Are all of the venture returns in B2B?

The Wall Street Journal has an interesting article today about how the resurgence of tech IPOs have really come from "less glamorous, business-focused companies selling such products as telecommunications equipment and computer storage."  In fact many of these companies have market caps > than $1b each.  The article is right in that alot of buzz gets centered on consumer Internet companies like Google or YouTube and that on absolute market capitalization many of the big returns are found in the B2B type deals.  However, I do disagree with the notion that because some of these "consumer web firms are selling themselves to larger Internet companies such as Google or Microsoft Corp. for a few hundred million dollars or less" means that returns for investors can be mediocre. In fact, what the article fails to look at is how much money some of these infrastructure companies have raised in order to get public.  Obviously if a VC is looking for 10x type multiples on their invested capital, the more money raised means the higher ultimate market cap a company needs to achieve.  Taking this a step further, let’s look at the amount of capital raised by some of the more recent IPOs:

Starent Networks: $100mm pre-IPO with first VC round in August 2000, $986mm market cap

Limelight Networks: $100mm pre-IPO with the big round in summer 2006, $1.6b market cap

Infinera Corp: $345mm pre-IPO with first VC round in December 2000, $2b market cap

Shortel: $102mm pre-IPO with first round in 1997,

Based on this data, one can see how many of the existing investors generated some great returns on absolute and relative terms.  So while there have been very few Internet companies worth $1b or more on absolute terms, one must look at the capital efficiency of these businesses to understand why companies that raised $20mm or less can still sell in the $200-400mm range and still create tremendous returns for their investors.  At this level of funding the risk/reward balance is just much different than in a traditional infrastructure play.  Sure many of these Internet companies being financed may not be standalone IPO candidates but that doesn’t mean that companies that generate 10-20x for their investors are bad investments either.  However what is beginning to scare me is that valuations for these consumer internet plays are continuing to creep higher.  In addition, many of these "capital-efficient" companies are raising bigger rounds of capital meaning the bar for exiting is getting higher and higher.  If these two factors continue to increase over the next couple of years, this could lead to disappointment for many VCs in the long run.

Don't forget to look at venture debt when raising a new round

We all know the story – it is incredibly cheaper to start a web-based business versus 5 years ago with the rise of open source software and commodity servers.  However, while getting started with thousands of users is cheap, scaling to significant numbers will require some dollars.  The good news for you and for venture investors is that your buck can go alot further today versus yesterday not only because of the commoditization of infrastructure but also because the venture debt market is alive and kicking.  In the last six months, we have augmented some of our existing venture financing with venture debt as the market has become quite competitive which means pricing and terms are getting more attractive for  all of us.  In addition, while most associate venture debt with investments in companies with core technology, more and more venture debt firms  are back and willing to offer capital to earlier stage web-based companies with  no  financial covenants and MAC (material adverse change) clauses.   Of course the more flexibility you have with respect to uses of cash means that pricing will go up.  All I can say is when evaluating your company’s cash needs and potential runway, looking at the venture debt market is not a bad idea.

There is also another market metric that is driving a renewed interest in web-based companies for these lenders- they are getting funded by VCs (venture debt lenders mostly like to do deals with strong financial sponsors which increases their likelihood of getting paid back) and these startups are better able to manage their burn rates reducing risk and offering lots of upside.  Sure, while some of these venture debt firms recognize that web-based businesses may not have as much hard and true intellectual property, the fact that they are more capital efficient and can scale more rapidly means they can also generate pretty nice returns from the warrant portion of their deal.  Getting in earlier also allows these venture debt firms to buy more of the company from a warrant perspective than getting in on later rounds.  The trick for entrepreneurs is to look at bringing on debt concurrent or soon after your close of equity financing. 

Why can raising venture debt be great?  It is quite simple –  the dollars are relatively cheap compared to an equity financing  and extending your runway to hit more critical milestones means a potentially better valuation for your company down the road.  And of course if you exit before raising another round, there are more dollars available for the equity holders.  A typical structure for an early stage deal could be an equity raise of $3-5mm with another $1-2.5mm of debt.  From a pricing and terms perspective, you should look for capital which is flexible in terms of use for true  growth capital (growing your business) with no financial covenants or MAC (material adverse change clauses) which can put more risk into the debt equation.   Of course, the more flexibility you have, the higher the interest rate will be relative to other types of loans. Most venture debt deals will have an interest only portion for a short period of time before amortization (monthly payments of principal and interest kick in).  Typically you will see terms of 30-36 months where your lender will get paid his full portion of the loan and interest by that time frame.  In addition, lenders will ask for warrants equal to a percentage of the dollar amount raised (for example, depending on the deal, a 5% coverage for $1mm could be equal to $50k of equity to be purchased at the current share price).

All is not rosy as there are some potential and hazardous downsides to this model.  If you burn through your cash and can’t make the monthly principal and interest payments, your lender can take over your company as their debt is usually secured against your company and intellectual property.  Trust me, a number of companies got burned with this during the Internet boom when their businesses were based on wildly inflated revenue projections and unilimited capital resources.  Just when you needed another month or two to sign that strategic deal, the venture debt guys would come in and pull the rug from under you.  Granted it is not that bad as your lenders are your partners and will negotiate with you, but at the end of the day, if they see their ability to get paid in significant jeopardy, they will do what they have to do to recoup as much value as possible.  For some investors and entrepreneurs, this risk may not be worth the dollars.  For others who are confident in their execution and ability to raise another round, there is no better way to stretch your dollars in the company and create more value with minimal dilution.  So the next time you hear the word "debt," don’t be scared and keep an open mind as you may be able to stretch your resources further and achieve some additional critical milestones driving increased value in your business.  The interest in web-based businesses is there and the competitive market means that pricing and terms are pretty attractive now.

Microsoft VC Summit 2007

The day after Microsoft’s TellMe aquisition, I was at Microsoft’s eighth annual VC Summit.  Unfortunately, I missed Steve Ballmer’s opening discussion, which in my opinion, is always one of the most entertaining and informative sessions of the event.  For the last few years, Steve spoke at the end of the event but for some reason they switched it on us and had him at the beginning.  Anyway, I am waiting for some other bloggers to summarize his discussion.  Notice the picture I link to from Paul Jozefak’s blog titled "Expanding Platform to the Cloud."  I must say that I came away quite impressed by Microsoft’s progress in its cloud and Windows Live strategy.  Last year, all of the Windows Live talk seemed quite rushed, disjointed and forced and seemed it was more of a response to the market saying that Microsoft did not get the SAAS thing.  This year the strategy seemed much clearer and well defined and the executives knew how the Internet and cloud fit into all of the various business units.  In the end, Microsoft has made some huge strides and will certainly be worth watching over the next year.  In addition, as with each year, I did find the Microsoft executives more willing than ever to network with startups to fill gaps in their product line and to be a more open, gentler Microsoft versus years ago.  There is nothing like real competition to get a company to change its mindset.  Sure, they didn’t tell us much in the public sessions as sometimes you can come away with the impression that Microsoft is doing everything and the only opportunities for startups are niche verticals built on Microsoft’s platform.  But truth be told, if you actually did get a chance to spend some one-on-one time with the executives, you will find a much different story. Reflecting on that point, Microsoft made a little over 20 acquisitions last year and plans on doing a similar amount this year.  One sure way to not get any partnership done is openly ask the Microsoft executives, "How do I get my portfolio company acquired?"  The real point is to find and network with the key executives at the summit and figure out how the individual business unit’s process works on a partnership discussion and get that started.

The consumer mobile breakout session was one of the more informative discussions that I attended.  Basically as the world moves to three dominant operating systems for wireless (Symbian, Windows Mobile, and Linux), Microsoft will look to increase its penetration by leveraging an extensive development platform to allow third party partners to develop new consumer services which can be easily deployed via its worldwide carrier partners.  Naturally, one of the questions asked was if these apps only worked on Windows Mobile or across the various operating systems.  As you might suspect, these apps would likely work better on the Windows Mobile platform, but the Microsoft folks did stress that it does and has to work with other competing operating systems as well. The gaps that Microsoft was looking to fill through partnerships or acquisition were, broadly speaking: games/entertainment, location aware services, TV/video (although the one Microsoft executive acknowledged it was overhyped), ad management, mobile content mgmt, and billing and payments.  One of the value propositions offered by the Microsoft mobile folks was key relationships with carriers across the world.

Another engaging talk was Peter Moore’s (Corporate VP, Interactive Entertainment Business) presentation on Microsoft’s move into the digital home with its Xbox360.  Of course, after a long day, seeing a commercial for the yet-to-be-released Halo 3 was quite energetic and refreshing.  Interestingly enough, it is quite amazing to see that as these gaming machines get more powerful, the games themselves end up being the commercial (think about The Gears of War commercial on television).  Despite the fact that Peter could have spent hours demoing games, his presentation centered around the full featured entertainment capabilities of the device which included the ability to synch with other PCs in the home and buy movies, television shows, and music in a simple way.  Once again, it is amazing how much progress is being made throughout the many divisions at Microsoft and how the Internet and on-demand services are getting weaved into the very fabric of the applications and infrastructure.  For a large company, one year has made a huge difference.  Finally, one of the other recurring themes I heard throughout the day was the importance of advertising in many of its product lines ranging from mobile to MSN to the digital home and video gaming.  If there are other acquisitions to be done, I am sure that some interesting advertising related technology and services will be on their radar screen.

Just to be clear, this is not in any way, shape or form a Microsoft love-fest.  I am just pointing out that while so many people are counting them out that they have lots of cash, renewed energy, and a long-term view towards winning in their markets.

The similarities between venture capitalists and social workers

I had an interesting call this morning with an entrepreneur who had been up until the wee hours of the morning reviewing legal documents for a big strategic partnership.   He apologized about his state of mind which wasn’t exactly calm and cool, and we proceeded to discuss the issues and parse out the major ones from the minor details.  As I reminded him of a conversation I had with my wife several years ago, we all had a good laugh.  When my wife and I first met, she asked me what a venture capitalist does.  Sure, there was the usual answer of we look for great people building great companies, invest in them, and help them through strategic discussions and introductions.  However, there was a subtler more nuanced answer in that a big part of being a venture capitalist was similar to being a social worker.  Our business is a people business and part of that means not only knowing who we are dealing with but also understanding what makes them tick and helping them through both the good and tough times.  We are part coach, part mentor, and part social worker.  We need to understand the psychological state of the entrepreneurs we work with and the management teams they build.  When an entrepreneur is on the ledge, looking down, and ready to jump, our job as a VC is to pull them off and help calm them down.  When an entrepreneur is too cocky or overconfident, we show them the ledge, have them look down, and then pull them off.  So in many ways, being a good venture capitalist is dependent on our ability to understand what drives the people we work with, how to constantly challenge them and motivate them, pat them on the back when they need it, and push them harder if they are slowing down.  For that matter, these are some of the more nuanced and subtle traits that entrepreneurs need to exhibit when dealing with their employees, constantly taking the pulse of the company and key individuals, and massaging the various personalities and egos to help them stay hungry and excited to perform at their best.  As much as some would like to think that being a VC is about the technology or numbers, it is all about the people.  Anyway, at the end of the call my colleague and I were able to walk our CEO off the ledge and help get him prepared for his next battle.  He never thought of us as also playing the role of social worker in our frequent interactions, but he certainly agreed as he thought more about it.

UPDATE-there are lots of different types of social workers but in this context think counselor or sounding board.  My comparison with social workers was not meant to make all entrepreneurs sound like they have serious issues-the point is that sometimes the daily bump and grind of operating a business can get to you and having a VC who knows your business and who is part counselor/part sounding board can be an invaluable resource.

Podcast with Heather Green of Businessweek

I recently had the opportunity to do a podcast with Heather Green of BusinessWeek and Blogspotting.  If you have a desire to hear about some of the areas I find interesting and to learn about pitfalls to avoid for startups, I suggest that you download the show.  My only regret is that we did not get to use Gizmo Project, one of my portfolio companies, to do the podcast.  After all, isn’t important for VCs and entrepreneurs to eat their own dog food?

Add Startup Review to your blogroll

Nisan Gabbay of Sierra Ventures recently contacted me with respect to his new blog, Startup Review.  According to Nisan:

Startup Review will be a blog that profiles successful Internet start-ups in a case study format. The case studies will analyze the key factors that made the companies successful, with an emphasis on strategy and product decisions. Each case study will also have sections discussing launch strategy, exit analysis, and links to other good analysis on the company.

I don’t think that there is a good forum where people can discuss what made certain companies successful, particularly the less publicized success stories. Sure there are whole books written on companies like Google and eBay, but what about the more modest success stories in the $10M – $2B range? My goal is to highlight lessons learned from companies like,, or Greenfield Online.

I took a look at his site and he has some great posts on companies like MySpace.  If you are interested in going more in-depth to understand how certain companies got off the ground and made it, I suggest subscribing to his site.  As for my two cents, it would also be interesting for Nisan to dive deeper into some more high profile failures in the market so others can understand the many things that can go wrong in a business.  I have found that digging into your failures and doing a post mortem on why your company lost a sale or a customer, partner, or employee can be more illuminating than just understanding why you succeed.

Platform Wars, battle for startup mindshare

Have we been through this discussion before?  Remember the eWeek article from last year titled "Is .Net failing to draw VC loyalty?" and the corresponding discussion in the blogosphere, including my post?  Well, it seems that SAP is taking a page out of the old Java venture fund camp to seed companies and help them build on a Netweaver platform.  As I mentioned before, I do not fund a company based on what platform they build on but if they choose one that is not open source then there better be a go-to-market reason for it.  Being at the Microsoft Summit last week, I kept asking myself why one of my portfolio companies would want to deploy its software on a Microsoft Sofware as a Service platform if it could do the same thing using open source technology and not have to pay additional license fees?  It comes down to tradeoffs.  If there is a clear path to customer opportunities and market adoption then it may very well be worth it to lock yourself into one vendors’s technology platform even though a majority of the customer dollars may not go to you.  From a VC perspective, I want to reiterate to not focus on what platform you have built on but on what customer problem you are solving, what market you are going after, and how you plan on ramping up your customer base.  If the opportunity is large enough (the problem is that many specific .Net-based or Netweaver-based companies are nice businesses but pretty nichey) and the market you are going after maps well with one of the big platform vendors, then it may make sense to align your company closely with theirs.  In the case of SAP and Netweaver it will be interesting to see how the market reacts to their investment plans.  Clearly, having big exits will spur some entrepreneurs to make a bet with Netweaver.  Sap’s Virsa and Frictionless Commerce acquisitions are steps in the right direction to get everyone’s attention.

I look forward to hearing more about this topic from Jeff Nolan (we are grabbing dinner Monday night) as he is blogging from Sapphire now.

Update: this discussion is enterprise focused, not a consumer one

Microsoft VC Summit

I had the opportunity to attend my third Microsoft VC Summit in California on Thursday.  It was a great opportunity for VCs to network with Microsoft’s top executives.  This year’s focus was on Unified Communications, Saas, and Windows Live (includes MSN).  While I won’t go into excruciating detail on the sessions, one of the highlights wass having Steve Ballmer give a frank discussion on how VCs and startups can work with Microsoft.  He made it very clear that the pace of acquisitions has increased, rising from 9 the prior year to 22 this past year.  And of course, his Corp Dev team has told Steve that they have the biggest pipeline of deals they have seen in years.  For those who care, the sweet spot for Microsoft is to buy a more engineering and technology focused company versus a sales and marketing oriented one.  In terms of price, I thought I heard acquisitions in the $50mm – 200mm range but Don Dodge of Microsoft (I suggest reading his post on the acquisitions) seemed to hear differently.  Anyway, the point is that there will be plenty of opportunities for VC-backed companies and startups to find a home in Microsoft.  Interestingly enough, of the 22 companies that were bought this past year 1/3 of them were not venture-backed.  This was surprising to Steve and also may be indicative of how many of the tech players have been snapping up interesting engineering teams and products before they really get to market.

One of the interesting questions posed by a VC was how Microsoft valued technology and engineering assets versus companies with lots of customers and revenues.  In short, Steve had a simple answer in that Microsoft knows how much a technology asset or new product is worth to Microsoft and then they can compare that to what the value would be using more traditional financial metrics.  In the end, Steve rightly said that it comes down to a negotiation since revenue ratios, etc. really do not apply to a bunch of engineers and it comes down to what the VC needs in terms of multiples and what the founders need to get the deal done.  I suggest keeping an eye out for Microsoft as it feels like they may even do more than the 22 acquisitions they did this past year.  As far as opportunities and trends are concerned, Steve pointed out the usual suspects:

  • Consumer market drives enterprise expectations
  • Open source – more pragmatism coming to the market, not just a religion but needs to deliver real value
  • SaaS – it works, it will grow, but there are still some opportunities like no higher level platform in the cloud – for example, how do you make presence work from site to site
  • Office 2007 – biggest area of innovation for Microsoft, think of Office as a client to all data, front end to SAP as an example.  Also will include Office Communicator in Office 2007 with Word, Excel, etc. highlighting how important communications and collaboration will be.  Btw, Office Communicator is SIP-based.
  • Mobility – Steve believes the hype was higher a couple years ago and that the reality is bigger today as we have smarter more intelligent devices at cheaper prices running over faster networks.  There will be a need for software to help intelligent devices in the cloud to talk to each other.

I have to admit I was pretty impressed by the openness of the Microsoft executives and the sheer amount of new technology they will be bringing to market in 2007.  My favorite technology which I saw in action was Windows Presentation Foundation (WPF, formerly called Avalon) and WPF/E (cross platform subset of WPF).  The demos that I saw really showed me what the next generation of rich, web-based interfaces could look like beyond today’s AJAX and Flash.  While WPF is great for applications, the fact that WPF/e is cross platform really opened my eyes to this being a potential Flash killer.  That being said, since WPF/e is programmed using XAML and Javascript, a couple of the demos I saw were web pages with some flash elements included as well.  For more detail on WPF/e, I suggest reading Ben Galbraith’s blog post on Ajaxian (excerpt below):

  1. WPF/E allows a subset of XAML to be rendered in a browser on IE and Firefox on Windows and Safari (Firefox?) on OS X (Linux and Solaris support uncertain).
  2. This subset consists of a pretty impressive set of functionality, including: 2D vector graphics, advanced text rendering, audio/video playback, imaging, animation, and advanced composition of graphical elements. In short, all of the pretty eye-candy coming in the new WinFX APIs with the exception of 3D graphics and the Metro document rendering (i.e., MSFT’s PDF killer; my my, they are really going after Adobe, aren’t they?).

Given the rich, interactive functionality that WPF and WPF/e offers end users and the productivity improvements it provides for developers and designers, I do believe that this will be one technology that will gain traction in the years ahead.

VCs and VOIP

Here is a link to an article on VCs and VOIP (via Andy Abramson of VOIPWatch).  There are some VCs who think it it too crowded and others (like myself) who still see opportunities.  However, the one thing I was not pleased about is that the only quote the author uses for me did not include the rest of our conversation.  I should have just pointed her to my blog post from last September on the topic where I say that:

This battleground is about software and not devices which is why I believe companies entering this market from a telephone-centric view of the world will miss out on a big opportunity.

When I say, VOIP is "moving beyond Vonage" what I mean is that the opportunity is not about making and receiving calls but about how VOIP becomes seamlessly embedded in all applications, into the very fabric of the web.  Imagine seeing any phone number on a web page and clicking it to dial seamlessly.  Or how about being in your CRM application and knowing which of your sales reps are online as you are reviewing the pipeline and clicking to IM or call them through the CRM app.  When you call them, you have no idea if they receive the call on their home phone, computer, wifi device, or cell phone.  All you know is that they are available and that you can call them with one click.  This is the direction we are heading in – it will take time, but it will be interesting and it is certainly more than just a phone call.  If you want to learn more about this I suggest reading Alec Saunders from Iotum’s post on Voice 2.0.   As Alec says, :

In the voice 2.0 world any application, within the bounds of permissions set by the subscriber, can access presence; initiate, accept, and redirect calls; and query directories.

Alec gets it and this is certainly some of the stuff we have up our sleeve at Sipphone, developers of Gizmo Project.

Kinnernet 2006 – geek camp

I just got back from a week in Israel having spent some time in Jerusalem for an Answers board meeting and then making my way to the Ohalo Resort on the Sea of Galilee for Kinnernet 2006.  Kinnernet is a techie geek camp organized and run by Yossi Vardi (cofounder of ICQ).  At Kinnernet, I had the privilege to spend time with some great people from Israel, Europe, and the US.  I suggest checking out Jeff Pulver’s blog and going to Flickr and searching for Kinnernet2006 for pictures and more thoughts on Kinnernet.  There were lots of robots, aerial shows with model planes and helicopters, great discussions on current technology trends, and of course, plenty of beer and laughs. 

One of the discussion groups that I led with Simon Levene (heads up Corp Dev in Europe for Yahoo and Yair Goldfinger (founder and CTO of ICQ and Dotomi) was titled "Are Internet VCs Dead."  You know the backdrop – it costs less to get a company started and to generate users and Google and Yahoo are agressively snapping up companies before VC rounds.  Google’s expertise seems to be buying engineers, many times before a product is even launched.  Yahoo, on the other hand, prefers to buy companies that have some nice user base, maybe no revenue model yet, but also before a VC round.  The last point is that companies are now more capital efficient (see an earlier blog post) where $10-15mm can get a company to cash flow breakeven vs. $30mm.  So what do VCs that invest in Internet companies do? Before I go there, I would flip the question and ask what do entrepreneurs do?  From my perspective, I wouldn’t take in more than $1-2mm to get my company started with a developed product and an idea of what usage will look like.  At that point, as Yair suggests, it is decision time.  Some of the questions to ask include:

1. Do I have a product or feature or can I build a real company (i.e., a growing cash flow sustaining business)? 
2. What is the risk I face in building a company for the long term vs. selling today. 
3. And finally, do the math – if I take in VC money I will clearly have to sell for alot more tomorrow than what I sell for today in order to generate the same or greater value.
4. Do I want to do it?

As a VC, I truly would not want to invest in a company that has not thought about all of the above with a founding team that is fully behind building out the company for a longer term play. All that being said, the numbers are still against the entrepreneur.  While there have been a number of acquisitions in the past year, it is still a fraction of the number of companies started.  Since it is so cheap to start a business, you can have anywhere from 5-10 companies out there in each category.  In addition, it is not clear that many of the acqusitions during the past year could have built real businesses rather than being a feature of a much larger entity.  While the math worked for a number of enterpreneurs that sold, one of the decisions you need to make is the likelihood and timing of being crushed by a larger player if you decide to go alone and raise VC funding.  Whatever you start, I would suggest thinking about what your potential revenue model is from day 1 and thinking through the economics.  Hell, it may change a couple of times, but building a company with the sole purpose of flipping is the wrong idea as your odds of success are very low.

Despite this, the opportunity for entrepeneurs and VCs could not be greater.  There are clearly more users globally, broadband is everywhere, users are more educated, companies can target more, capital efficiency has increased, and there are real business models out there generating tons of profits.  I do not think that Internet VCs are dead, but rather, need to reinvent themselves.   It is also clear that the VC model is broken and needs to change.  As you can see this is slowly starting to happen as smaller funds ($200mm vs $750mm) are being raised, VCs are doing less new deals per year and sitting on less boards, and many are trying to get in earlier.  Having a smaller, more focused fund allows a VC to make some investments during the Angel round ($500k-$1mm), watch the company closely, and give VCs the opportunity to lead the first real institutional round.  If the company has the chance to flip, then great, everyone wins.  If the company want to take the next step, then we can be there to lead or co-lead the next funding round.  It is imperative for VCs to get in early and structure their funds around this because in the Internet space companies can build momentum quite quickly which also means that valuations tend to move quickly as well.  That is also why the Googles and Yahoos of the world are trying to identify the emerging opportunities before the VCs get involved. 

All in all, it was a wonderful time, and I feel honored to have been one of Yossi’s guests and for having had the opportunity to network and participate with Israel’s tech elite.  Unfortunately, I had to head home on a redye Saturday night, but many of the attendees ventured to the Marker Tech Conference where 3500 people were expected to attend and hear panel discussions led by many of the participants at Yossi’s Kinnernet.  Kinnernet was great and I had a blast, made many new friends, and came away clearly impressed with Israel’s thriving and talented startup community.