Five Years Too Late

February 5, 2009

Is Capital Efficiency the Enemy of Innovation?

Filed under: venture capital — Tags: , , , , , , — fiveyearstoolate @ 2:17 pm
Eric Wiesen

Eric Wiesen

I’ve been thinking about two themes that have generated a lot of discussion lately. The first is a growing sense that we are in a period of weak innovation; that Silicon Valley (and the rest of the US tech ecosystem) is broken, and that most of what’s being invented today is incremental, with no real innovation taking place. The second is strong focus on capital efficiency within the technology startup world.

At this point, given both the trends in web development and the macro economy, it’s practically a race between the entrepreneur pitching and the investor being pitched as to who will bring up how capital efficient the business is. The large majority of companies we see these days make a point of how capital efficient their models are, and the majority of investors (VCs and angels alike) are quick to dismiss companies that are viewed as capital inefficient.

Let’s step back for a moment and talk about what capital efficient means, and then we can get to the heart of the question. Capital efficient, in its simplest form, means you can accomplish a lot with a small amount of capital. And of course if you stop there, it sounds like an unadulterated good thing. More for less, right? And as a first-order question, I think the answer is yes. Doing more with less is a good thing.

But the second theme contextualizes the first for purposes of our question. We are in a period where much of the technology innovation taking place is in “soft technology”, be it software, web services, technology-enabled services or data businesses. And while it’s certainly an enabling environment that so many of the tools required to create these businesses have become commodity and free, there is an increasing concern that people are simply using free, easy tools to create slightly better versions of things that already exist.

Because how many of the really innovative technology companies throughout history were actually capital efficient? Whether we’re thinking about Edison Electric or Google, Amgen or Intel, Nvidia or Nucor, we often find that companies that really transformed industries with new technology or approaches took a large amount of capital and significant time to achieve it. And while these are clearly cherry-picked data points, I think that even on the web most of the really significant, innovative companies have taken in quite a bit of resources along the way.

I was recently on a panel with a friend of mine who’s an angel investor. And what shocked me was when he said that his group was looking primarily to invest in businesses that could, from a dead start, achieve profitability on significantly less than a million dollars of capital. And while, on its face, this sounds amazing – who wouldn’t want to invest in businesses like that? – another part of me really had to wonder, can you build anything interesting or important if that’s the hurdle you establish at the outset? Would any of the companies who have significantly raised the innovation bar have fit that screen, back then or now?

So I don’t think there’s a clear answer – we at RRE Ventures are clearly going to continue to seek businesses that can accomplish their goals with as little capital as possible, because it’s essentially obvious to do so. But I also agree with the criticism that “Web 2.0” has been at least in part an exercise in excessive capital efficiency, and that people were building incremental products and services with no real innovation in the hope of a quick flip or tuck-in acquisition. In the back of my head, I’m still going to be thinking about opportunities to create something really transformative, even if the road is a little longer and tougher.

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December 12, 2008

Go to War with the Army You Have

Filed under: venture capital — Tags: , , , , — fiveyearstoolate @ 12:18 pm
Stuart Ellman

Stuart Ellman

Eric Wiesen

Eric Wiesen

We recently had the opportunity to talk about the current funding environment with a bunch of smart people at a brown bag lunch hosted by our friends at Betaworks. A lot if important angles were discussed, including best practices for entrepreneurs, the mindset at different VC funds and tactical suggestions for getting a funding done in the current climate.

One point that’s worth stressing was raised by several people (including us): When you raise money, make sure you have investors who are prepared to continue to support you the next time around.

Backing up somewhat, let’s acknowledge that when times are good, fundraising usually follows a fairly standard pattern. An investor or group of investors funds a company at the Series A level for a given amount. When the company has reached sufficient proof points in the business and when new capital is needed, the company will raise an additional round of financing. A new investor usually leads this round, with participation (on a pro-rata basis) from the existing investors. The new investor is brought in for a number of reasons:

• This investor may be more oriented toward a later stage of the business and can add additional value;
• New investor may bring needed capital for future rounds of funding; but most importantly
• A new investor can set the price for the company. Prior investors may have conflicts relating to the prices of prior rounds.

When a new investor can’t be found, then the current investors face the choice of whether or not to do an “inside round”, meaning fund the company themselves. The point today is that many if not most follow-on financings are being done as inside rounds right now. The new investor who comes in and prices the company and puts in fresh capital is, in many instances, very hard to find. They are either trying to figure out how they are going to fund their own portfolio companies (and doing inside rounds for them) or they are struggling to raise their new fund and aren’t making investments in new companies.

All of this rolls up to the original point: when you build your syndicate for your Series A round, make sure you have a group of investors who will continue to support you when you need to raise more money. It’s fine to have an investor involved whose charter is solely to make Series A investments and then participate pro-rata down the road, but you should ALSO have an investor who is comfortable making Series B investments. Because as a lot of startups raising Series B and Series C rounds are learning, new investors are very hard to come by right now.

At RRE we are currently looking at funding two very promising early-stage deals. In both cases we could easily (given the amount of capital being raised) take the entire round ourselves, but we aren’t just thinking about today. Both of these companies are likely to raise more money later on, so in both cases we are bringing in partners who can both add value to the company, and who we believe will help us ensure that the company continues to be funded should the current climate last longer.

They say you go to war with the army you have, and the same is true for your venture syndicate. If at all possible, bring in investors you think can go the distance with you. It can make a big difference.

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November 17, 2008

Kashless

Filed under: venture capital — Tags: , — fiveyearstoolate @ 7:19 pm
Stuart Ellman

Stuart Ellman

We recently made a decision to invest in the Series A round of a new company called Kashless. This investment is one we’re very excited about, and reflects a lot of our investment philosophy here at RRE. The company is still essentially in stealth mode, although certain details leaked out via SEC filings we did around the financing. Rather than go into a lot of detail about what Martin Tobias, the CEO of Kashless, is planning on doing with the company, we’ll talk a little bit here about our process and thinking that led to this investment.

As we’ve mentioned in this space before, at a highly abstract level, we (and most investors) look for excellence in three key areas: people, markets and technology (the order depends on which of us you ask). In certain sectors, technology will be the key differentiator (materials science-based cleantech or semiconductors), in others it will be the vision and execution capabilities of the management team that will primarily distinguish the big successes. In all cases you need a market that’s capable of supporting interestingly large businesses.

Two major positives intersected to make us very excited about the opportunity here. The first was the opportunity to back Martin Tobias again. As the writers of this blog discussed offline the other day, Martin is a winner. We don’t just know him in a business relationship, we know him as a friend as well. Stuart stays with Martin when he travels to Seattle. They ride the 200 mile Seattle to Portland bike ride each year. Stuart and Martin have spend a great deal of time trying to figure out what business to start. Kashless is the culmination of this strategizing, much of it done during bike rides. Martin has demonstrated a great nose for the very beginning of trends, and that’s a terrific quality in an entrepreneur. He’s also extremely good at building organizations and getting them to scale. We know Martin’s strengths and weaknesses. We know that we can work with Martin and we know that there is mutual respect. We also know that he has lived through bubbles and busts before and we have a shared history on the appropriate ways to react to new market information.

The second is that (true to form for Martin), we think Kashless is poised to catch a big wave. Often times when we evaluate companies that seem good, but don’t quite feel right, one question we ask internally is, “what wave is this company riding?”, which helps focus the conversation around large, meta-trends that can propel a company and its target market into a high growth trajectory. Kashless is riding a big wave – call it “green”, “sustainability” or what you like, but economic, cultural and social forces are all moving us toward a world where issues of sustainability are more important than ever. Kashless looks to enable people to live more efficient, sustainable lives, and that’s an objective of which we are both supportive and optimistic. Also very important for RRE, as we mentioned in previous posts, Kashless can achieve these objectives in a capital efficient manner.

Stay tuned for more from Kashless, but we think big things are coming.

November 14, 2008

Flipswap

Filed under: Uncategorized — Tags: , , , , , , — fiveyearstoolate @ 11:19 am

We are happy to have our partner Harsh Patel here guest posting about our recently-announced investment in Flipswap. – EDW

Harsh Patel

Harsh Patel

It’s probably safe to say the current climate for startup venture financing has been thoroughly documented over the last few weeks, both here and elsewhere. I think you get it. But as my partner Stuart mentioned in a recent post, despite this climate we still see opportunity and we are still doing deals. We recently announced our investment in Adaptive Blue and now I’m happy to announce another new investment in Flipswap, a Series B financing co-led by RRE and NGEN Partners.

This investment reflects an evolving thesis we have in Fund IV around “Green Technology”, where traditional information technologies and associated business models intersect with a new set of global challenges. Recyclebank and Flipswap developed unique business models that generate real economic incentives that allow consumers, businesses and governments to act more sustainably while still acting in their own self-interest. Tendril is attacking the demand side of the energy problem by directly linking energy consumers to utilities, enabling both sides to proactively manage energy usage and reduce cost. So while financial markets may be busy painfully remaking themselves in the near term, they will not affect this macro thesis (or many other macro trends which underpin our investment decisions).

But of course macro alone is never enough. Underlying trends and investment theses are only academic unless embodied by entrepreneurs who can execute. Sohrob Farudi and his team at Flipswap did exactly that. Even as we all consult our tea leaves and crystal balls to see where the markets are headed, the best entrepreneurs know they don’t have that luxury. So instead they control what they can and react quickly when they have to. One of the simplest but most compelling points of evidence I look for as a VC is that an entrepreneur continues to perform throughout the fundraising process the way they said they would at your first meeting. Even in the best of times fundraising can be a lengthy process, and your ability to accurately forecast your business and execute against it is critical. So while any investment decision can be complex and the diligence process long, it very often comes down to this – do we believe in the market and do we believe in the team? We said yes on both counts and we’re delighted to welcome Flipswap to the portfolio.

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October 28, 2008

Adaptive Blue

Eric Wiesen

Eric Wiesen

When we launched Five Years Too Late, it was for a few reasons, one of which was to provide transparency into our investment process and how we think about both the investments we’ve made and those we choose not to make. We hope that this transparency will add some value to the overall conversation happening on the web around venture capital and entrepreneurship, and that entrepreneurs will better understand RRE and the deals we do through this effort.

Today we are happy to announce our investment in AdaptiveBlue, a Series B round led by RRE. AdaptiveBlue is a New York company developing semantic and social web technology and products. This announcement coincides with the release of the company’s new product, “Glue“, which allows users to socially interact and connect around common objects like books, movies, restaurants and music. Glue is a contextual network – meaning that it enables consumers to browse the web and seamlessly see and interact with everyday things, while simultaneously gaining a social layer of insight and reference related to those objects. Because of the way Glue attaches to the user’s browser, users don’t have to make substantial changes to their browsing behavior – the Glue toolbar will simply drop down where appropriate.

This investment is the result of a sector-wide analysis we conducted of the “semantic web“, a set of technologies and approaches that we think address some of the fragmentation issues starting to become problematic across the web. As users spend their time and attention on an increasing number of websites, both product-related and social, the user’s experience is being increasingly divided into smaller and smaller pieces when what is needed to create a better interaction is some level of connectivity between these silos.

At a high level, we chose to make this investment for two big reasons, and these reasons map pretty cleanly to the highly-abstract investment framework we sometimes talk about: People, Technology and Markets.

  1. People. We are extremely impressed with Alex Iskold and his team. Alex has struck us over the course of many meetings and time spent together, as a creative, thoughtful and deeply intelligent technical founder, who has been able to crack some pretty difficult problems in some very elegant ways. His public-facing web persona, as evidenced by his writing for ReadWriteWeb and his various other blogging bits and pieces, strongly reinforce this viewpoint. We think that he’s already developed innovative products, and we are happy to have the opportunity to bet on him to continue to do so as semantics becomes a bigger and more central part of the user experience webwide.
  2. Technology. The notion of using technology to understand the meaning and intent of pages on the web (rather than merely parsing for keywords) is a non-trivial exercise to say the least, and we are impressed with AdaptiveBlue’s development to date. We think there is real value being built in the company’s technology and that defensibility will be built along two fronts – difficulty of replication and a growing network of users. This first is further along today, but with the release of Glue the second can begin to gain some momentum. The dual goals of connecting silos of data and of providing social sentiment around the things contained in those silos are problems we think are well worth solving, and that Adaptive Blue is on the right track.

Where we think we might be taking some risk is the market today, only insofar as it is nascent. But we are quite confident that we will live in a world where semantics are used to digest, connect and curate the web in a way that helps us as consumers to consistently be presented with a sort of socially-filtered web experience, where the preferences and viewpoint of our friends and others around the web inform our consumption of web content. We think AdaptiveBlue is well-positioned to capitalize in a big way on this vision.

So, welcome Alex and the AdaptiveBlue team to the RRE family. Happy to have you on board.

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October 6, 2008

Good Money After Bad?

Filed under: venture capital — Tags: , , , , — fiveyearstoolate @ 4:42 pm

Eric Wiesen

Stuart Ellman

Lately we’ve been talking about how VCs respond to the current climate in terms of hurdles for new deals, fundraising and focus on specific sectors. But we’ve also been thinking a lot of about how to keep our current portfolio companies running effectively and successfully. Venture-backed companies almost always need additional rounds of financing, and turn first to current investors to provide that financing. Sometimes, the decision whether you continue to fund new rounds is easy. For example, imagine you funded a Series A company with a great CEO. He (or she) took the first round of financing and built a great product in a growing market that looks like it will have overwhelming demand. So when the time comes to fund again, you take (at least) your pro rata share in the new round of financing. Everybody is happy.

Unfortunately, the picture is not always so rosy. Let’s take a different and more difficult example. Let’s say your portfolio company previously raised a Series B round at a valuation of $30 million (your piece was $6 million) to roll out the new, exciting product. The company discovers that demand for the product is significantly less than budgeted. The CEO realizes that the product is in trouble and lays off much of the staff. He has a new idea for reformulating the product and offering it in a different market. But he needs $6 million from his existing investors to take on that market. On a pro-rata basis, it means a $2mm check from RRE. What should we do?

This is an issue that keeps VCs up at night. On the one hand, we want to support our existing portfolio companies, and we already have $6 million in this theoretical deal. If we don’t participate in this new financing, our equity position will be “washed out” (diluted into oblivion by the new money). The question we ask ourselves is: Are we putting in “good money after bad”? In other words, was our thesis good the first time but turned out to be wrong and are we just throwing money away now? On the other hand, was the original plan flawed, but the new one fixed the issues and it will now turn out to be a great business?

Guilt always plays a role in this decision. The company will likely go out of business if we don’t hold up our end of the syndicate. The other venture capitalists in the deal will scream and yell that we have tanked the company.

There are a number of reasons why we should invest our pro rata here:
• The new money will keep the company alive for another day.
• By continuing to fund, we don’t lose our previous investment in the company by getting washed out.
• We maintain good relationships with the other investors in the company, rather than being viewed as the firm that didn’t play and brought the company down.
• Funding maintains our relationship in the community as being VCs are who supportive of our portfolio companies.
• We’d like to maintain a strong relationship with management, particularly if it’s a team we’ve backed before and/or would like to back again.
• And lastly (but most importantly) whether we think the new product or strategy is going to make money.

The harder decision, which is often the right decision, is not to fund. Each time a VC makes a follow-on investment, it is a new and independent IRR decision. The money that went in previously is a sunk cost. In the above example, the product you invested in did not work, the money to create and market that product was wasted, the people that you relied on to make the product a success have failed or left, and the company did not live up to its expectations. You have to look at an old deal’s “new idea” as if it were a new company looking for funding in your office. That is the economic decision you are making for your limited partners. Trust me; you are looking for reasons to say yes to fund your existing deals. It is really hard to say no to them. But you have to be objective.

For us, just like with new deals, it comes down to markets and management. First and foremost, do we believe and trust the CEO? If it is the same CEO that sold us the last business plan that did not work, what led him to make his decisions all throughout the process? Do we still trust his judgment? Does he still have credibility within his company and in the marketplace? Has he done the right things in a timely fashion in reaction to marketplace changes? Second, what happened to the market? Was the company just wrong about the market or did the market change quickly? Where is the market now? Is the new product really compelling for the new market? These are tough questions, and questions that must be answered.

When financings are buoyant, new rounds are often led by new VCs at higher prices. When financings get tougher, there are more rounds that need to get done by the insiders and more companies that have missed their projections. Whether to re-invest in existing portfolio companies is a question that more and more VCs will struggle with in the upcoming year. Over the last 15 years, we at RRE have built a reputation for always trying to do what is right for our companies. We are clear to them, have open lines of communication and do everything we can to come up with reasons to support them. However, sometimes, the right thing to do is to not fund them. Prolonging the eventual demise of a company is not better for anybody in the long term.

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October 3, 2008

Please Hold the Google Comparisons

Filed under: Pitching, Startups, venture capital — Tags: , , , , , — fiveyearstoolate @ 8:56 am

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.

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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 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 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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