm of the $1.7bb earnout (see Eric Savitz from Barrons post and press release).  I am not going to comment here on whether or not the Skype deal was a complete failure for eBay, but rather I thought I would more importantly share my thoughts on earnouts in M&A transactions.

Quite simply, be wary of performance based earnouts unless you get significant value upfront.  Many times an acquiring company may say that they can’t pay higher than a certain value for your business but if you perform they can pay alot more.  In other words, they want you to put your skin on the line and also incent you to stick around.  That is fine as long as you get more than enough upfront for your business so that any dollar from earnouts is just pure upside.  If you feel that you are not selling for enough and that too much is tied in the earnout, then trust your gut and either rework the deal or walk away. 

Earnouts in theory sound great – the better you perform the more you get.  However in practice it doesn’t always work out well.  First, earnouts could potentially put the acquiring and target company at odds by creating potential perverse incentives for the acquiring company.  Hmm, the company I just bought is doing great but I don’t really want them to hit it out of the park just yet so I may delay giving them their marketing dollars?  You can obviously think of a bunch more examples on this front.  More importantly, though, I feel that unlike a startup, you have relatively little control of your own destiny.  In any M&A with performance numbers, the acquiring company will say it is offering all of these resources and distribution and therefore the revenue, profit, and customer targets should be quite high yet attainable.  In a startup, if you fail it is your fault.  As part of an operating business or larger entity that isn’t always the case as you are most likely dependent on the acquiring company for resources, distribution, and cash to grow and deliver on your promises.  Big companies move slow and you are more likely to not get the support you need in a timely manner meaning that realizing your earnout becomes a very tough proposition.  Even thinking about the ebay-Skype saga, I can remember reading the countless news items and stories about how the 2 cultures clashed, how ebay did not understand the Skype business, and the management changes and reorgs that took place.  All that being said, I am sure the investors are bummed about leaving another $1.2b on the table in earnouts but at the same time they are still ecstatic about the initial $2.6b they received upfront.