Five Years Too Late

September 29, 2008

Oy Vey, says Stuart’s Mother

I got a call recently from my mother. She read in the New York Times that all the hedge funds and LBO funds are in real trouble and she wanted to know if RRE was OK.  Since most Jewish mothers like to worry all the time, she wanted to know if she could ratchet up the worrying about me.  While I hate to deprive her of the opportunity, the truth is that if a venture capital firm invested wisely, it’s likely in pretty good shape.  Let’s look at the current state of running a VC firm right now.

How does the Credit Crunch Affect the Venture World?

In a recent post we wrote about the current and near-term climate for fund-raising becoming more difficult because of mark to market issues and asset allocation.  So, let’s take for granted that the bar is raised for new investments and even supporting existing portfolio companies. Two critical (and related) points:

First and foremost, venture-backed companies have essentially no leverage.  With very few exceptions, the only bank lines these companies employ are tied simply to a balance equal to the amount of the loan in cash at the bank.  That is not leverage; it’s working capital management.  Given this lack of leverage, that bank lines are now essentially unavailable doesn’t interfere with these companies’ operations. These companies’ capital structure is (for the most part) 100% equity, 0% debt. Those companies that employ “venture debt” are few, and generally have a very heavily equity-oriented capital structure.

The second piece is that VC funds themselves are also 100% equity. Others have covered the basic structure of venture capital funds, but the short version is that we don’t use leverage. Hedge funds, private equity/LBO funds and some mutual funds raise money from investors (equity) and then borrow more money to juice their returns. VC funds don’t. We raise equity capital from our Limited Partners, and then make equity investments in companies. Those companies, as mentioned above, are also all-equity.

So the fact that the debt/credit markets are a complete disaster affects us only indirectly.

So What’s the Problem?

The real frustration for VCs is the lack of exits.  In the 1990’s, once you grew a company to $40 million in revenues, you could get one of tech investment banking firms to take you public, like Hambrecht & Quist (now part of Chase), Robertson Stephens (gone), Montgomery, or Alex Brown (now part of Deutsche Bank).   Then, after the bubble burst, the bar got raised.  In the post-bubble world, you grew a company to $100 million in revenues and then you could get Goldman, Morgan, or CSFB to take you public.  Once you filed for an IPO, or even got ready to, that also put you in play to be acquired.  Now, there is no current IPO market.  Which leads to the frustration.

RRE has a number of companies that had zero revenues when we invested and which are now doing $100 million or more in revenues and growing very quickly.  These companies have achieved what they needed to achieve, become market leaders, yet they cannot go public or exit under the assumptions that employees or founders assumed when they began.

So what do you do?  Sit tight, be patient, and continue to grow the company.  It’s as if somebody told you that your goal was to jump five feet in the air.  After a few years of practice, you build up the ability to jump five feet, and then they change the height to six feet.   It won’t kill you, it is just annoying.

What Next?

As the economy slows, there is no doubt that it has an effect on consumer spending.  Does this hurt all companies?  Some companies, certainly.  Other companies it should help.  Those companies that allow people to do things more cheaply or make money from activities should grow even faster.

RecycleBank will pay you for recycling.  Tendril will save you money on electricity costs.  Peek will give you cheaper mobile email service.  These companies should thrive in a down economy.  I am working on a seed deal that entails free items for consumers.   What could be better for those who have been downsized?  In addition, companies that make capital available when banks dry up such as PrimeRevenue or On Deck Capital should be huge benefactors.  There are lots of opportunities out there for startup companies.  We at RRE intend to take full advantage of them.

Mom, don’t worry about me.  We didn’t overpay for overpriced deals with no revenue.  We didn’t commit ourselves to cleantech deals that need $500mm of CapEx to get to scale.   We did mostly smart deals at good prices and continue to hold their feet to the fire to keep the costs down in these hard economic times.  And no, I will not stop buying these stupid sports cars.  And yes, I can still afford to take you and Dad out to dinner in New Jersey.

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September 25, 2008

Thinking about Google’s New Platforms

Filed under: Digital Media — Tags: , , , , , , , , , — fiveyearstoolate @ 1:10 pm

In the last month we’ve seen the release of both Google’s new browser, Chrome and the first handset based on Google’s mobile operating system, Android, the G1 from T-Mobile. In both cases, the knee-jerk popular response arc seems to be the same, “Hey new product from Google this is great… hey wait a minute, it’s not that great… ah forget it”.

With Chrome, people got excited because a) it was a new browser, b) it was from Google and c) it was (is) fast. But then people realized their firefox plugins wouldn’t work, and some web applications (like … Microsoft Office Live) don’t work, and it didn’t change their browser experience THAT much. And so while some people are using it every day, the tech cultural zeitgeist essentially moved on, at least for now.

With Android and the new T-Mobile G1 phone, the large majority of the conversation I’ve seen has focused largely on feature-by-feature comparisons with iPhone. The conclusion seems to be that this phone isn’t as cool as the iPhone and kind of looks like a Sidekick. Oh, and it’s not open enough because you can’t use VOIP instead of T-Mobile’s minutes. And because you can’t buy it from T-Mobile, and then ditch T-Mobile for another carrier (“Sim-locked”). So people conclude that Android’s openness is a sham and that the project is a failure.

Let’s step back from both of these sets of immediate concerns and think about what Google is actually trying to do with both Chrome and Android. For a number of years now many people (myself included) have wondered what comes next for Google. The company has thousands and thousands of employees working on all manner of things, but essentially only two of the products (Search and Ads) contribute to the top line in any meaningful way. And so the question arises, what is going to be Google’s next great business?

Chrome and Android aren’t designed to make money for Google. They are designed to advance Google’s unifying position as a company that produces applications that run on networked devices (and sells ads on the inventory generated by those applications). To date, Google has developed primarily for PCs running Internet Explorer and to a lesser extent Firefox, Safari and (back in the day) Netscape. But moving forward, the great trend (both on the consumer side and on the business side) is toward applications that run out of the browser (web services if you like, or Software as a Service). In fact this is the vision that drove the first “browser war” between Microsoft and Netscape back in the 1990s. Even then it was clear that enormous volumes of activity and time would be spent on browser-initiated interaction, rather than on client-side applications.

So with Chrome, Google is looking to build out a big piece of browser real estate that is built in ways that will optimize the operation of Google’s (and presumably others’) web applications. Some of the architectural features – each browser tab runs as a separate process, there is a task manager for the browser, etc… indicate that Chrome is an attempt to take web applications seriously. And of course if Google controls the underlying browser’s technology, it can assure optimal operation of its applications both offensively (in terms of designing the apps and the browser to work well together) and defensively (against the possibility that IE/ActiveX might unduly benefit Microsoft’s own emerging web application ecosystem).

With Android, Google looks further into the future. Developing for mobile devices is a complete disaster today. Mobile software companies who want to develop applications for various dominant platforms today (iPhone, Blackberry, Windows Mobile, Symbian and a host of others) have to employ teams of engineers, manage multiple codebases and learn the ins and outs of various handset hardware and OS restrictions. The idea behind Android isn’t that as a developer you will be able to be free from all carrier restriction (Google doesn’t have that power, neither does Apple). The carriers are still a very powerful and very challenging force here in the US. I think that Google’s notion is that developers should have a superior environment in which to build applications that can access capabilities of the handsets on which they reside. I think that looking forward, Google sees the mobile web as pervasive on handsets as the consumer web is on desktops today. The current universe of mobile devices renders this vision nearly impossible to realize.

Ultimately, the handset released by T-Mobile yesterday has almost nothing to do with the long-term possibilities Android represents. Sure, it’s a first-generation device that’s less sexy than the iPhone. But the real battle isn’t going to be between these two physical devices. In some sense it hearkens back to the original Apple vs. Microsoft battles of the 1980s. Apple built a beautiful, closed system while Microsoft let any PC manufacturer install DOS. Again, Apple curates the App Store while Google gives Android away to handset manufacturers and application developers as an open-source product.

We’re still in the early days of this, but both of these products indicate significant forward thought by Google. It will be fascinating to watch both of them advance (or not) the company’s agenda.

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September 22, 2008

Why Venture Firms Tighten the Purse Strings in a Down Market

Anyone who has raised money during a down cycle like this one has noticed two significant changes in the fundraising climate.

1. Valuations come down
2. VCs make fewer investments

The first is probably fairly straightforward even to those entrepreneurs who don’t like it. When we’re in boom times (like the late 90s, 2005-6 for Web 2.0 or today for Cleantech), deals get bid up and investors pay high prices to get into great and even not-so-great deals. The inverse is also true – in tough times, the leverage shifts and investors hold the upper hand, often getting better terms and lower prices for good companies. That’s just the operation of what is, at the end of the day, a capital market.

The second of these is probably counterintuitive to some and deserves some attention. There is reasonably good evidence that firms are best-served by investing when prices are low and there is less competition for deals. It’s classic contrarianism. Well, aside from the basic truth that most people aren’t contrarians (by the definition of the word), there is another force at play here: When things are good, VC funds invest their funds as quickly as they can and go out and raise another (typically larger) fund. When things slow down, however, venture funds also slow their pace.

Why? Because it’s harder to raise that next fund. Venture funds are hit by an indirect consequence of problematic public markets.

Here’s how it works: Let’s say that you are an institutional investor (like a pension fund) with a $1 billion fund. Part of your fund is invested in venture capital funds. Your allocation to venture capital and private equity is set at 20% (for example). Now further imagine that the other 90% of your portfolio (equities, fixed income, real estate, etc…) goes down by 20%.

So prior to the market going down, you were invested like this:

Equities/Bonds/Real Estate             $900 million 90%
Private Equity/Venture Capital        $100 million 10%

Now, however, you are invested like this:

Equities/Bonds/Real Estate             $720 million 87.5%
Private Equity/Venture Capital        $100 million 12.5%

You are now over-allocated to PE/VC. The problem is that your public-market investments are “marked to market”, meaning that their value changes as the market provides a signal as to a new price. With a publicly-traded security, those signals are provided every business day via price quotations. Venture capital investments, by contrast, are marked to the most recent valuation, and that typically only comes with a new round of financing. There is a significant delay in the marking-to-market of these investments. They will eventually be marked down in this kind of environment, but it takes longer.

The way that most institutional investors respond to this situation is simple and devastating – they stop investing in new funds until their allocation returns to plan. Sure, if a top-tier VC fund comes calling, they’ll find allocation for them, but newer funds raising their first or second fund, funds that haven’t performed particularly well, and other less well-known investors will have a hard time raising capital.

In addition, there is a reduction in the velocity of money that flows through a portion of the Limited Partner base for venture funds. Many wealthy individuals, family foundations and other potential investors in funds use the distributions they receive from successful exits to fund their participation in new funds. In an environment where there are fewer and smaller exits, these investors’ money is locked up in their existing funds, and hence unavailable for new funds. To compound the problem, many of these individuals are technology founders and CEOs who make substantial money from big technology exits, typically IPOs or large acquisitions by public companies. When these types of transactions aren’t taking place, these individuals aren’t potential players as VCs look to raise new funds.

All of this combines to compel venture firms to be more patient and slower-paced with funds, because the bar is set higher for us as well, and we want to make sure that in a climate where fewer venture funds are getting funded, we’ve done only the very best deals that fit closest to our firm’s capabilities.

We know you need the money more than ever in times like this. It’s not personal.

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September 19, 2008

What to Do When the Sky is Falling

We are less than ten years removed from a complete meltdown in the equities markets, and yet once again we collectively find ourselves in the midst of a frightening financial collapse. The last one, from 2000-2002, was directly centered on technology, and it still feels recent to many of us. Companies had raised too much money, avenues for monetization dried up, and there was a shakeout throughout the tech industry. This time around, financial services firms are at the root of the crisis, and for a while people in the technology world were optimistic that it wouldn’t affect us much. That would have been nice.

There is a tremendous amount to be said about why this happened, who’s to blame and what happens next. But for now, here are a few thoughts about how this is going to impact our portfolio and technology startups generally. What is happening this week (even considering the public market reaction to the new bailout proposals) will have some meaningful effects on stakeholders in the technology industry, both direct and indirect. Earlier this week, we commented on likely fallout on the security industry, but even firms that don’t sell directly to Wall Street will be indirectly affected. There are a few takeaways from this:

First, be aware that raising money is going to be harder. In times like this, investors raise the bar for potential investments. This happens not because investors are cruel, but because our calculus around growth and return has to change during an economic contraction. Whether you are selling to Wall Street, media, retail, small business or consumers, economic troubles like these probably slow your growth. If you are offering a free service that will later be monetized with subscriptions or advertising, it’s time to adjust your projections for uptake. All of this impacts our view of how much money you will need to reach break-even, the likely proof-points you will have achieved the next time you go out to raise money, and how much a likely acquirer will pay for your company. This analysis raises the bar and tends to contract valuations.

Second, and related to the above, if you can raise money, raise as much as you need. There have been people calling the bottom since before the real problems began. Expect this to go longer than you think, and adjust accordingly. Cut your burn. Hire great people who can do the work of two or three. Be careful, because if this goes on for two or three years like it did the last time, you don’t want to raise twelve months’ worth of cash now.

Third, and particularly relevant to New York, expect to see a bunch of interesting, if non-traditional talent entering the market. One thing we’ve known for a long time is that there is a lot of technical talent locked up in the big Wall Street firms. A lot of those people are going to be shaken lose. First Round Capital has a great little site put up that looks to capitalize on this. If you are looking for people, this could provide a great new source of talent, and could certainly go toward the frequent complaint that New York is a hard place to recruit.

As we advise our portfolio companies and look to make new investments, we’re thinking about all of the above. The fundamentals of technology businesses haven’t changed, but we expect sales cycles to elongate, pilots to drag on, user growth for anything paid to slow and churn to increase. The IPO markets are on hold, and we don’t know for how long. Public companies will be getting their own houses in order, and with depressed stock prices will pay less for the startups they acquire.

Good companies will continue to be successful, but we are going to be very careful about follow-on rounds for our companies and will be encouraging them to be as lean and judicious as possible. These cycles come and go. Make sure you are managing the turbulence as best you can.

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Eric’s Email Misadventure

Filed under: General, Uncategorized — Tags: , , , , , , — fiveyearstoolate @ 9:08 am

We love hosted software models. You can call it SaaS. You can call it cloud. You can even still call it ASP if you’re old-school like that. Scalable. One code base.  Subscription revenue. Users can’t screw it up and incur a bunch of support costs. All good.

But a few weeks back the potential downside of these services showed up in an unpleasant way, right in my inbox. All of a sudden I just wasn’t getting very much email. This isn’t ego – the volume of mail was suspiciously low, especially given how many emails I had sent out the previous week, having recently returned from vacation. There was nothing obviously wrong. Emails weren’t bouncing and if you sent an an email called “test” it arrived no problem. The IT guys sent me emails in from all kinds of crazy domains to see if I had an overactive spam filter. Mail from Russian ISPs arrived unmolested. “No problem” they declared.

Problem was I’d had several people tell me they’d sent me emails that I didn’t receive (including a company that showed up at our offices having confirmed a meeting via an email I never got). So they looked. And looked. They deleted my profile on the exchange server and reinstated it. They were about to blow up the whole exchange server and start over when they figured it out.

When I got back from vacation I had put in place a new signature for my emails, one which featured the URL for my tumblelog, wiesen.tumblr.com. It had not occurred to me (or to anyone) that this would be any kind of issue, but when the IT guys started pulling apart an email we knew failed through repeated testing, it was in fact my signature causing the problem. Specifically, the string “tumblr.com”.

Any email that contained that string failed to deliver to my inbox. Apparently (we later learned) a hosted security product used by our (hosted) disaster recovery product had somehow flagged poor tumblr as dangerous, and was simply killing any emails containing the domain. No quarantine, no spam filter. These were killed long before they ever got to our server.

All’s well that ends well, of course. I changed my sig (although I’m sure many people are deprived for the lack of my scintillating content) and sent out a big mea culpa to anyone I’d emailed in the affected week (since it was all replies with my quoted signature that got blasted) and we moved along.

But it certainly highlights a slight lack of control and transparency that comes with outsourcing (for lack of a better word) one’s software. Convenient and easy to administer? Absolutely. But imperfect in ways I hadn’t necessarily focused on prior to this misadventure.

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September 16, 2008

Security Feels Risky

Filed under: security, venture capital — Tags: , , , , , , , — fiveyearstoolate @ 4:13 pm

I have been wondering about security startups recently.  We made a bunch of great security investments in the late 1990’s and at the time our underlying premise was pretty solid:  Many other types of software could be pushed off in the purchasing cycle, but important security functionality and protection could not.  This is what I called the “hair on fire rule”.  While a fortune 500 company could look at the hottest accounting, marketing, collaboration or governance software and think it was pretty nifty, they weren’t compelled to buy it RIGHT NOW.  Why not?

Largely because entrenched software vendors like Oracle, SAP or Microsoft would freeze out the startups by promising to bundle those same features into the next release within 9 months (whether they really planned to or not).  From a corporate executive point of view, why take a risk by paying more to an unknown startup company when my existing vendor will just give it to me for free for just waiting a little while.  However, security was an exception.  If your company is being broken apart by viruses, phishing or spam, then your hair is on fire.  You have to do something right now, not just wait for the future promises of larger companies.  So, you buy from the startup firms.  The startups would then get traction, ramp to $30mm in revenues, file to go public, and probably get bought. Good deal all around.

These days, however, even when the security startups seem to get to about $25mm in revenues (which are the fortunate ones) they get stuck.  What is happening?

First of all, there is a problem with the customers (and that is more true today than even last week when this post was originally written). Wall Street firms are the classic early adopters for security software.  Who needed to be more security-conscious than Citi, Lehman, Goldman, Merrill, and Morgan?   They frequently accounted for the first bunch of revenues the startups were able to book.  So what do you think is happening to those contracts today?  The big financial services firms’ own hair is on fire about staying solvent (or figuring out what to do post-insolvency). They aren’t focused on buying new software, even important software like security. At best, they are engaging in the type of endless pilots that kill startups.  So, our theoretical security startup starts to see revenue growth stagnate or start to drop.  And those who have taken corporate finance (or who have ever been part of a valuation or M&A process) will know that growth rate drives valuation, and that flattening growth kills it.

Secondly, and more troubling insofar as it’s not tied to current events quite so much, there is a problem with the public markets. Even getting to $40mm in revenues no longer means you are close to a public offering.  The public markets’ appetite for enterprise software generally (and technology even more generally) is demonstrably lower today that it’s ever been in the past, perhaps out of recognition of some of the above problems with the space.

A really smart CEO came in to see me this week.  He had been a very successful entrepreneur back in the late 1990s.  He had just finished selling a tired security company for cents on the dollar and felt lucky to have been able to do that.  As we talked, we thought about what happened to the security industry, and he had an interesting take on the situation:

He said that there used to be three levels in the security software ecosystem.

•    Big Fish: These were big companies like Microsoft;
•    Middle Fish: These were public (but not monolithic) companies like PeopleSoft;
•    Startups: New players with innovative technology.

The rules of the game were pretty well established. The Big Fish looked around and bought companies with $100 million in revenue. The Middle Fish were around to buy the startups.  So there were multiple exit points for smaller fish.

What happened is that the middle fish were eventually purchased by the big fish and by big fish in tangential spaces (like Oracle).  So now all you have are big fish, and none of the startups can grow large enough to get their attention in a meaningful way.

So where we are today is an environment where there are a number of security companies with between $5mm and $35mm in revenues that just cannot get the scale to be noticed by the big fish and don’t have the high growth rates necessarily to raise big rounds of capital to buy their way into higher revenues.  I don’t fish much but it makes sense to me – Marlins don’t eat minnows (I don’t think).

The problem isn’t the business case for security software – the hair on fire necessity around security is still there. But problems with the customers, the public exit opportunity and the difficulty of getting to acquirable scale make us very cautious in this space today. For us to get really excited about security, we’d need to believe that the problem being solved is monumental, and that the path to high revenue is both visible and achievable without large inflows of capital. That’s a high bar.

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September 15, 2008

Is Green the New Black?

Filed under: Green IT, venture capital — Tags: , , , , , , , — fiveyearstoolate @ 11:46 am

By far the largest trend in technology venture capital over the last two years has been the extraordinary shift in attention from traditional areas of focus like security, telecom and semiconductors into the area known as “cleantech” or “greentech”. This has resulted from both the decline in some traditional sectors as well as from increasing awareness that there are real problems to be solved around energy consumption and production, and that they are the types of problems that might be addressed by high-growth technology companies (and hence the purview of venture capital).

I think it’s safe to say that all VCs have at least noticed this transition, but there have been a number of different approaches to the new opportunities proposed by cleantech. To borrow analogy from poker, here are a few ways firms have chosen to play the clean technology hand:

1.    “All in” – Some firms have essentially pushed in all (or virtually all) of their resources, betting that cleantech will replace traditional IT sectors. These firms have either repurposed their existing IT investors to focus on cleantech subsectors or they have hired additional personnel: materials scientists, chemists and others with energy sector expertise. Some of have raised new funds specifically to address cleantech while others invest out of their primary funds.

2.    “Fold” – Other firms take the view that their value-add as investors would be compromised by an out-of-scope shift of focus to the energy sector given the disparity in underlying technologies (biofuels, thin-films, photovoltaics, etc…), and so they continue to look for opportunities in sectors where the investment team has expertise and contacts in traditional IT areas.

3.     “Smooth call” – The third approach is to view the energy sector as a vertical market that is partially addressable by information technologies. This view holds that the economic, business and environmental problems being solved by cleantech companies are too large for investors to ignore, but that certain areas of clean technology are not a fit for the relatively small funds raised by venture capitalists. The play here is to map these new opportunities to the current VC evaluation process – size of problem, quality of team and appropriateness of technical solution to that problem. The additional layer here is the evaluation of technologies outside of software, networking, semi-conductors, etc… that have comprised IT investing for the last few decades.

We here at RRE pursue this third approach, selectively deploying our capital toward “green IT” companies that are solving serious energy sector and environmental problems using technology and business model innovations in ways that we’ve valued since long before the cleantech movement began in earnest. Today we have several investments that can be described as “green” investments: Recyclebank, which is building an infrastructure to enable incentivized consumer recycling, Tendril, whose software powers smart meters that enable consumers to manage their energy use, and Ember, whose chips and suite of products enable the sensors and devices that will power the awareness and reduction of energy use by consumers and businesses. We have a couple of others in the hopper, too, but this isn’t the place to announce them.

In each case, we have invested in a business we understand (software, semiconductors and technology-enabled networks), but which seeks to solve a green problem. We are not the right investor for capital-intensive project finance, and are unlikely to get involved in those types of businesses. We probably couldn’t tell you which type of algae can convert waste into oxygen faster than another and don’t want to try. But just as the mainframe computer solved large problems for enterprises, and personal computers solved large problems for consumers and small business, and the way the internet solved problems for everyone, we think technology can effectively address a lot of the problems associated with energy use and efficiency. And we will continue to aggressively pursue great companies solving these critical problems. We think that venture-backed startups can be as important in the green sector as they have been in other IT areas, but we’ll be selective about which hands we’re willing to play.

September 13, 2008

Barnacle Companies

Filed under: Startups — Tags: , , , , , , , — fiveyearstoolate @ 10:13 am

From time to time we see a company come in to pitch RRE that pitches us on a business that is fundamentally dependent on another (typically larger) business. An example of this would be Xobni, the (very useful) inbox extension for Microsoft Outlook. But it’s not always a big company (think Summize, the search company recently acquired by Twitter). We sometimes call these companies “barnacles” because of the way these companies latch onto a larger host and add incremental value to users of the host company’s products. This is becoming more and more common as companies either actively promote an application infrastructure built on top of the core platform (Salesforce.com, iPhone App Store, Facebook Platform) or as companies simply open up API access to allow other applications to take advantage of functionality or data.

There are pluses and minuses to these types of businesses, and like everything we see, the ultimate decision of whether or not it’s a business we’ll want to fund comes down to the strength of the people and how big a problem their product purports to solve. But barnacle businesses have some specific characteristics to them that are distinctive.

GOOD: Barnacle companies don’t have to build an ecosystem of interest to support their products.  Xobni, to continue our example (and note that we are not investors in Xobni) doesn’t have to convince millions of users to use Outlook – Microsoft has already done that. They just need to convince existing Outlook users to install their product to enhance productivity. Now that’s not the easiest sell in the world, especially given the IT attitudes present in many large Microsoft environments, but it’s a lot easier than trying to build the ecosystem from scratch.

BAD: The flip side to the above, of course, is the vulnerability barnacle companies have to host companies. When your business is entirely dependent on another company, that company has substantial power over you. That can come in the form of a decision to duplicate your functionality, at which point you rely on any IP you might have or the stickiness of your product, or to modify their product (or API) to block you. If the host company decides to prohibit one of these products from attachment, the startup can find itself adrift at sea.

GOOD: There is no more obvious acquirer for a barnacle company than the host.

BAD: There may be no other acquirer for a barnacle company than the host, so be very careful to establish a good relationship.

In an era where a greater and greater number of ecosystems are being built (Microsoft, Facebook, Salesforce, etc…) it is becoming increasingly feasible to build a business that is a barnacle, but these come with an unusual set of challenges, and require some careful maneuvering, particularly around fundraising and exit.

September 10, 2008

Can RealNetworks be the “iTunes for Movies”?

Filed under: Digital Media — Tags: , , , — fiveyearstoolate @ 5:36 pm

RealNetworks has been in the business of playing and streaming media on your PC since the way old days (1995!), and today they announced a foray into DVD ripping. The idea here is that RealDVD will be a fully-legal way to rip your own DVDs to a computer, easily and without angering the MPAA or other movie industry litigants.

Lots of people rip their media today. The most mainstream usage, of course, is ripping CDs into iTunes, and for some that’s probably all “ripping” means. But the idea of pulling music off physical media to store in the more flexible and easily-navigable environment of the computer is quite a bit older than iTunes.

Ripping became feasible mostly as a result of storage growing ever more expansive and cheaper over time. When the first CD-R drives came out (back then we called them WORM drives for Write Once Read Many), a good-sized hard drive was 2Gb and a CD of uncompressed music was 650MB. MP3 was still essentially a science project and there were no MP3 players. This was 1996. The drive cost thousand dollars. So at that point there was no real way to store your music collection on your PC.

Flash forward a few years and we’re all happily ripping away, putting our CDs onto our machines and onto players like the iPod. Originally you could use WinAmp, stand-alone rippers or Windows Media Player, but in a well-known story, Apple managed to get the majority of users to put their music into iTunes, where it comingles with DRM-laden music people buy on the iTunes Music Store to essentially lock people into Apple’s platform (and I say this as someone who has owned several iPods and isn’t really unhappy about using iTunes as my music hub).

So Real wants to be that hub for DVDs. Right now you can rip DVDs to your computer (storage, once again, has cheapened sufficiently for people to store collections of movies even on laptops), but it’s a messy process used primarily by tech-saavy users, and it’s of … questionable legality. By including a DRM’ed setup (including an copy of Apple’s 5-user file use maximum) Real pacifies the movie industry while allowing you to put your movies on your computer, enabling easier management, portability and freedom from the physical failings of DVD media.

Great, right? Sort of. On the one hand, some will complain bitterly about the DRM-ness of Real’s solution. There’s only so much legitimacy to this point of view. At the end of the day, when you buy a DVD, you’re buying the right to play a piece of media with content on it. You didn’t buy the right to give copies to everyone you know, and if technology can allow the creators of that content to have some measure of distribution limitation on the individual instance they sold you, that’s fine. As long as it doesn’t interfere too much with your genuine use (i.e. you should be able to have the file on each of your family machines), that’s fine.

Where Real gets it wrong (and where they are meaningfully distinguished from iTunes) is that they are charging you for the privilege. RealDVD is going to cost $50 and will carry a $20 per machine cost for the additional 5 machines you can deploy into the system. Clearly there are distinctions with iTunes on the economics (namely that Real isn’t trying to sell you movies or movie players today), but the free distribution of iTunes is partially what made it so widespread and pervasive. If Real is trying to place itself at the center of my movie-watching (and presumably eventually BUYING) life, charging me $150 to enable my household on their software is certainly not the way to do it.

September 9, 2008

Is Tech VC Dead?

Filed under: venture capital — Tags: , , , — fiveyearstoolate @ 4:52 pm

The idea for this blog originally came out of the ongoing whispers that “VC is dead”, dramatic as that sounds. We’re now 7 or 8 years from the crash of the “dot-com” boom economy, depending on how you count. Those who follow trends in the tech economy and the venture capital industry know that these years have seen lower returns, longer hold times, a weak IPO market and consolidation within the ranks of the erstwhile acquirers for technology startups. So it makes sense to ask, rhetorically or otherwise – Is tech VC Dead?

The short answer is: no, we don’t think so (or we wouldn’t still be doing this).

The longer answer is: Dead compared to what? If by “Is Tech VC Dead” you really mean, “Are the returns and short hold times enjoyed by internet and software venture capital funds raised between 1993 to 1998 likely gone for the foreseeable future?” then the answer is … probably, but that’s a poor standard.

From 1995 to 2000 we saw an unprecedented era in venture capital. Companies merely needed wide distribution (Netscape) or simply an online delivery mechanism (Pets.com et al) to gain astonishing valuations in both the private and public markets. That ended, as all speculative excesses eventually do (five years too late for condos in Florida…), but a lot of venture investors did extremely well while the merry-go-round continued to spin. So if we’re going to compare returns, hold times and the influx of capital into technology investing to those heady days, we’re probably going to conclude that technology VC is no longer attractive or, if you prefer, dead.

And there are some real challenges today, particularly as regards valuation on exits. We have telecom investments that, as businesses, are doing extremely well. But the way that the market views these investments today relative to ten years ago is dramatically disparate. A company with $100M in revenue in the late 90s in the space would have been worth a couple of billion dollars (see the likes of Siena and Cerent back in those days), but today (given the multiples being assigned to the likely acquirers of these companies) such a business is worth maybe $300-400 million. At 3-4x trailing revenues, one has to ask why an investor would seek out this type of company today.

With enterprise software we see a similar dynamic. Many of the great VC funds were built on the success of enterprise software in the 1980s and 1990s, huge software packages that cost high six or seven figures, took 180 days or more to sell and came with a perpetual license business model. Many of these companies turned into enormous wins for VC funds back then, but today the model is quickly being abandoned as the willingness of firms to pay for such unwieldy software diminishes and the world moves to a Software-as-a-Service model. The problem there is that these business, at least so far, have proven difficult to build to scale. With the exception of Salesforce.com (a $6.6B business as of this writing), how many large companies have been built with SaaS?

And finally there’s the Web 2.0 sector, where so many have gone in the face of decline in sectors like those mentioned above. We think Web 2.0 is interesting, depending on how you define it, but we question some of the money that went into this sector chasing things that were shiny, but weren’t necessarily solving real problems. And many of the acquisitions that have come out of this space have been small – great multiples but small in actual dollar terms.

All that being said, if we step back and take a longer view, we start to think about what technology VC has always been about, what it’s for. For the last few decades, the lifetime of modern venture capital, our capital has been used to build out the leading edge of different evolutions of technology, from large computing to smaller, from semiconductors and devices to software and web services. And this is still what it’s for today.

The questions we’re asking ourselves a lot these days are:

  • How much do we worry that information technology has been superceded by newer technology fields like cleantech or biotech?
  • What do we make of the influx of capital from hedge funds, sovereign wealth funds, the increasing importance of angels, etc…?

The first is a longer discussion, one that we’ll be thinking about substantially in this space. The short answer is – we think that biotechnology is a fascinating field that has relatively little relationship to what we do. Life sciences venture capital is a scientifically and capital-intensive business with binary outcomes that requires a totally different skillset and attitude toward company-building than IT investing.

On the cleantech side, we are much more interested, but more as IT investors who think the energy sector is a fascinating vertical. We have three investments that can be considered “green”: RecycleBank, Tendril and Ember (and a couple more in the hopper). In all three we leveraged what we are already good at – identifying strong technology entrepreneurs and helping them build great businesses. To us, the emergence of cleantech is an opportunity (of sorts) for IT investors, in that it is revealing a whole new galaxy of problems that need to be solved with innovative technologies.

As for the second – we think it’s something of a non-issue at this point. Angels have long been and continue to be an important part of the tech ecosystem. As VCs we rely on them to help entrepreneurs get businesses of the ground develop products and often devote their time (as well as their money) to getting some momentum going so that the company is ready for firms like RRE. As for hedge funds and others – there’s a lot more to this business than providing capital. Ultimately people come to RRE or to other VCs for our expertise in building companies, our access to partners and customers, and our judgment as much as for the dollars we put in.  Don’t mistake – we know financing is at the core of what we do, but the right VC can add a lot of value. We do as many repeat deals with the same entrepreneurs for a reason.

So is Tech VC dead? Ultimately the business is harder in 2008 than it was in 1998. But it was also harder in 1988 than it was in 1998. We are optimistic about today’s opportunities. We’re excited about clean energy, mobile, cloud computing, the business and consumer webs, digital media, and the continuing use of modern IT to change how business is done and life is led. These areas need innovation, and innovation comes from startups, often venture-backed. Are there questions around the decreasing cost of web startups, consolidation among large software companies and the appetite among LPs for venture capital investments? Sure. But the overall trend is up. And those are future posts anyway.

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