.Net and VC Loyalty

Robert Scoble has asked the VCs to respond to an eWeek article titled Is .Net Failing to Draw Venture Capital Loyalty?.  There is not much for me to add to this article as we all know that the only loyalty VCs have is to their Limited Partners to generate long-term capital gains.  This means we do not fund a company because of what technology platform it chooses to develop on but rather what problem the company and product is solving and how big that opportunity is.  It reminds me of a panel that I spoke on in 1997 at the Red Herring Java Technology Conference.  The moderator asked me what types of Java companies we were interested in and my reply was that we do not look for Java companies, but rather solid management teams that are solving large problems in innovative ways.  If Java happens to be the right technology platform to use, then so be it.  Nothing has changed since then.  As Brad Silverberg from Ignition rightly says in the eWeek article, "We’re technology agnostic here at Ignition."

To that end, let me talk about .Net.  I have spent time over the last few years with .Net evangelists and they have been helpful in certain situations.  That being said, most of the fund’s portfolio companies (90%+) are not using a .Net platform.  When I dig deeper into technology and platform decisions, I like to think in 2 separate buckets, the consumer market and the enterprise market.  On the consumer side, one big value for Microsoft has been its hold on the desktop as Tim Oren strongly points out, but as we move more and more into a web-based world its strength is diminishing.  Look at Google, Firefox and new scripting services like Greasemonkey and Yubnub which are increasingly offering users more and more functionality through a web-based interface.  I am sure Microsoft will get it right with Longhorn but it has taken way too long and many a more nimble, startup has out-innovated Microsoft and decreased its competitive advantage.  While the OS is important, Microsoft has lost its complete and utter dominance as we move to a service-oriented world where broadband is everywhere, apps are in the cloud, and the browser becomes king.  All that being said, I will not make my decision to fund a startup based on whether or not it uses .Net.  For example, if you want to see a great app built on .Net go to a friend’s web service, Phanfare, and try using the application.

On the enterprise side, the only reason I would support having a company move off an existing platform to .Net is if there was significant customer demand for it and if Microsoft would really provide the company with access to its channel.  Microsoft has been putting a huge effort in promoting their go-to-market support for startups but the irony is that Microsoft really wants companies to develop vertical, industry-specific applications on the .Net architecture.  In other words, many of these companies are nice businesses but not venture-backable opportunities where VCs can make big returns.  If Microsoft can change this attitude and show me where and how to make money leveraging its Ecosystem and partners, I am all ears.  In the end VCs have be loyal to its Limited Partners, not a technology platform, so the eWeek article itself is overblown.

LP Conference

I am not sure how many entrepreneurs understand the structure of venture capital funds but the bottom line is that while VCs manage funds, we ultimately report to our investors or Limited Partners (LPs).  It is not our money, and we have a fiduciary responsibility to manage it properly and generate the returns our LPs expect of us.  And like you, we have to go out and raise capital every 3-5 years for a new fund and similar to entrepreneurs we need to network with the right people, have the right meetings, and go through extensive due diligence.  Every year the Dow Jones Private Equity Analyst puts together a show where fund managers can listen to what the LP community is interested in and where they plan on allocating their dollars.  This year’s show was billed as an opportunity to meet "more LPs per square foot" but truth be told, it was a place where I could meet more VCs or private equity managers per square foot.  In the early morning, a show of hands revealed about a 20% LP audience and 80% fund manager group. It reminded me of a typical VC/entrepreneur conference where you have panels of VCs talking about where they want to allocate capital and entrepreneurs trying to flag them down to hear a pitch.  In these conference you typically have a similar ratio, 20% VCs or those with the money and 80% entrepreneurs or those seeking funds. 

Anyway, as I had time to think about it, it might be helpful for entrepreneurs to understand how VC funds operate to better understand our motivations and to better align interests.  At the end of the day, VCs are in the capital gains business.  We make money when our LPs make money which means that the companies we fund and entrepreneurs that we back need to be successful.  Clearly when VCs and their LPs negotiate their agreement, economics are the most important topic at stake.  While VCs get management fees to pay the bills, it is the carried interest portion or % of profits that VCs receive that really drives our thinking and aligns our economics with performance.  In any typical fund, we except 1 to 2 deals to be homeruns with 10x or greater returns, 3-4 to be pretty good returns, and the rest to either get our money back or lose money.  What that means is that every one of our deals needs to have significant return potential and market size for us to think about investing in a deal.  In addition, companies should be capital efficient (see an earlier post on capital efficient business models) meaning that no more than $25-30mm should go in, especially if a home run deal acquisition is $200-300mm (not $1b).  If only 1 to 2 deals have home run potential, the chances of us getting any one of them to really work is slim to none.  If the majority have this potential, we get more at bats at the plate and more opportunity to create real value for the fund.  As a fund matures, VCs need to demonstrate real cash-on-cash returns to go out and raise the next fund.

This is the point at which conflict could exist.  First, there could be situations where the VC says no to a great opportunity to sell the company but for whatever reason wants to hold out for a greater return.  On the other hand, there could be situations where a VC wants to exit too early with a decent return but not optimizing the overall value of the company in order to return capital to investors.  At the end of the day, what this means is that entrepreneurs and VCs need to get on the same page pre-investment in terms of everyone’s expectations for performance and goals.  In addition, there needs to be constant communication as the markets and company evolves to ensure this alignment.  The good news is that given a VCs economics, we only do well when the entrepreneur and company does well so what better alignment could there be.  A point of diligence for entrepreneurs could be understanding where in the fund lifecycle a VC is and what some of their returns to date have been.

The laws of supply and demand for VCs and IT Buyers

There is a supply and demand equation for every startup’s product or service.  In early stage companies, I sometimes see too much from the supply side and not enough from the demand part of the equation.  In other words, inventing great products that no one wants to buy is a waste of time, money and effort.  While there are not nearly the amount of startups on the East Coast as in Silicon Valley, being in New York I do have tremendous access to Fortune 500 companies.  One of the ways we like to invest is by talking with the buyers in the market, the CIOs and CSOs, and understanding what their pain points are, what solutions they are evaluating, and how open they are to working with early stage companies.  We have gotten many a referral using this methodology and it has helped us develop our own investment thesis on certain markets where we can look ahead far enough into the future but not so far ahead that we invest in just another technology looking for a problem to solve.  We also like to speak with strategic partners and understand gaps in their product portfolio (to the extent they will share that with us) to further triangulate our thoughts on the market.  Bill Burnham has a great post on thesis-driven investing and why it matters in today’s competitive venture world.

Tying together a demand-driven approach to investing means that you have to have access to the IT decision makers with the budgets.  This is typically not easy as every tech vendor in the world is pounding on their door to give them a pitch.  That being said, if there are more IT buyers like James McGovern that understands the value that VCs can bring to IT buyers then we will all be in great shape funding companies that solve real problems. James, an enterprise architect at a major Fortune 100 company, recently wrote a post  on ITtoolbox explaining how his brethren can continue to innovate and stay ahead of the curve.  He goes on to say:

The methodology used today within corporate America is fundamentally busted. Sitting around waiting for a vendor to show up on your doorstep with the right solution at the right time is simply gambling (I really wanted to say irresponsible). Enterprise architects need to not sit on their butts waiting for the "right" solution to magically appear. Instead they need to make sure the venture capital community understands what problems we face so that they fund the right portfolio companies.

Competitive advantage within corporate America via the use of technology isn’t gained by implementing service-oriented architectures or any of the other hype in published in industry magazines. SOA is a reality of today’s marketplace and everyone will be doing it (hopefully doing it the right way by purchasing my upcoming book).

Competitive advantage can be gained though by being first to implement new waves of technologies before your competitors even learn about it or it appears in a matrix by your friendly neighborhood industry analyst. It is in the best interest of enterprise architects to start setting aside time to learn about technologies that are not yet released within the marketplace and are seeds within the minds of CTOs of Internet startups.

With this thought in mind, I have decided to take deliberate action in making this situation better for both parties. I am reserving Friday’s at 5pm on my calendar to talk with venture capital firms who want to bounce ideas off me related to funding or to listen to the pitches of early stage Internet startups that simply need a sounding board for someone who sits in the walls of corporate America on a daily basis…

The same principles go with VCs as well – sitting around waiting for deal flow in this competitive VC market will not get you very far.  Be proactive, develop an investment thesis, and reach out to the end users like James – I wish more IT buyers thought like him.  Of course, as VCs we must remember not to solely rely on the buyer’s advice and use as many data points as we can to further validate or kill our investment thesis.  The danger of solely relying on IT buyers is that the solution may only be necessary for a handful of buyers and that the problem is so near term that by the time your product is ready another vendor has already stepped in to fill the void.

Fundraising is a distraction

I was speaking with a friend yesterday who recently signed a term sheet to raise a Series B round.  While he did not hit it out of the park with the valuation, it was a nice step-up none-the-less and would provide his company with the capital to move forward and stay ahead of its competition.  He and I both fully acknowledged that he could have pushed the valuation higher if he spent time with more than two venture firms, but we both agreed that the right thing to do was take the money and build the business.  This was an easy decision because fundraising is a distraction and valuation isn’t everything.  When you are a lean and mean startup where you are just beginning to build your management team, every second you spend fundraising means more time that you are not working on your business.  I have seen too many entrepreneurs go on the VC tour, spend too much time on fundraising, and consequently miss important milestones.  In the end, the extensive fundraising process ends up backfiring since the VCs get concerned about lack of progress.  So the next time you are faced with the prospect of raising money painlessly and quickly, the slight discount you take on your valuation today will be well worth it in terms of what you can do to build your business and continue innovating your product or service.

Venture capital in China

I recently caught up with my friend Derek Sulger, founder of Linktone (Nasdaq: LTON) and current founder and CFO of Smartpay, a Paypal-like play in China (I really like what Derek is doing with this one-no credit in China, use the mobile phones for debiting from bank accounts).  Derek and I are college friends and we certainly have come a long way from college when he finds my email on Google under a heading "Geeking out with Ed Sim" (thanks to Jeff Clavier for this one!) because his mobile device with all of his data on it is cracked on his flight from China.  That being said, we had a great chat on VC in China and opportunities he sees there.

First, from his perspective, he would rather pick one or two ventures at a time then spread out investments VC style.  If you think about it, there have only been around 7 or 8 internet-type companies that have gone public in China since the last bubble in the US (Linktone is one of those) when the Sina.coms were out in the market.  Given that, he would rather pick a couple sure bets and really work with them cradle to grave.  It is also tough to have any real governance and control of an investment by just sitting on a board in China, especially if you are monitoring a deal from thousands of miles away.  Secondly, he said it is tough to find good, experienced talent.  That is one of his gaiting factors in ramping up his ventures.  Finally, from an investment perspective, he would rather go consumer than enterprise.  His first business was a systems integration play which spawned Linktone and Smartpay.  He said it was difficult because the private companies you are selling to are really quasi-government agencies.  It is tough to get paid and very tough to protect your intellectual property.  At least on the consumer side, if you price your product or service appropriately, you can build a real PAYING user base and protect yourself from competitive threats with your base of subscribers.  Look at the history of China going from Boeing to the automakers like GM which did joint ventures with companies in China only to have their IP recreated and used against them.  I am sure GM could have protected themselves by charging less for their Buicks!

So there you have it from an experienced entrepreneur in China.  His thoughts make a ton of sense.

Go early, go late, or go home

After having returned from vacation last week, I had the chance to reflect on the current venture and investing market.  Yes, one of the big challenges is that there is still way too much money sloshing around in alternative assets.  As I think about how to make money in this competitive environment and where to make new investments, I keep coming back to the thought that there is still opportunity very early or very late in a company’s life cycle.  On the late side, the tech sector is clearly maturing, growth is slowing, and forward P/E ratios relative to the S&P are pretty equal or even less indicating strong value.  Combine this relative value with the fact that many tech companies, particularly large software companies, derive 50-70% of their revenue from annual recurring maintenance and you have an opportunity to buy out many of these businesses due to their predictable cash flow.  I see this as a trend that will only accelerate in the next few years as you have venture funds, LBO shops, and even hedge funds get into the tech buyout action.  Witness the recent Sungard deal and others.  If the private investors are willing and able to pay $11.3b for a company then no public software company is sacred.  This includes companies like Siebel and BMC who both recently missed their earnings targets.  There is plenty of value left in these software companies that the public does not see, and therefore plenty of money to be made by smart investors.

On the early side, I continue to believe there is much innovation to be done.  As the VC funds get larger and larger, they are under increasing pressure to put more dollars to work in every deal.  Therefore, it remains quite difficult for the larger funds to dole out money in $2-4 million chunks, and the valuations are quite attractive at this stage.  As a fund, we typically like to lead or co-lead the first institutional round (post-angel) where the company has a strong entrepreneur, innovative technology, and a handful of customers to prove the market need.  Where I do not want to be is in a Series B or Series C round in a "hot, momentum" company.  I have had a number of these companies come through my door, and I keep asking myself how a company which is only a feature of a much larger offering will create a significant return for the fund after having raised too much cash at too high a price.  When I see "hot" companies with revenue less than $5mm raise capital at $50mm pre-money valuations, I start getting worried, and it further reinforces my thinking on where to make good investments.

In the end, making good investments is predicated on taking advantage of inefficiencies in the market.  As we look at every new deal, we always revert back to the lesson that Warren Buffet’s mom gave him, "Buy low and sell high."  This includes investing on both sides of the barbell, very early with innovative technology in new markets and very late with established, out-of-favor software companies throwing off good cash flow.  Considering that I am an early stage VC, I will have to play the later part of the barbell with personal investments in the public markets.

When competitors are acquired…

It is clear that we are moving towards a consolidation phase in the technology sector.  M&A activity has been heating up over the last 18 months as strategic acquirers are looking to bulk up and broaden their product offerings.  During the last few months, we have had a few board discussions on this very topic.  The conversations were not about us trying to shop any of our companies as I firmly believe that companies are bought and not sold (see an earlier post).  Rather, our discussions focused on what happens when one of our competitors are acquired.  Usually when a competitor is bought at a huge price the first reaction is why it wasn’t me.  The second reaction usually becomes fear as you begin to worry about what your competitor’s product will do in terms of market share with a huge sales force and partner channel, strong brand name, and global infrastructure to support the customer growth. 

Having been through this a number of times, this is the point at which you need to take a deep breath, stay the course, and look at the situation in a positive light.  First of all, the majority of acquisitions fail.  Secondly, your competitor will be inwardly focused and quite distracted for the first 6 months trying to integrate with the parent company.  Finally, depending on how the acquisition was completed, employees will begin to leave as soon as they get the bulk of their money off of the table.  When a competitor is acquired, rather than sulk and worry about why it wasn’t you, try to aggressively exploit the situation and use it as an opportunity to grab market share and poach some experienced and talented personnel from your nemesis.  Last year, for example, one of my companies was able to build an incredible sales team overnight, saving us six months of hiring and giving us an opportunity to hit the market harder and faster.  So the next time this happens remember that you will more likely than not be in a better situation after your competitor is taken out of the market leaving you with plenty of opportunity to grow.

Highlights from a recent VC panel

On Thursday, I had the opportunity today to speak on a panel at the SAEC Global Venture Congress.  Other panelists included the moderator, Scott Maxwell from Insight Venture Partners, Bob Gold of Ridgewood Capital, Robert Dennen of Enhanced Capital Partners, Todd Pietri of Milestone Venture Partners, and Roger Hurwitz of Apax Partners.  Our panel was focused on helping entrepreneurs build a winning technology company.  While there were a number of interesting thoughts presented by my fellow panelists, a few important highlights were the following:

1. Release early and often – It is better to release an imperfect product, get feedback, and continue evolving than trying to release the perfect product because you may never get there and run out of cash before doing so.

2. Filling the product management/marketing role early is key.  Having a person who can shape the product and prioritize features by gathering the data in terms of what customers need near-term and what the market may need longer term is imperative.  More often than not I find early stage companies that are engineer-driven that spend too much time on features that the market may not need.  Avoid this problem early on and focus your limited resources on the right priorities.

3. Sales ramp – Do more with less and be careful of ramping up sales until you have a repeatable selling model.  In other words do not hire too many sales people and send them on a wild goose chase until you have built the right product, honed the value proposition, identified a few target markets with pain, and can easily replicate the sales process and model from some of your customer wins.

While our panel was focused on helping entrepreneurs build a winning technology company, we also did have the opportunity to digress briefly and dive into business models that we liked.  When Scott made all of us pick what type of company we preferred in terms of its target market from a list of enterprise, SMB, or consumer, it was interesting to hear the responses.  I selected enterprise with the caveat that the company have a scalable business model (capital efficient, channel friendly, OEMable, possibly hosted, etc.) while a number of others voted consumer, SMB, and hosted software.  If you asked the same question a few years ago, I am sure that enterprise would have been the overwhelming choice.  While there was no consensus on SMB vs. consumer, it was quite clear that all of us had a limited appetite for investments in traditional enterprise companies predicated on large direct license sales.   

It takes time to build value

During the boom, many VCs funded companies and created great exits within 12-24 months of funding.  Before that time, the standard rule of thumb was that it took about 5-6 years for a company to reach maturity, profitability, and potentially become an IPO candidate.  We did our own analysis of venture-backed software IPOs a couple of years ago (based on SEC filings, etc.) using pre-bubble data and this is what we found.  Companies pre-1998 that went public received on average about $20mm of venture funding, were 6 years old, were EBITDA postive, and had a pre-IPO value of around $170mm (includes companies such as Peoplesoft, Intuit, Mercury, Documentum, Checkpoint, and Veritas).  An interesting side note is that Veritas and Peoplesoft both went public in 1993 and were both acquired last week.  This reminds me of a conversation I had this summer with a Veritas executive who said how difficult it was to scale beyond $1-2 billion in revenue and that size matters.  There were a number of companies in that revenue band but very few above it like Microsoft, SAP, and Oracle.  Getting back to the data on software IPOs, during 1998-1999, the companies that went public received around $30.0mm of VC funding, were 5 years old, were not EBITDA positive, and had an average IPO value around $375mm (includes comps like ISS, Micromuse, Art, Interwoven, Vignette, Informatica).  The rule of thumb these days is that companies need to have around $50-60mm of revenue and be profitable for 1-2 quarters before going public.  That is certainly a high bar and many companies will not get there.

Another way of looking at company maturity is to look at M&A data.  This week’s Plugged In column from Barrons has some great data on M&A in 2004 and how many of the companies that went public or were acquired were the very ones left for dead over the past few years.  Of the 247 venture-backed companies which were acquired this year, 222 or 89.9% received its first venture funding prior to 2000 and 159 or 64.4% received its first round of funding between 1999 and 2000.  Anyway, as I look at the data from Thomson Venture Economics and the NVCA, it is further proof that we are returning to normalcy in terms of the time it takes to build value.

Vc_ma_copy_5As you can see from the chart at the left, average valuations of M&A deals while trending upwards in 2004 to $91mm, is still way below the $231mm and $338mm numbers in 1999 and 2000.  As we return to a state of normalcy, the point is that it takes time to build value and nothing happens overnight.  In addition, I also see the definition of what makes a great exit changing.  If we are returning to a pre-boom normalized valuation level where you need to make good money at exits of $50-100mm and a home run deal is around $250mm, it behooves us to make sure that we invest in capital-efficient business models to generate the same 8-10x that we once could with an average deal size of $300-400mm (see an earlier post for more on this topic).

Strike while the iron is hot

I was speaking with a friend of mine today who mentioned that his term sheet for his Series A round fell through. Things looked great for the last 6 weeks and then the deal process went into a stall regarding intellectual property rights. To make a long story short, one of the co-founders of the company built the company’s software in his spare time. However, he also had a full time job and decided ultimately to stay there rather than join the startup. Well, you can imagine that down the line the company that the co-founder worked for could potentially claim rights to the IP. Rather than leave this open to chance, the VC and the early stage company did the right thing and decided to clean up the ambiguity. Today, the IP is about to get assigned in the proper manner. However, the VC got cold feet and backed out of the deal.

So what happened? You see, deals take a life of their own. The more time it takes to close a deal, any deal, the more chance there is for it not to happen. Momentum is a powerful force but deal inertia can be more powerful. It sounds like the VC just got tired of the deal and also got cold feet as it seemed that a competitor or 2 cropped up during the deal closing process. This is not the only story of delayed deal closings. I was interviewing a CFO candidate for one of my portfolio companies yesterday and one of our discussion points was why a potentially large deal fell through. From his perspective, his side tried to overnegotiate the fine points, extending the closing out by a month. During that time the potential acquirer missed its numbers, got hammered by the street, and decided to back out.

My advice to you if you are going to raise a round is to make sure that you are prepared for all that may come at you in terms of due diligence. Have your financials clean, make sure your IP is owned by the company and not by any consultants, and have your references teed up to talk to potential investors. The more prepared you are the more impressed the VC is and the quicker the deal closes. One other point to remember, do not overnegotiate. Figure out the big picture of what you want in a VC partner and deal, negotiate those points but be willing to give up other points that the VC cares about. I have been in a few situations where an entrepreneur overnegotiates, and it certainly makes me wonder what it will be like to work with that person post-closing. Will there be give-and-take in our VC-entrepreneur relationship or will that entrepreneur always try to get his way?