Five Years Too Late

February 12, 2009

Rolling 8 the Hard Way

Filed under: Startups, venture capital — Tags: , , , , — fiveyearstoolate @ 5:45 pm
Eric Wiesen

Eric Wiesen

Stuart Ellman

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.

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January 30, 2009

Smaller is Better

Filed under: Startups — Tags: , , , , , — fiveyearstoolate @ 2:43 pm

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

will

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.

November 20, 2008

What’s in a Name?

Filed under: Uncategorized — Tags: , , , , , , , , , — fiveyearstoolate @ 7:59 pm
Eric Wiesen

Eric Wiesen

I’ve been on a few panels (and been in the audience for many more) that focus on starting up a company. A lot of the questions (unsurprisingly) are about starting up web companies and best practices around doing so. Inevitably, one question arises:

“How much does the name matter?”

What does surprise me is the answer I usually hear from VCs, successful entrepreneurs, and other luminaries:

“It doesn’t matter.”

They go on to say focus on your product, great customer experience, scalability and all the other important company-formation features. And I agree that those are all critical, first-order concerns. But I disagree that names don’t matter, at least where consumer-facing applications and services are concerned.

Businesses generally don’t care what things are called – they have the time and financial interest to due significant due diligence on various offerings (although truthfully it doesn’t always happen) and decisions are made around more metrics-oriented decision criteria. But consumers are a whole different ballgame. You need to grab a share of their increasingly overwhelmed and attention-deficit suffering consciousness. You need, to use a metaphor I like in many contexts, to be no or low-friction. And your name is the first thing they are going to see.

So I’d lay out three rules for naming a consumer-facing web product:

  1. Be easy to spell
  2. Be 8 characters or less
  3. Be in plain language

You don’t need all three. But you need the first and one of the last two to have a good web name. Looking at some of the top (US) consumer-facing websites, let’s see how they stack up:

Yahoo (Easy to spell, 5 characters, arguably plain language): 2.5/3 PASS
Google (Easy to spell, 6 characters): 2/3 PASS
YouTube (Easy to spell, 7 characters, plain language): 3/3 PASS
MySpace (Easy to spell, 7 characters, plain language): 3/3 PASS
Facebook (Easy to spell, 8 characters, plain language): 3/3 PASS
Blogger (Easy to spell, 7 characters): 2/3 PASS
Ebay (Easy to spell, 4 characters): 2/3 PASS
Amazon (Easy to spell, 6 characters, plain language): 3/3 PASS
Flickr (5 characters): 1/3 FAIL

This is a somewhat cherry picked list, but most of remaining top sites by traffic are either abbreviations (MSN, AOL) or similarly compliant sites (live.com, photobucket, etc…). We find only one site – flickr – that doesn’t meet these criteria for consumer-facing name success.

We can speculate about why this is, but I would suggest that the obvious answer is likely the right one, as Occam would say. If consumers can’t remember, recognize or spell your name, they are unlikely to get to your site via direct, type-in traffic. That leaves you with SEO, SEM and other indirect methods for drawing in users, all of which are important, but without that initial primary funnel you may struggle. To pick on Charles (because I know he can take it), iminlikewithyou is not a good consumer-facing name. It’s 15 characters, is plain language, but includes a word with an apostrophe, so it only partially passes the spell test. Really good product, bad name.

We can draw some conclusions from Flickr’s success, or we can just say it’s the exception that proves the rule. Flickr built its audience largely of “net natives” who quickly adopted the “missing e” as the next creative web naming convention (sort of like ____ster became earlier), and we’ve soon lots of similarly-spelled “Web 2.0” company names. In fairness, a lot of this is driven by domain squatters taking many of the plain language names. But in the absence of plain language, I would argue that your new company’s name should be short and easy to spell, even if it’s meaningless (worked pretty well for Google). Sure, the tech-saavy crowd may figure out del.icio.us but will your parents or your friends who aren’t “webheads”? If you are comfortable building a big, successful business out of just us (it can be done), by all means. But if you are going for mainstream…

Ultimately, if you are being thoughtful about your core site, service or application, you are carefully instrumenting your processes (registration, sign-on, setup, etc…) to minimize the waterfall of dropped users and are being diligent about removing friction to lower bounce rate and registration failure. Don’t start out on the wrong foot with a name that won’t stay with potential users. Path101? Good. Xoopit? Well…

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October 15, 2008

You Can Lead a Horse to Water…

Filed under: Startups, venture capital — Tags: , , , , , , , — fiveyearstoolate @ 11:24 am

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.

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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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October 1, 2008

Why You Might Want a Lower Valuation for your Startup

Filed under: Startups, venture capital — Tags: , , — fiveyearstoolate @ 9:55 am

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.

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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 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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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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