Rolling 8 the Hard Way

Eric Wiesen

Stuart Ellman

Experience in the venture business teaches many lessons. One that is often painfully learned is very easy to see from a distance but hard to see when down in the trenches. There are easy ways to make money and there are hard ways.

At one level this is intuitively obvious, but at another level, it’s clear that a lot of folks (founders and investors alike) don’t necessarily see the world through this lens, and as a result, a lot of businesses get started that are just not really geared to creating excellent investment returns.. At this point, we must make it clear that making money (i.e. generating profits), is not the same as successful deal exits. Many companies come in the door to our firm with clear paths to go from $10mm in revenues to $50mm in revenues and they are much less interesting as investment than some companies that have no revenues and fuzzy plans for profit generation but can solve large problems and will be highly sought after. This may seem confusing, but lets dig a little deeper. It really comes down to markets and competitive positioning..

What’s the easy way to make money? The easy way is the traditional way: solve a problem that lots of people have (or a very big problem that a few people have) and offer them a really good reason to pay you lots of money for what you made or do (we might call this a “value proposition”). Hopefully you’re doing it in a way that isn’t being done by a dozen other companies, and in a way that isn’t easily replicable by others. The easiest business in the world is one where you have something everyone needs and you’re the only one that has it. So if you could manage to situate yourself over the world’s biggest undiscovered oil well, you’d be set – you have something people need and (milkshakes not withstanding) you are very hard to displace. To use an example closer to home, a startup came to us looking for money. They had four people and an idea. The idea was a technically elegant way to create additional money for e-tailers with little downside. They had nothing built and two pilots lined up. They wanted a high valuation and they got many competing term sheets. They also had $0 revenues and it was unclear when they would really start to make money. Why was this deal “the easy way?” Because it was a hard ROI, created money in a sector that needed profits, was reasonably hard to copy, and whatever e-tailers used it had a competitive advantage. Therefore it would either get big very fast or get bought very quickly no matter what the financials looked like.

A friend recently asked, when told about this way of looking at companies, whether Google was an easy model or a hard one. And the truth is – Google was a hard model that turned into an incredibly easy one. If a startup came in the door and said, “we’re going to become the primary destination for search on the web, then sell ads against that search activity”, my guess is they’d have a hard time convincing us (or anyone else) how they would accomplish the first part of that, since changing consumer behavior around search is extremely challenging and expensive. However, if Google came in the door in 2001 and said, “We are already the primary destination for search on the web – now we’re going to sell ads against that search activity”, it would be moderately obvious how easy it would be for them to make money at it. Because the hard part of the model – building a huge stream of consumer activity – had already been accomplished.

So with that backdrop in mind, we’ve been looking at new deals that come in the door explicitly with this question in mind – does the company have an easy model or a hard model? This has particular resonance around B2C companies. While a lot of people in 2009 view the web as synonymous with “software”, B2C web companies that give their service away and monetize with ads (or other behind-the-scenes streams like lead generation) are media businesses, not software businesses. Those that charge for web services are software businesses. So – salesforce.com is a software business while Yahoo Finance is a media business. And startup media businesses are challenging, especially today. The really tough part is how many of them there are. As previously mentioned, there was an explosion of B2C web companies a couple of years ago, along with an explosion of ad networks launching to try to monetize them. This crowding, along with the current collapse in display ad rates, makes a web-based media startup (especially one starting from a dead stop) a very hard way to make money.

Let’s look at another example to compare the startup that sold to e-tailers above. A different startup came in selling a useful but inexpensive enterprise solution. It had $5mm in revenues, a clear pipeline for more sales up to $10mm, a very solid and earnest CEO and management team, solid reference accounts and well known VC backers. This is the “hard way.” Because this is a specific industry with large players that dominate the competitive landscape, the exit possibilities are few. The existing players are large and trade at about 1X revenues. Even if the startup struggles and really succeeds for the next five years, it will not be large enough to remain a standalone company and there will only be two to three potential acquirers who will not have the stock multiples to pay much more than the money being put into the company. And this is if everything goes right.

Without turning this into a portfolio survey for RRE, one thing we’ll note is that many of the companies in our portfolio that are continuing to do well even throughout this difficult economic period are those that have easy models – they make something someone (either businesses or consumers) need (or at least really want) and sell it in a relatively lightweight way. They are also answering unique problems and are changing the competitive paradigm of the industries in which they compete. And this learning will likely inform how we look at new opportunities that come in the door.

Smaller is Better

Today we’re happy to have a guest post from our partner Will Porteous on the benefits of small, entrepreneurial teams. – EDW

Will D. Porteous

Over the years we’ve come to believe that small teams can be stunningly effective at the early stages of a company, often much more effective than larger teams. We have also found that, when they are good, such teams typically only need a modest amount of capital. This may sound overly simplistic. After all, some endeavors are just more complex and require a wider array of skills. But in our experience good entrepreneurs understand that resource constraints can make it easier to focus on what’s really important in a new company. What follows are some observations on this idea:

Product development is a fundamentally creative endeavor that requires incredibly tight coordination among the participants. Three great developers are usually better than thirty average developers, particularly if they have worked together before and if there are one or two strong leaders among them. Over and over we see core innovations that become great products coming from small teams (often just three to five people). In our current portfolio this has been particularly true at companies like Drop.io, Payfone, and Kashless. And this phenomenon isn’t just limited to software companies. At hardware companies like Data Robotics and Peek (both current RRE portfolio companies) we’ve seen the innovations of two or three founders get to market as products with fewer than fifteen people in either company. This is not to say that there aren’t some tasks that large teams, or even large communities do well (e.g. look at the strength of many open source products that were refined by hundreds of thousands of person hours from their communities). But in pursuing a new opportunity, at the early stages smaller highly focused teams tend to do better.

And it’s not just creating great products that small teams do well. Small founding teams should also be able to prove real customer demand. Good founders tend to know the problem they are solving intimately well. And they tend to know more than a few prospective customers. If they don’t, they know how to reach them without the formality and expense of a big marketing effort.

When I first joined the venture business in 2000, at the start of the last downturn (was there an upturn in between?), we were receiving a lot of inquiries from systems companies making gear for the telecom equipment market. Their target customers were both the established carriers and the emerging CLECs (Competitive Local Exchange Carriers). Most of these new systems companies had already raised heaps of money. There was a lot of capital available for these new equipment companies after the multi-billion dollar exits of companies like Chromatis and Cerent. It was as if the race was on to build the next “God Box” and get bought for a ten figure number. I remember walking into one such systems company that had raised a lot of money. They were raising a Series D. There were thirty hardware engineers, thirty software engineers, ten people in QA and documentation, ten in marketing, plus a whole complement of senior management including VPs for every area. And they were all good people working very hard. And they had never shipped a product.

Not only had this company never shipped a product or booked a dollar of revenue, it couldn’t definitively tell you when it would. The glut of resources early in the company’s life had contributed to an undisciplined culture. Product plans were not clear and too many people had their “hands in the code.”

What was worse, the established carriers weren’t buying and the CLECs were going out of business. The management team had never anticipated that there might not be demand for their products and they couldn’t conceive of a way to build the company that didn’t entail burning $2.5 Million per month. While they were growing the organization they had lost sight of what was changing in the markets they hoped to serve. They had raised too much money and made too many promises to their existing investors to stand up and say “this isn’t working; we need to make something else that somebody actually wants to buy.” Instead, they kept running the company like nothing had changed hoping to persuade a new group of investors to underwrite their outdated view of the world. You can imagine what ultimately happened.

Companies that have raised too much money in pursuit of the wrong idea are scary places. They are like a parallel universe where everything appears normal, but it really isn’t (movie buffs, think of “The Truman Show” or “Stepford Wives“). Getting back to reality is always painful and usually includes a major reorganization and often a recapitalization. The motivational challenges that come with downsizing or restarting on a new idea with a smaller team can be withering. And the odds of long term success in a restart are never as good as in a new company. More on that another time.

The point of this story is that it is better to stay small and wait until you know you’ve got something great before you raise a lot of money. Good entrepreneurial teams can achieve a remarkable amount on just a few million dollars. They can usually build at least a Beta version of their product. They can put that product in front of some potential customers and learn a LOT. They can iterate until they have something that prospective customers REALLY like. Along the way, they can learn a lot about how to sell the product and what customers are willing to pay. And, by keeping their team small and their burn rate low, they can preserve their option to change direction if they need to.

So, why is it that small teams are often so effective? There must be many reasons for this. Certainly, good entrepreneurs tend to hire strong and surround themselves with broad gauged, talented people who can lead, manage, and also be major individual contributors. Such agile teams know how to both live in the details of making the product and to focus on the larger questions of building a business. They bring together many different skill sets in a small number of people. There’s often a high degree of trust in such teams, especially if team members have worked together before. In addition, the sense of having been chosen to be a part of something new and special is often very inspiring and motivating. The work at the early stages of a company is massive in its apparent importance – and there is a lot of both work and responsibility to go around. Good teams must have a tremendous work ethic and reject any team member who doesn’t measure up. And perhaps most simply, communication is easier in a small team with a shared sense of mission.

Small teams are also hard emotionally. They often feel very anonymous to people coming from large, well known organizations. They demand tremendous amounts of vision and faith. They tend to be fairly democratic, which can be good in the early days, but doesn’t work for too long. They are stark, demanding environments. They can also be a lot of fun. They are the true crucible of company formation and long term value creation. So, if you want to get big for the right reasons, it helps to start small.

The Truth, or What We Want to Hear?

Eric Wiesen

Years ago, when I was a Silicon Valley lawyer, a VC client related an amusing anecdote about being pitched by early-stage companies (I know, VC jokes are always the funniest). The observation he made was that every startup, regardless of sector, business model or average sale price has the same 5-year revenue projection: $50 million, plus or minus a few. The reason, he explained, was that if the 5-year number is much lower than $50M, the VCs won’t be interested, and if it’s much higher than $50M the VCs won’t believe the projections.

Last week, a company that didn’t follow this rule pitched RRE for their Series A round. This was a good pitch – a credible entrepreneur with deep industry experience and network, looking to take a “2.0” approach to a business where the entrepreneur had already had some success back in the 1990s with a “1.0” solution. It was all looking pretty good, and we were progressing smoothly through the presentation, checking off a lot of the boxes I’d need to see in order to start a process internally. Until we arrived at the financial projections.

As a sidelight, the financial projections for an early-stage company are always speculative. Entrepreneurs know it and so do investors. But they help us, if nothing else, get a sense of how a given founding team thinks about the scope of an opportunity. And in this case, the financial projections showed the company quickly ramping up to about $15M and then almost totally leveling off, to the point where the 7-year projection was around $25M. And while I didn’t want to play into the stereotype above, I was professionally obligated to ask why the growth slowed dramatically in the “out years” in the model?

There are a few possible answers to this question, frankly none of them particularly encouraging.

1. You can (and most people, facing this question, do) argue that the assumptions in your model are so overwhelmingly conservative that while your projections say a small number, you really expect a much larger one. That doesn’t do well – while we appreciate conservative projections, it should be at the margin. If you really think this is a $100M business, your number should be relatively close to that.
2. You can tell us that this simply isn’t a particularly big market, and that the slow growth in the out years represent an early ramp to scale, and a tough fight for market share once the original ramp has been climbed. This is troubling, as early-stage VCs rarely want to get involved unless the addressable market is large enough to generate a big outcome.
3. You can tell us that the market is very fragmented, and that growth will be hard to come by as you fight with incumbents for share. This, too, isn’t something we like to hear, as it implies that it will be expensive and difficult to grow, and as Stuart sometimes says, “Some markets are just too hard”.

When pressed, this entrepreneur gave answer #2 – this is a market with a finite number of customers, and the financial projections he gave me reflect his (expert, I agree) estimate of his ability as a newcomer with a superior product, to gain market share – quickly at first, and more slowly in the out years.

The challenge is this – I appreciate the honesty this founder showed in telling me his genuine viewpoint on where the company can go. He also shared that he views this is a “good but not great” exit. A “double” if you like baseball metaphors. He’s doing this the right way, building realistic expectations for his business rather than telling me what I want to hear.

And yet – what I want to hear is that this can be a $100M revenue business that we can credibly see as a billion-dollar exit if everything goes according to plan. Because early-stage investing is simply too difficult to bet on companies where the best-case scenario is a $100M exit, even if that’s a great multiple on a couple million invested. Because best-case scenarios are rarely achieved, and when they are, it needs to be a real event for RRE.

So if I were this entrepreneur’s friend, and he asked me for advice on pitching RRE on this business, what would I tell him? I think the route he chose is admirable, but isn’t going to get him an investor. I simply can’t pound the table at our Monday meeting and insist that we have to do this deal, because even though I really like the team and the product vision, if they don’t think it can be a huge winner, I can’t. And I certainly don’t want him to lie to prospective investors about likely success, because that will simply lead to an unpleasant and combative Board of Directors/Management dynamic, when investors realize they’ve been sold a bill of goods.

No, I think what I would tell him is this: Go back over your plan from the beginning and see if there’s a way to make it bigger. Are there adjacencies you can exploit once you’ve established a beach head in your target market? Are there additional streams of revenue you can exploit? Underlying data assets, lead generation, marketing partnerships, greater distribution? Are there different verticals or other opportunities for value-added services within the vertical you’ve chosen?

If you want to be a venture-funded company, try to find a way to have a $50M business doing what you’re doing. Because while the anecdote at the outset is amusing, the risk profile of early-stage venture capital is such that you are going to get a lot of no’s if you can’t look us straight in the eye and get to some number close to that.

You Can Lead a Horse to Water…

Eric Wiesen

When talking to companies, frequently consumer-facing companies, I often have a version of the following short conversation below:

Me: So the product looks really great – how are you going to convince consumers to switch to you from [old, hidebound web 1.0 service or manual process]?

Founder: Well, that old [site/product/service] is terrible! Ours has better functionality, is more reliable and look how pretty the rounded corners are (ok, I made that last one up). People will see how much better our product is and users will flock to us. Word of mouth will be inherently viral.

This is a dangerous place to be with your business, and if you’re talking to me or most of my colleagues you’re going to get a lot of push back on this line of reasoning.

Let’s step back. When I was in business school I was fortunate enough to have taken a strategy class from Bruce Greenwald. Professor Greenwald has a powerfully descriptive and predictive framework for considering the competitive positioning of a given company (although I am still working through how to best apply his precepts to early-stage businesses). The framework essentially posits that while there are many different strategic forces acting on a company (including Porter’s five, for the MBAs and business geeks out there), the one that matters far more than anything else are barriers to entry. And if you break down Greenwald’s view of barriers to entry, he looks to one of several sources.
1. Proprietary Technology
2. Economies of Scale
3. Customer Captivity

The first two are pretty well-known in the technology world. Many of the first several generations of successful companies were built by developing technology that others couldn’t match and couldn’t legally copy. There are plenty of examples on the web and elsewhere of companies that have built scale advantage (Ebay, Amazon). And the best companies will have all three (Google).

But I want to talk here about an aspect customer captivity and a how it potentially impacts early stage companies. Professor Greenwald argues (and I agree) that customers (particularly consumers, although businesses as well in limited circumstances) can become captive through sheer habit. There are other, more obvious forms of customer captivity (technology lock-in, ongoing investment, loyalty programs, etc…) but these aren’t present in, say, a consumer-facing web service. And so it seems pretty easy to lure customers away with a better product. And to some extent this logic is rationale, in that if you have chosen to compete against companies without these more obvious forms of customer captivity, you’ve done your business a favor.

But it’s a mistake to think you’re out of the woods just because switching costs are low. In fact, the unseen switching costs of customer habit can be dauntingly high. By way of example I’ll use (as I often do) my mother. My mother uses AOL. My dad got the whole family AOL accounts in 1995. I never used mine because I already had a university account and my younger brothers eventually ditched theirs as well. Even Dad ultimately switched. But Mom is still chugging away on AOL. My brother (who spent almost four years at Google) tried endlessly to convince her to switch to the more elegant, functional and reliable gmail. No dice. She’s used to AOL. And so she stays.

I bring this up because it demonstrates some powerful captive behavior. Email is an impure example because the archives and persistence of a long-standing email address provide additional sources of captivity besides habit. Think about someone you might know who still uses the travel site they started using in 1997. Or the mapping site they started using in 2000. Better alternatives have arisen since then, yet people frequently “just stay with what they know”.

This has powerful implications both offensively and defensively for your web business. Offensively it means that you can’t simply rely on “if you build it, he will come” product superiority. Customer habit is such that EVEN IF users can be convinced with marketing to check out your terrific new product, your war is far from won, because some large percentage of them will say some variant of, “Yeah that’s cool. But I’m fine with what I have”. Your marketing battle with this customer has just begun. On the defensive side, it is useful to think about instrumenting your product or service to encourage customer captivity. And while that sounds nefarious, it doesn’t have to be – building habit and addictive experience is powerful medicine, and by building customer habit you are generating captivity explicitly by delivering value to your customers.

Build something that users want to use every day and by the time someone comes out with something a little shinier, you will have the benefit of customer habit. Today, though, you need to work on how to overcome it.

Please Hold the Google Comparisons

We get pitched on a lot of products that are designed to be hugely profitable primarily at very large scale, or which are platforms for the underlying monetization of otherwise less valuable digital assets. And with the aim of highlighting the scope of the opportunities presented by the business being pitched, many stray into comparisons to a certain successful company that is very profitable at great scale, and that succeeded in monetizing a big piece of the web. Whether your business is directly analogous (as a few are) or not particularly so (as most are), I’m asking you to please be very judicious with the Google comparisons.

Every investor you pitch knows that Google was the most successful venture-backed company of the past 10 years. And it goes without saying that every one of them would like to back “the next Google”. But please also note that every startup that wasn’t Google didn’t turn out to be Google. It’s ok to analogize your service to either consumer or advertiser modalities that have been proven out by Google. Generally speaking, we at RRE don’t like to see business models that require major shifts in user or customer behavior underlying the success thesis, so if you think either your users or your customers (to the extent that they are different) have been “trained” by Google (or some other highly successful company) to act in certain ways that enable your business, by all means demonstrate that you understand your users well enough to make the point, and that you have seen major proof in the real world that users will act the way you project.

Ultimately, though, please be mindful that making repeated references to Google is not going to cause investors’ eyes to turn into dollar signs as they envision a 1000x return on your company. The more frequently you repeat it, the less effective it becomes. If what you’re doing is deeply vertical, don’t say “we can be the Google of fishing” because the whole point of Google is its staggering horizontal reach. A corollary of this is only say that you are the “Adwords of ___________” or the “Adsense of __________” if you have a really good story to tell. Adwords monetized search and adsense monetized the long tail of content. Those are big stories. If what you have an interesting self-service model, try to figure out a way to tell the story without claiming to be Adwords. If you have a cool distributed content story, tell it in a way that doesn’t just try to associate with Adsense.

In the end, the investors you want involved with your company won’t be fooled by Google analogies, and the companies good investors want won’t try to do it.

Why You Might Want a Lower Valuation for your Startup

The most obvious point of negotiation in any venture financing is the valuation of the company. The first-order logic is pretty simple: Founders want the highest possible valuation and investors want the lowest. Pretty straightforward. Founders want to go high because it minimizes dilution. Investors want to go low because they get a higher ownership percentage.

For those who aren’t familiar with this math, it works pretty simply. Investors are going to put money into a company. More accurately, they are going to buy shares of stock from the company at a certain price. The higher the price of the company, the fewer shares the investors get for a given number of dollars.

What this winds up meaning is that at a higher price (price = valuation), the money put in by investors (let’s say $5 million) buys a lower percentage of the company. If you say that the company’s valuation walking in the door is $10 million (the “pre-money valuation“), the $5 million put in by the investors buys one third of the company (because the company will then have the $10 million of presumed value plus $5 million of cash in the bank, resulting in a $15 million “post-money valuation“). If, on the other hand, you say that the pre-money valuation is $20 million, the new money will only buy 20% ($5M out of $25M) of the company rather than 33%.

Just to do the simple arithmetic, if you assume this is the first money into the company, the outcome of these two scenarios looks quite different for the founders. In the first scenario, the founders own 66% of a $15 million company. They are worth $10 million on paper. In the second scenario, they own 80% of a $25M company and are worth $20 million on paper. In both cases their company ends the financing with $5 million of cash to grow the business.

So you are now asking why I’m suggesting that you might not want to raise the round at the highest valuation you can possibly get. And a good many of you are rolling your eyes at the obvious self-interest we as investors have in this negotiation (which is undoubtedly true – we are interested, but bear with me).

There are at least two very good reasons why you might not want to go for the highest possible valuation.

1. You are probably going to have to raise money again.

2. The valuation you get today impacts your exit possibilities.

The first is critical, and many first-time entrepreneurs miss this. When you raise money, you should have it in the back of your mind that you will probably be raising money a second time. While most companies (especially web companies) come in with the idea that the raise being done today gets them to cash-flow positive, realistically it often doesn’t turn out that way. We understand this and it’s ok that you will need more money, but you should understand this too. When you go out to raise that next round, recognize that your current investors are going to want a step-up in valuation and so will you. Secondly, new investors are going to want to see momentum in the business.

The critical point is this: If you raise money at too high a valuation, you are going to have a very hard time raising money the next time around. Your current investors are going to balk at taking a flat or marked-down valuation, and they will almost assuredly have anti-dilution protection that will keep them whole while diluting YOU, the founder (and your team). New investors are going to be wary of investing in a company that has to be marked down from its previous price. Either way, your overpriced first round is going to be a huge headache when you go back out to raise money, and new investors are likely going to re-price the company anyway.

The second reason is equally important. Simply put, if you raise money at a high valuation it will be very difficult to sell your company for anything less than a significant multiple of that valuation. When your investors purchase a portion of your company, they do so with the hope and expectation that they will earn a multiple on their money when you eventually sell the business or take it public. Put in more concrete terms, if you raise money at a given valuation, you should assume that in the near term and in a success situation, you will be expected to get more than 4x that valuation in an exit.

So when you go to raise money, think about both of these factors. Think about what proof points you will likely reach when you go out to raise more money, and be wary of a valuation that puts you in a difficult position when that time comes. And try to be mindful of what constitutes a successful outcome for you. If you raise money at $50M post-money valuation, you are implicitly saying you can build a very large business and you are taking a good (but not huge) outcome off the table for yourself. Make sure this is a decision you make consciously.

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.

Barnacle Companies

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.