BeyondVC

Besides taking a brief time out to celebrate the Expertcity deal, I have spent a fair amount of time interviewing VP candidates for one of my portfolio companies. As with any smart executive who cares about the value of equity, the question I am often asked is, “What is your exit strategy.” My answer is quite simple-every company we invest in must have IPO potential (IPO potential as defined by non-bubble metrics) but along the way if someone makes an offer for the company because it is an attractive, rapid growth business, we can evaluate it appropriately. What we will not do is invest for the sole purpose of having a company acquired. That is a losing proposition. The ultimate way to create value is to have a real business with real cash flow and a strong balance sheet where you can show your potential acquirer that you do not need any other sources of funding besides self-sustaining growth. VMWare certainly used this approach when it decided to sell to EMC. You have to be able to show your potential acquirer that they are not the only way to create liquidity for your business.

Companies are bought and not sold. What I mean by that is good exits usually happen when someone tries to buy your company rather than you trying to sell your company. In other words, these good exits usually happen when your company is approached by a potential buyer-i.e., you are seen as desirable in someone else’s eyes rather than you telling someone how pretty you are. Typically, these types of exits result from already existing, revenue-generating business relationships. It is not that big of a leap for an aquirer to make an acquisition offer on the higher end of a valuation range knowing how its partner does business, how the management teams work together, and how the product sells through to its customers. Other times it can happen when your company consistently beats out a competitor in the market and is seen as a thorn in the side. In either case, your company is a known quantity and the potential acquirer has seen you perform in the market.

What does this all mean? My advice to entrepreneurs and management is quite simple: if you focus on what you can control (growing and managing your business), then the external factors (exit strategy) will take care of itself. However, if you try to force it and shop your company, that shows a sign of weakness and more often than not will result in a fire sale. Remember, companies are bought and not sold. If you do not get the price you want, it will not matter since you have a business built for the long-term. For a strong, well manged company, opportunities will always present themselves.

Om Malik (ex-senior writer for Red Herring) has been writing about the commoditization of hardware. In a recent article in Business 2.0 titled “The Rise of the Instant Company,” Om talks about how hardware has become commoditized to the point where hardware expense as a cost of goods sold is de minimis. In other words, companies can now cobble together off-the-shelf-hardware with proprietary software to create companies that can quickly and cost-effectively go after large incumbents. This is a great point and what it comes down to is that software companies can now “package” themselves as hardware plays and successfully leverage the hardware channel from a sales perspective. This is quite attractive from a VC perspective because now we get the opportunity to invest in business that can grow rapidly like a hardware play at software like gross margins (depending on price point 65-85%).

Given this backdrop, I believe that we will see 3 types of software companies in the future. The first will be companies selling expensive applications which will rely on extensive professional services to install and customize. This is the market dominated and characterized by large companies like SAP, Siebel, Peoplesoft and their ancillary professional services partners like Accenture, IBM Global Services, and other consulting companies. The second will be companies that will sell their software as a service (ASP model). These are companies like Salesforce.com, Liveperson, and Expertcity (LPSN and Expertcity are both fund investments) which took the above market segment and made it really easy for customers to buy and in effect, removing the complexity of managing and installing the software. Finally, there will be software companies that have a componentized product that is easy to install which can and may be packaged into an appliance to leverage the channel sales model. This could mean that companies are selling their own appliance or OEMing their software to hardware vendors who in turn sell an appliance. Companies like Neoteris and Network Appliance fit this model. From a venture perspective, the sofware companies that are most interesting to me are the ones with ASP and appliance offerings. In this posting, I would like to focus on software packaged as an appliance.

While the average selling prices for companies that leverage the channel are much lower than pure, direct enterprise sales, I like the fact that these types of companies can utilize a seed and harvest model. In the seed and harvest model, companies that have lower price points can seed a number of customers with a low, entry price product and go back to them later to harvest accounts to sell multiple instances of the product. While the initial sale may not be $1mm upfront, you may be able to get $1mm in the life of a deal. The benefit for the software company is hopefully a shorter sales cycle (it is easier to get sign off for $50k vs. $500k) and the ability to leverage other people’s feet to sell your product.

From a VC perspective, I like to see companies which can leverage other people’s sales forces to grow. Yes, your company will give up some points in margin and also lose some control over customer relationships, but will hopefully make up for it in terms of more volume. For early stage companies, it is already quite difficult and expensive to sell into Fortune 1000 accounts. Many of the companies under the first model (pure enterprise license sales) need expensive direct sales forces which sell high-priced products which have long sales cycles. If the price point of your product is not high enough, then there is little likelihood of you ever building a real, profitable software company from direct sales alone. In addition, if you want to get the excitement and interest of service providers like IBM Global Services and Accenture, you better be able to drive $10s of millions of dollars of service revenue.

Just to be clear, I am not saying that software companies do not need direct sales forces as it is incredibly important in a company’s early phase of development to own the customer relationship and gain valuable feedback about its product. In fact, no matter what kind of software company you aim to be, you need to have customers to get channel partners, know what it is like to sell to an end customer, and successfully manage an end customer in order to train your channel and OEM partners. Therefore, most companies will require some form of direct sales force to begin with, but over time, I like to see the mix of revenue moving towards greater than 50% into the channel and OEM model. What this means, at least for me, is that selling $1mm software licenses with 3-6 month installation processes is not interesting and has gone the way of the dinosaur from an attractiveness perspective in terms of funding. The fact that hardware has become commoditized has really opened up new ways of selling software and building companies, ways that can be quite attractive for both entrepreneurs and venture capitalists.