Jerry Colonna has an insightful post on what it’s like to be a CEO of a venture-backed company. Having worked with Jerry on a board before, I find his advice quite practical and thoughtful. One takeaway from his post is about being overcommunicative with your board meaning that VCs do not like surprises. I totally agree as I’ve written about this before.
Month: May 2004
Stock option expensing
Jeff Nolan has a good overview of stock option expensing, and why we should get involved. While I agree for the need for complete transparency of stock options, I also do not believe that expensing all options at the grant date will get us closer to true economic reality. In addition, I believe the unfair burden of stock option expensing falls on private companies-FASB even recognizes this. As for public companies, the market will adjust and look at numbers with and without option expensing, converging on what all other investors use. So from a public market perspective, while hurting the perceived earnings of a number of companies, I do believe that expensing stock options will not make as big a negative impact as some think. We all know that investors will use a number of different proforma income statements to designate value anyway whether or not options are expensed.
Therefore, what concerns me is what happens to the non-executive employee at public companies and how stock option expensing affects private companies. Rather than go into a diatribe on the ineffectiveness of Black Scholes and the Binomial Pricing model, I want to focus my efforts on what happens when stock option expensing goes into effect. It will eliminate broad-based option pools for public companies and private companies. Why? It is easy for me to say that the market will be efficient and see through all of the numbers creating its own set of rules for valuation. However, companies will choose the path of least resistance which means keeping the income statement as clean as possible which means eliminating broad-based option plans and the variability that comes with it. If anything, companies may give restricted stock to executives and other key players but not to all employees. The bigger concern is that the extra reporting burden it creates for private companies will be quite costly and burdensome, possibly outweighing the positive effects of issuing broad-based options. Without options, this will make it harder for cash-starved private companies to attract talent as they will not be able to pay the cash compensation that larger companies can afford. Since I am in the business of funding private companies (a big engine for job growth) that use an ESOP as a competitive tool to attract talent, I am concerned by the FASB proposal. Therefore, I ask you to get involved while FASB is in its review period and write to them:
Go visit Jeff Nolan’s post for links to articles to further educate yourself on the stock expensing issue and to learn how to get involved. As per his post:
– emails should be directed to director@fasb.org with a cc: to jcdowling@nvca.org – if you have specific questions about the proposal, Michael Tovey is the project director for this at FASB, his email is mtwovey@fasb.org – your email should reference file # 1102-100
I would also keep an eye out for a new bill (H.R. 3574, the Stock Option Accounting Reform Act) being pushed around Congress. According to CFO Magazine,
The bill would require the Securities and Exchange Commission to complete an economic impact study before FASB is permitted to implement its proposed rule. In addition, the bill would require companies to expense only stock options granted to the CEO and the next four highest-paid officers. Small businesses would be entirely exempt from FASB’s rule; newly public companies could forgo expensing for three years.
While a compromise this bill does partially address my concerns about hurting private companies and the regular employee.
Don’t overhype your company
It is on the newswire today-Cometa Networks, the wi-fi service provider backed by IBM, AT&T, and Intel, is shutting down. There is much analysis out there discussing the merits of the business and what went wrong. In a recent News.com piece, analysts discuss how Cometa did not build critical mass quickly enough to make the economics work. Rather than focus on what went wrong, what strikes me about Cometa Networks is not the business or market it was going after, but the hype and attention it drew to itself way before its service was even in operation. It was all over the news (well done, by the way), but the problem is that it promised too much and never delivered. At the very least, if you are going to hype yourself, make sure you can deliver relatively quickly to capitalize on the buzz. When you have a grandiose launch you set high expectations for your company. As my colleague, Ben Tanen, put it, “they would have to be the next generation phone company” to deem their execution worthy of their launch. Anything short of that and they would be deemed a failure. Of course, this puts a ton of pressure on the team to deliver and exceed expectations. Along those lines, it even seems that the company was quite aggressive in its dealings with business partners, acting like a market leader even without a network (see Sky Dayton’s comments on wifinetnews). Call me understated, but I prefer my companies to “underhype and overdeliver” rather than “overhype and underdeliver.” So whether Cometa was a victim of the market or not, the way it was launched, one could claim it was a victim of its overambitious start. Even if they succeeded bit by bit they would have been seen as an underperfomer as it would have taken them years and a ton of capital to meet the hype that they generated from the initial launch.
Portfolio company promotion-collaboration service
As you all know, part of a VC’s job is to promote their portfolio companies. And yes, even though Expertcity is no longer a portfolio company since it was bought by Citrix, I would like all of you to know about the new collaboration service that the company is launching, GoToMeeting, which will be FREE until July. At the end of the day, I love the service and product and that is why I thought you would like to try it out. Yes, it will be in a field competing with the likes of WebEx and Placeware. However, the company’s design philosophy since I invested in them 5 years ago is the KISS (Keep It Simple Stupid) method. This means simplicity in terms of usage and pricing. The service is designed to take advantage of the ad-hoc collaboration where an IM or email turns into a working session. Here is an article talking more about the service.
Insights from a recent CIO meeting
This month seems to be my month for CIO meetings. Part of a VC’s job besides helping management with strategy and hiring people is to help with customer introductions and strategic partnerships. In this tough market, my partners and I have been doing our best to help along these fronts. While being in New York can be a disadvantage in terms of finding new companies and hiring great industry people, it is great for our access to customers and the Fortune 500. In New York, we can keep a close ear to the ground and learn about spending priorities and other short and long term problems that CIOs need to solve. This is yet another data point we can use to help us place our bets. I met with another CIO yesterday in the financial services market and thought you would be interested in hearing a few tidbits from the meeting.
1. IT Budgets are loosening up across the board for capital expenditures and people-lots to do, he is looking to hire people for the first time in a couple years, although he does not want to hire too many people if the market collapses in 6 months.
2. IT Priorities-one of the big areas of new spending will be for technology that supports revenue creation instead of cost cutting. For example, this includes making sure that the trading systems can keep pumping out transactions-there is alot more volume today with the market coming back and they have not upgraded their systems in a couple of years when they either overbought or were oversold too much technology. In addtion, his firm wants to upgrade existing applications (many run in old perl scripts and mainframes) and put them on a new application infrastructure like J2EE. Other high priority categories include business continuity/disaster recovery and security, which is not a surprise.
There was nothing earth shattering about this meeting except it does confirm my belief that spending is increasing and that CIOs are starting to look at expenditures that will help generate revenue for the first time in awhile. In addition, it seems that given his priorities, larger IT vendors like Dell, EMC, BEA, and Sun would benefit from his increased spend. As usual I spent some time pitching my companies and the first question he asked after each pitch was, “What other financial service customers do you have?” This is not unlike any other meeting with a CIO and just reminds me how hard it is for a startup to get its first, high-profile, referenceable customer as no one wants to be a guinea pig. Secondly, it shows how important it is to find the early adopters in a particular vertical and make them referenceable so their peers can follow. CIOs spend alot of time these days managing risk not taking on risk.
The increased cost of offshore development in India
In our weekly partner’s meeting yesterday, we ended up in a discussion about the progression of offshore development in a variety of portfolio companies. In the end, the companies that were doing the best job with development were the ones that had their own operations offshore. While a couple of our companies chose to use consulting partners to begin with due to lower upfront costs and better time to market, we found that over time (the last 2 years) that employee churn is becoming a huge problem in these consulting companies and making us less productive in the long run. For example, one portfolio company had 5 consultants from India trained for 3 months on the product. 6 months later only 2 are left. On the other hand, our companies that have their own people on the ground are better able to manage their teams and motivate offshore employees through competitive compensation and a career path. So while we are increasingly going to make sure we create our own teams in India versus use consultants, we will still not be immune to churn and the competitive nature of the economy.
The great aspect of doing business in India is that you have lots of talent. The problem is that offshore development has become so popular that the cost of doing business has increased since wages have been bid up and since employees have many job options. In the past year, SAP and Oracle and a number of other large companies have opened up offices in India or made larger commitments to developing products offshore. What does that mean for us in the future? While it is not as cost effective to do development in India today versus 2-3 years ago due to supply and demand factors, I still believe that having an offshore strategy is important as our portfolio companies still can do alot more with less. However, in the long run, given the competitiveness and cost increase of doing business in India, I am sure that many companies will increasingly look to other locales with strong talent and less competition like Belarus, Romania, Argentina, Russia, and China. I am already seeing that happen.
What needs to be done to make us more secure
I was in a meeting with an executive at a large financial services company today discussing some of his technology problems and how my portfolio companies could address them. One of the big issues he mentioned was spam and stopping worms. Even though his company has spent real dollars in those areas, they are still problems which need to be solved. As Sasser and other worms and blended threats spread rapidly around the Internet, it got me thinking about what needs to be done to make us more secure. Techdirt has a great piece about taking a hyrbid strategy to stopping these threats, an approach I agree with wholeheartedly. I have always been a fan of a defense in depth strategy where you have security devices at the network level and down to the desktop. Have you seen Cisco’s recent advertising campaign about self-defending networks? While it is a broad-based strategy which you can read more about on their site, one aspect I like about the NAC initiative is that it does not allow anyone to access a network wirelessly or wired before a scan is done to make sure the device is virus and worm free and up-to-date with its patches and antivirus software. They currently have an enterprise focus, but the logic behind the initiative makes a ton of sense. Recently, Earthlink launched a deal with Symantec where consumers could get antivirus and firewall software from Symantec on their monthly bill. While I like the direction Earthlink is taking, I think all ISPs should take this a step further and replicate the Cisco NAC initiative where no user can log on to a network until their system is scanned and updated with the latest patch and antivirus software. Charge consumers an extra $1 a month but make it a prerequisite to get on the Internet. On top of that ISPs are and should continue to apply a number of different security devices on the edge of the network to prevent attacks from reaching end users. Vendors sellling home networking equipment like Linksys and D-Link should figure out how to embed and price antivirus and antispam software in their boxes as well. For the most part this will only stop the vulnerabilities and attacks that we know about, but the reality is that many of these attacks take advantage of known vulnerabilities. Helping the naive consumer in a proactive way will help us take one big giant step in making the Internet a more secure place.
Transitioning from a service business to a product-driven company
It has been awhile since my last post as I have been busy with board meetings. In addition, I met a number of interesting companies, a couple of which were service businesses in the process of transitioning their models to become product-driven software companies. It is a familiar formula to many out there. More often than not, the principals of a service business may have developed expertise and a network in a particular industry, developed a solution for a customer, and decided that they could resell it multiple times turning their business from a service one to a more scalable product-driven company. This makes a ton of sense as the entrepreneur gets to understand a particular market and pain point for customers. In addition, the early stage business gets the customer to pay for its initial product development. Having met with a couple of these types of companies this week, it reminds me to issue a few cautionary warnings for entrepreneurs:
1. Just because one customer wants it does not mean you have a big market opportunity-do your homework to make sure the customer’s pain is not unique and that this is not a custom development job
2. Have one version of your product, not one for each customer-I have seen a number of companies that claim they are a product-driven business with 5 customers when in reality they are still a service shop because their customers all have different versions of a product.
There is one company that my team met with a couple of years ago that had a marquee list of customers, all of whom had license deals greater than $300k. However when we did customer reference checks and deeper due dligence on the technology, we learned that all of the customers had different versions of the product. We ultimately passed on the deal as it was quite evident that the business had not made the full transition to a product company. I recently caught up with the former VP Engineering who was looking for a new job. In discussing why the company failed, this is what he basically had to say. While the company had great customers, the support costs associated with supporting 3 different versions of a product killed them. He had to spend too much of his team’s team fixing problems for the installed base rather than devote most of his resources developing the next generation product. Consequently, their product suffered and did not meet the demands of the wider market.
While turning yourself from a service company to a software business may be a good idea, be extremely careful about the customers you sign and remember to make sure that you really have one product not multiple, custom platforms because that can kill you in the long run.