BeyondVC

Occam's Razor and the current state of venture

I have made many posts in the past about focus and doing more with less, and as I continued on this path it reminded me of Occam's Razor, the idea that the simplest explanation to any problem is the best explanation.  Of course Occam's Razor can get more complex but over the years it has been associated with the idea that "less is more."  And when I apply this philosophy to the current state of venture, I can see many applications of this theory.

From a VC fund perspective, there has been much discussion about how venture funds have become too large to deliver outsized returns.  First with the lack of an IPO market it is much harder to generate $1.5b for investors on a $500mm fund then it is to deliver $300mm on a $100mm fund.  Secondly having too large a pool forces VCs to invest much larger amounts of capital into companies pushing up valuations and also exit hurdles for success.  Finally, as I have written in the past, I have learned firsthand the problem of giving companies too much money too early.  It can lead to a growth at all costs mentality, a lack of focus which means chasing too many opportunities at once, and a lax attitude on how to generate revenue. Enter Occam's Razor as it seems that the new trend is for smaller groups of GPs to form smaller funds to be able to invest in earlier stage companies.  With the new operating model of capital efficiency, a little amount of money can go a long way and help VCs generate excellent returns at much lower valuations.  Having a smaller fund allows VCs to write smaller checks and take advantage of the current market.

From an entrepreneur's perspective, Occam's Razor can be applied to many different avenues. As we all know, a great entrepreneur must be able to effectively allocate his scarce resources of time and money to fulfill a market need.  The longer it takes to develop a product that the market wants means that it will cost more money and that it also opens the door for a competitor to step in before you.  If you look at the current Internet and SAAS market, the idea of "release early and release often" certainly fulfills the Occam vision.  Rather than spend cycles creating the perfect product with every bell and whistle, many nimble startups have focused on a more reductionist theory of releasing an often simpler product quickly with the idea of getting market feedback for the next iteration. 

Occam's Razor also applies to how an entrepreneur should operate his business.  Don't pursue too many markets at once, focus on what is delivering the most return for the dollars invested, and hire people and scale your business when you absolutely have a repeatable revenue model.  I have been burned like many others by aggressively building out a sales team too early without a repeatable sales model.  In addition, from a sales and marketing perspective, we have seen a movement to more of a frictionless sales model where there is less hands-on interaction with customers selling and delivering a product.  This would include customers being able to go online and sign up for free trials or download software versus having an expensive direct sales force sell million dollar licenses and one month of professional services to install a product.  Finally and most importantly, the idea of less is more certainly applies to raising capital. With the rise of open source software and cloud computing, companies can now get started with less dollars and scale more cheaply and efficiently than before.  As all entrepreneurs know, raising less capital means retaining more ownership.

In summary, it is becoming increasingly clear that Occam's Razor and the idea of less is more will continue to spread as the cost of technology continues to decrease, as entrepreneurs get even more efficient in building businesses, and as a non-existent IPO market and the factors above lead more VCs to create smaller more nimble funds to capitalize on the new market realities.

Cover the basics before you raise capital

No matter how many times I told my friend that he needed to get a deck together for a potential capital raise and model out some thoughts on market sizing and financials, I ran into resistance.  It was not because he didn't think it was important or that it mattered.  It was because he was understaffed and going 60 miles per hour trying to get a product released.  I can understand that pain but at the same time, if you want to raise capital from anyone, you need to have the basics covered.

Fast forward 6 weeks from that last conversation, and we ended up having a meeting with a "friendly" VC to receive some market feedback on where his company stood and what needed to get done to raise capital.  And sure enough, it didn't take long for my friend to be questioned on the revenue model, potential market size and opportunity, and how long the cash would last.  Of course, he did have some strong answers but they were not what the VC was looking for - it was not quantitative enough.  We all know that coming up with market sizing and revenue forecasts for a startup is as accurate as the weatherman predicting the weather.  That being said, VCs want to understand the logic behind the numbers as much as the numbers themselves. 

Overall the meeting went as I suspected it would - a VC who was very interested in the product but also highlighting the fact that the revenue model was not clear.  The kiss of death for me on the revenue side was when the entrepreneur said that he would monetize the company like Facebook and Twitter.  Hmmm?  We all know that Facebook and Twitter are unbelievable web phenomenons and suck up incredible user attention.  And yes I am sure that Twitter will find a way to monetize the stream of data flowing through the system and I am sure that Facebook has tremendous value.  That being said accumulating users and worrying about revenue years from now is yesterday's news.  Unless you have tremendous scale when you show up at a VC's door, then don't bank on ad revenue as your only revenue source.  We have seen the market numbers-overall online ad revenue declining but search revenue increasing.  In addition we all know that social apps on the consumer side have incredibly low CPMs and that you need massive numbers to turn into a business.  So if you want to get funded, you better have a clear answer on how you will make money and either be implementing that model today or in the short-term.  What VCs are looking for is a revenue model today that makes sense - this can include premium subscription revenue, analytic revenue, and even lead generation revenue, but don't ptich massive scale and advertising as your go-to revenue souce 24 months from funding.  You will be shown the door quite quickly.

Positioning and pitch decks for startups

A friend of mine is putting together his first deck for potential investors.  In typical startup fashion, they launched a product, got a number of users, and then iterated several times to improve the service.  With the product in the hands of tens of thousands of users, they started getting inbound requests from larger organizations who were willing to pay for customized and private group related services.  While Version 2.0 will be released to the greater world in the next 6-8 weeks, you may be interested in what I had to say about the pitch deck. 

IMHO, a great pitch deck is concise (15 slides) and highly focused.  And in the deck I like to see the following points covered (yes, this is my preferred order):

1. One/Two sentence pitch for company -value proposition (1 slide)
2. Brief history - founded when, capital raised to date and from whom, capital needed in new round (1 slide)
3. Who/Team - give me some context of who you are, your backgrounds, success/failures so I can get an idea of your ability to deliver and surround yourself with experienced talent, also include any board members or advisory board members that may be relevant (1 slide)
4. What's the problem? - too often I see pitches where the entrepreneurs dive right into the product and I scratch my head thinking why in the world we need another lifestreaming service or social network or ad network (1 - 2 slides)
5. How do you UNIQUELY solve the problem? - solving the problem just like everyone else is not exciting.  You need to show how you solve the problem UNIQUELY and ultimately deliver a 5-10x improvement for the customer in terms of ease of use/functionality and cost.  What this boils down to is your simple product pitch. (1-2 slides)
6. Product/Tech - make sure to tell me about your secret sauce or core tech that enables you to deliver a unique service - screen shots, overview, etc - could be good time to go into demo in a live meeting (1-2 slides)
7. Customer traction - is product in hands of customers?  if so, how long in market and share some data on users or beta customers or customers (1-2 slides).
8. Market size/Competitive Overview - how big is the market and how do you come up with that number - how are you positioned in the market - show graphically maybe by offering or value proposition (this is where you get your typical top right hand corner Gartner like quadrant).  A sin is to tell me you have no competition (1 - 2 slides)
9. GoToMarket Strategy - how will you grow quickly and in a capital efficient manner?  How will you sell your product - online, direct, or indirect sales?  any potential partners signed or game changing partners that will help you deliver?  (1 slide)
10. Business/Revenue model - show me that the economics of your business work - note that single digit gross margins will get you thrown out the door pretty quickly (1 slide)
11. Financials - yes I know for early stage customers it is at best a guesstimate but give me an idea of how this will grow, what the revenue numbers look like over the next 3 years to give me an idea of how the business scales, and ultimately it helps me understand the true cash needs for the business to get to breakeven (1 slide)
12. The financing round - lay out the dollars you are asking for, how it will be used, and how long the cash will last (1 slide)
13. Milestones-what milestones have you hit so far and what do you plan on realizing during the next year with the new cash (1 slide)

Ok, pretty basic and that's it.  For those of you have triskaidekaphobia or fear of the number 13, it's ok as it is a lucky number in our house since my wife was born on the 13th.  Anyway, if you cover all of these points the deck should be about 15 pages in length and provide a great overview for potential investors.  One other point that I want to highlight is that how you position your business is key.  Take a look at this post from April 2004 titled What Aisle, What Shelf. You need to make sure that your audience gets where you fit in the ecosystem quickly and how you are different from what else is out there.

UPDATED: One item I forgot to mention: in this world of constant digital bombardment, you must figure out how your product or service becomes a "must-have" versus a "nice-to-have" solution in a customer's daily life.  If you are a "must have" with minimal substitute products then people will clearly pay for what you have.  If you are a "nice to have" in a world of many substitute products even though you may get some usage you will never be able to monetize that base. 

Be prudent but don't panic!

The alarm bells are ringing in Silicon Valley and start-up land today with Sequoia Capital and Ron Conway telling companies to prepare for the economic meltdown and to raise cash by cutting their burn.  This is not new news as being in New York we started to feel the real economic impact in mid-September as Lehman melted down and as Merrill Lynch was bailed out by Bank of America.  This is all prescient advice and something I have been espousing to my portfolio companies for awhile - see my last post from mid-September on Doing More with Less, a mantra that all startups should live by.  All that being said, it is not time to hit the panic button.  Don't go out and fire everyone wholesale and skinny down just because everyone else is. Do it because it is right for your business and because all of your leading indicators tell you to do so.  Do it the right way by not making a 20% cut across the board but by thoughtfully thinking about your business, your priorities, and where you need to focus your capital and resources to grow your revenue but conserve cash.

The good news is that many companies I have seen have learned their lessons from the last bubble bursting and rather than subscribe to the "if you build it they will come" model have turned towards the "release early and release often" model of gaining customer traction sooner rather than later and at much lower costs than before.  As I look at the current landscape, obvious areas of concern are any companies with high fixed costs and heavily reliant on direct sales whether it be advertising related or enterprise related.  It is clear that for these big ticket sales that many corporations are in the mantra of doing nothing rather than doing something and that startups should adjust their budgets accordingly to reflect this reality.  For those companies that live by the frictionless sales model and that are capital efficient with a low fixed cost base, take another hard look at your organization and priorities and haircut unneccessary expenses.  Once you do all of that and feel that you have 18+months of runway, look on the positive side as there will be many great people on the market.  Yes, cash is king and if you have it and conserve it, there will be some phenomenal opportunities to pick up some great talent.

M&A - it ain't over till it's over

The economy is clearly slowing down and the IPO market is nonexistent.  As I have always said, this is the time to hunker down and tweak your business to get your model right.  If you are interested in exiting today, M&A continues to be the only viable path along that front.  Having been through a number of acquisitions and potential acquisitions through the years, one point I must remind you of is that any deal isn't over until its over.  On the surface, this seems so obvious.  And yes, once a term sheet is signed and a price and general terms are agreed to, you are in great shape.  But recently, through discussions with other VCs and entrepreneurs, I am hearing about more situations where strategic buyers may significantly change the deal terms after more serious due diligence or even potentially walk away from a deal.  This can be especially painful if you have spent a number of months meeting with the strategic and going through due diligence in lieu of running your business. Trust me, this happened to one of my portfolio companies last year and reasons cited can include we had a change of strategic priorities and or look at the economy, there is no way we can value you like we did when we started the deal.

While I can offer you no protection from this happening to you, all I can say is to be prepared and skeptical, be willing to walk away, and make sure that you both do enough diligence and meet with the right decision makers before you sign any term sheet and embark on the extended process.  Once the term sheet is signed, run like hell to get the deal closed because the longer a deal lingers the more opportunity there is for it not to happen.  Keep the hammer down and always have next steps and a defined timetable.  In addition, to the extent that the strategic acquirer has made other aquisitions in the past, I would try to leverage your personal network to reach out to some of the VCs or entrepreneurs involved to get a flavor for how the strategic will run their due diligence process and what doozies or surprises the strategic throw at you.  Before you start spending your money from the acquisition, remember there is a lot that can change and that probably will change so keep that in the back of your mind as you go through the process.

What do I see in venture through 2010???

The Jordan Edmiston Group recently asked me and a few other VCs a few pointed questions about the future for circulation in their July Client Briefing.  As an aside, I worked with JEGI two years ago and they did a fantastic job helping us sell Moreover Technologies to Verisign.  They understand the media and online world, are well connected, and work diligently to get the job done.  Anyway, here are the questions and my response:

Even though there is uncertainty in the credit markets, a stalled IPO market, and few billion-dollar plus M&A transactions, the investment activity level and appetite for quality businesses in the middle-market continues to be vibrant. Venture Capital firms continue to invest in companies that are providing answers to key disruptive market forces and are exiting those investments via M&A. The Jordan, Edmiston Group, Inc. (JEGI) solicited a handful of key VC executives for their responses to the following questions:

1. What are the key market forces you believe will impact your venture activities through 2010?
2. How do you envision capitalizing on or responding to these market forces?
3. How is the environment changing for deal exits (e.g., IPO vs. M&A)?

(My answer is pretty consistent with what I have been blogging about during the last few years.  Here is an excerpt from the briefing and if you are interested in reading more and some of the other VCs responses, you can get it here)

We are continuing to move to a broadband connected world, where everything that we do on a device increasingly lives in the cloud. Our business applications, our music, our videos, pictures, and messaging will be easily accessible from any device, any time, and anywhere. We will continue to see new cloud-based applications and services, and data-driven services will play a larger role in this new world. There will be some great opportunities to invest in companies that take existing data and run algorithms over these streams of data to deliver better and more targeted advertising, personalized recommendations and search, and better overall services for end-users.

One of the next phases of growth and large revenue opportunities will be driven by what is captured every time you click on a page and move from site to site. How companies use this data to improve a user’s online experience is the next game changer. What I love about these kinds of opportunities is that algorithms scale, have high gross margins, and are highly defensible. With our computing world living in the cloud, there will be a whole new generation of mobile applications that leverage the increased computing power and faster broadband speeds that are offered today.

Mobile carrier voice revenue is declining, and data revenue is the next huge growth area for carriers. However, data revenue cannot increase without applications that drive usage. Obviously, there are concerns about carriers’ “walled gardens”, but I see a future where carriers increasingly provide open access to allow innovative apps to drive data growth. In addition, as mobile devices become better, cheaper and faster, we will see an increase in the number of users accessing the web from their wireless devices, as often as they do from their home PCs.

Capitalizing on Disruptive Market Forces
Dawntreader Ventures will capitalize on these disruptions by investing in the entire food chain, from infrastructure layer to the apps and services that touch the end-user. This includes investments in companies like Greenplum, which is powering the back-end data warehousing for a number of high profile Internet companies for targeted advertising; and Peer39, which provides semantic advertising solutions by using natural language processing and machine learning. This technology enables the company to go beyond keywords to understand page meaning and sentiment, to deliver the most effective display and text advertising to end-users.

Exit Strategy

Unfortunately, the market for IPOs is currently “dead”, but it may reopen in 2009. M&A continues to be strong for the right companies that fit a strategic hole in an acquirer’s portfolio. In the end, I continue to tell my portfolio companies that if you focus on what you can control (growing and managing your business), then the external factors (exit strategy) will take care of themselves. However, if you try to force the issue and shop your company, that shows a sign of weakness and more often than not will result in a fire sale. Companies are bought and not sold. For strong, well managed companies, opportunities will always present themselves, as long as you can avoid making desperate decisions.

To read some other VC responses and to get an update on the state of Interactive M&A, I suggest getting the JEGI briefing here.

Raising capital and meeting expectations

What I like to tell portfolio companies is that on average it will take 6 months to raise capital with some cycles being shorter and some being longer. Given that, it is imperative for a company to start thinking about its next round well ahead of time and the milestones it needs to hit to have the right momentum to get potential investors excited. One area that I would like to caution entrepreneurs is being too aggressive on the milestones and revenue forecast, particularly in the near term.

Let me explain. Like any other VC, I love to invest in companies going after big markets with huge revenue potential. That being said, I also like to see plans grounded in reality as well. Rather than get me excited, showing a revenue ramp from $1mm to $17mm to $65mm will actually do the opposite for me, raising more questions and concerns than general excitement. Along those lines, it is also imperative that when you share your plans with investors that you are pretty confident that you will realize your milestones or hit your numbers in the next 6 months as investors like to see if you can deliver on your promises. One cardinal sin is being overly optimistic in the near term and falling flat on your face in the due diligence process. It is much better to position yourself in a way that you can meet and exceed expectations during the due diligence process than the other way around. When this happens the rest of your forecasts become more believable.

Top tech M&A advisors for 2007

I just got the 451 Group's summary on the top M&A bankers for 2007.  As with 2006, Goldman Sachs was #1 on the list.  Take a look:

Top five overall advisers, 2007

                        

Adviser	Deal value	Deal volume	2006 ranking
Goldman Sachs	$79bn	43	1
Credit Suisse	$75bn	29	3
Morgan Stanley	$74bn	29	6
Citigroup	$61bn	23	5
Lehman Brothers	$56bn	21	4

Of course if you break down the numbers, you can see that the average deal size for all of these banks range from $1.75 to 2.75 billion.  Let me translate back for the startup community.  As I have written before, I am a firm believer that companies are bought, and not sold (see an earlier post).  In other words, I am not a fan of hiring a banker to shop a company around but rather find it better when a portfolio company receives an unsolicited offer and you then bring a banker in to leverage that bid to create a more competitive situation.  Assuming you are in this position, every startup I know says, "Let's go get Goldman or Morgan Stanley."  While in theory we would all love to have these guys as advisors, the chances are that you are not going to get them on board.  First, they typically have high minimum thresholds of exit value typically in the $300mm plus range and secondly even if you fit that criteria you may not get all of the attention you need since a $5 or $10 billion dollar will clearly trump yours.  What I would advise is that you find a banker that has the recent experience selling companies in a price range that you are seeking, will give you the PERSONAL attention that you need to make the transaction successful, and has the network to reach out to the right people on a timely basis.  Based on my experience, I have found that some of the firms like Thomas Weisel Partners and Jefferies Broadview who are not bulge bracket but with strong reputations in the technology markets can be a good fit.  I am sure there are many other great firms that I am missing but you get the idea.

Greenplum closes on $27million round of financing

Congratulations to Bill, Scott and team on our new $27mm round of funding led by Meritech and including Sun Microsystems and SAP Ventures.  You guys have been pushing the envelope since I have known you and delivering some spectacular results to boot.  It is nice to see our team and product get validated with a significant round of funding so we can continue our battle to bring our customers a better, faster, and cheaper way to access and analyze massive volumes of data.  When we made our first investment years ago, our fundamental bet was that a new approach was needed to deal with exponential data growth driven by network computing and internet applications.  We certainly had some fits and starts tackling this data problem by utilizing a software-only approach built on top of open source software and delivered on commodity machines, but with this funding and our continued customer momentum, we are certainly on the right track.  For more on this investment, read the following quotes from Jonathan Schwartz, CEO of Sun Microsystems, and Nina Markovic, head of SAP Ventures:

"Alongside Sun's acquisition of MySQL, our investment in Greenplum is further evidence of our commitment to the open source database community and marketplace," said Jonathan Schwartz, CEO and president, Sun Microsystems. "Postgres has been a critical part of our support offering to customers, and Greenplum's leverage of Postgres to disrupt the proprietary vendors with breakthrough business intelligence solutions creates opportunity for their investors, and more importantly, our mutual customers."

"We invested in Greenplum because we're seeing a growing demand for scalable database technologies to support analytical and data-driven applications," said Nino Marakovic, head of SAP Ventures. "From a technology perspective, the Greenplum database is very strong and complementary to our offerings. We share the vision of enterprises harnessing ever-growing data repositories to make optimal business decisions in real time."

Should I flip or should I build?

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

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

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

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

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