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.

Learning lessons from Amp'd Mobile

I am not here to pile on the Amp’d Mobile situation, but I find it is always important to learn as much as you can from your mistakes and from other people’s mistakes.  Rafat Ali has a great interview with Peter Adderton, the former CEO of Amp’d Mobile.  Here are a couple of interesting points that Peter says helped to ultimately bring the company down:

— You don’t raise $400 million in 18 months by spending time inside the office. Trying to ambiguously raise that amount of money, while at the same time trying to create something new and different was a challenge that caught up with us in time.
— On the financing, we were learning as we went along. With the amount of cash that we required, it probably made more sense to go with one or two big pockets than a lot of smaller pockets.
— The biggest struggle I had [with the board] was agreement on where the company should go. We had way too many board members and then we had observers at top, and the any partner could dial in, to a point where it became very difficult for the management to manage.

Rather than dive into some of the operational or economic lessons like how a company that raises $400mm can’t get to profitability, I thought I would focus more on the financing side that Peter discussed with Rafat.  In short, some of the lessons learned from Peter include having too many investors and too many board members.  One VC once told me that having a great board did not guarantee success but having a bad board can almost certainly guarantee failure.  Speaking from personal experience, it is pretty easy to see how differences in strategic direction and plans combined with egos can get in the way of real productivity.  The more people you add to the mix and the more complicated and time consuming it can get.  In fact, I remember spending at least 3/4 of my time on one of the weak boards dealing with bickering between other board members instead of spending my time helping management and focusing on the important issues.  The CEO also had to spend just as much time massaging egos and different incentives to keep driving the company forward.  At times, It was close to impossible for the board to come to agreement on a budget, hiring plans, and strategy and ultimately the company missed many opportunities.  I can only imagine what Amp’d board meetings were like when you mix in a number of VCs, hedge funds, and strategics, all of whom invested in different rounds at different prices and with different preferences.  So one of the lessons to be learned is to choose your partners wisely and less is more.  Rather than try to spread out ownership of your business with lots of investors so one or two don’t have too much control, you are better off looking for a couple of investment partners who share the same vision of the business and who you believe will act rational through both good and bad times.  This is where references can help tremendously. 

One other point, every second you spend fundraising is another second you are not running your business.  Companies have to be well prepared and go through a number of meetings to raise $5mm let alone $400mm in 18 months. It is not hard to see how the CEO and management can get distracted and not spend enough time on operational issues when they are constantly raising capital. And of course, the more money you raise, the bigger the exit you need to get investors their 8-10x.  I am not saying this happened in the Amp’d situation, but when capital is abundant and the pressure to create significant returns exist, it can force companies to try to get big fast and try to spend their way to success instead of finding the right mix of organic and inorganic growth.  That is why I have always loved capital efficient business models.

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 Rent.com, HotorNot.com, 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.