Category: Venture Capital

Yesterday I participated on a panel at the Mid Atlantic Venture Conference on the current venture capital market and how to raise capital. While this was a plain-vanilla panel about venture investing, there was one theme that was echoed by a number of my fellow panelists from Rho Ventures, New Venture Partners, Edison Ventures, and Cross Atlantic-today’s world requires software companies to have a capital-efficient business model. What is a capital-efficient business model and why does it make sense? From my perspective, a capital-efficicent model is one that allows a company to use as little cash as possible to generate significant growth and become self-sustaining and profitable. Growth at all costs without profitability does not get you there and neither does profitability with no growth. Finding the right balance is important. Given this backdrop, the real question is how does today’s VC generate a 10x return? Yes, that is easier said than done, but let me walk you through why it is imperative for VC investors today. During the bubble years, a $500mm to $1b exit for a software company was not uncommon. A bad deal for a VC was a $100mm sale. However, many of the software companies during the bubble years required $50mm or more to create meaningful exit value, and in many cases the companies were still not profitable. Today and into the future, I believe we will return to a sense of normalcy where a great exit for a venture investor will mean $100-200mm of value. If it takes $50mm or more to get there you are talking about a 2-4x multiple for a GREAT deal. That is not terribly exciting. A capital efficient software model should only require $20-25mm to get to profitability. With those numbers a VC could earn 4-10x their investment, even at today’s reduced values. Given my perspective on what ultimate exit values will be, it will serve the entrepreneur and venture investor well to do as much as they can with as little capital. This is doable-looking at history, Peoplesoft only raised $10mm of venture funding, Documentum raised $13.5, and Veritas raised $6mm. This does not mean skimping on growth, but it requires companies to:

1. Focus on getting product into the hands of its customers earlier rather than later-do not build the perfect product (see an earlier post);
2. Grow carefully-do not ramp personnel too far in advance of revenue;
3. Leverage offshore resources where appropriate;
4. Leverage reseller and OEM relationships (direct sales is way too expensive).

Each bullet point above deserves its own lengthy discussion, and I hope to address some of these in future postings. The impact this will have on the industry will mean that venture capitalists will need less capital for each company resulting in smaller funds and a better ability to generate multiples of invested cash for its investors. For today’s entrepreneurs, it will mean that they rethink their go-to-market strategy and remember to balance growth with getting to profitability sooner.

I had the opportunity to speak on a panel today at the Corporate Venture Capital Summit. There was an interesting crew of speakers representing corporate-related venture activities for companies such as Hitachi, Intel, Nokia, Panasonic, Siemens, and Kodak. While one moderator cited numbers showing that the amount of corporate venture investing in terms of dollars is down 50% from 2000, in my mind, that does not seem that different from the change in the general VC market. While there are less corporate investors today, there are also less VCs. From the 3 panels today, it was very clear that the nature of corporate investing, if I can lump all the different players in one bucket, has changed. Like today’s VC, they are doing less deals. However, the deals that they are doing need to be more strategic and less opportunistic. This means that someone in a product group needs to somehow get behind the company and act as an internal sponsor. This does not mean that a company looking for funding will get a strategic partnership before a financing.

One of the questions I was asked today was how an early stage company can make a strategic investment successful. Here is what I had to say:

1. Show me the revenue-I would rather have an OEM or reseller deal than a strategic investment. Strategic investments do not mean anything if you are not going to generate revenue for your company and for your partner. In addition, when you sign a reseller or OEM contract it means that the hard work has yet to begin-an early stage company has to throw resources behind a partner to make things happen.

2. Go in with your eyes wide open-what is strategic for you may be tactical for your partner. In addition beware of deal terms that may limit your ability to be flexible. These include rights of first refusal, exclusivity, and other non-standard VC terms.

3. A strategic investment is not an exit strategy-in many cases, it could actually limit your exit opportunities as other competitors to the strategic investor may not want to partner with you.

4. Do your due diligence-how successful has your strategic investor been in setting up relationships for other companies, how much juice does the strategic investor have to make things happen?

5. Manage expectations-constant communication between both sides is key to maintain a healthy relationship.

I could go on and on here but I just wanted to highlight a few of my top of mind thoughts. Suffice it to say that looking at the 30+ companies we have funded, partnering with strategics has been a mixed bag. There have been some that have worked out well and others that have not. However, if done right, I do believe that both sides could substantially benefit from a relationship as long as there are real dollars being generated.

I recently spoke with Richard Adams, founder of Referral Networks, which was later sold to Peopleclick. He has started a new venture, RipDigital, which does the dirty work of converting CD collections into MP3 libraries. Basically all you have to do is place an order on the website and the company ships a box to you, you pack your CDs into the box, RipDigital does the conversion, and then ships your new library on either a DVD or portable hard drive along with your CDs. It is truly frictionless commerce. While interesting, this is not the only project that Richard is working on these days.

I have also been staying in touch with Owen Davis who co-founded Sonata (Thinking Media) with Vid Jain. Owen and Vid are back at it again with a new company, Petal Computing. Petal, according to its website, provides software that allows a dedicated group of PCs to operate like an enterprise server or mainframe. Its solutions are further optimized for the high performance needs of the financial world, including modeling, cash management, risk analysis and pricing. In other words, Owen and Vid have created cluster computing software which is highly specific and focused on the financial sector. While the cluster computing space is a competitive market with some established players, I like their approach to building the business. They have actually been working on the software for the last 2 years.

In fact, many NYC 2.0 entrepreneurs (those NYC veterans on their second venture-I hesitate to use the word Silicon Alley since that leaves a bad taste in many people’s mouths) are starting companies with a new philosophy to build businesses that uniquely solve a real customer problem. Embedded in the new way of starting companies is strong financial and product discipline. In other words, NYC 2.0 entrepreneurs have learned to keep the burnrate low until they have a great product they can sell repeatedly with feedback from living, breathing beta customers. With this philosophy, these entrepreneurs just may have a better opportunity to create some real businesses that will generate meaningful cash flow.

BTW, I placed my order with RipDigital today for 250 CDs today and will report on the finished product at a later date.

I had breakfast with a friend the other day, and he was in the process of a bankruptcy filing for his startup. We started talking about why his wireless company had failed and one of the main reasons he cited was that the price was too high. Many of you may ask why is that a problem. Isn’t getting a high price a great thing? The term sheet that the company signed was led by a strategic investor and contingent on finding another VC as a co-lead. While he had some strong interest, no other VC or purely financially driven investor was willing to step up at that price. The only other term sheet he had was at a much lower valuation but in his mind a little too onerous. He was willing and ready to take the term sheet, but he had made a promise to his team of 10 that he would make sure they got some backpay as part of the deal. While it was a hard decision, I applaud him for sticking to his deal with his team. Consequently, the company had no other choice but to shut down since it was not at a stage to generate meaningful revenue. So what can other entrepreneurs learn from this?

1. Price isn’t everything-sometimes too high of a price can cripple your company. Other investors may not want to fund the company, and you may set unrealistic expectations for you, your employees, and your investors.

2. VCs like sweat equity. Don’t hire people that expect to get paid back salary. Isn’t the whole point of working at a startup to build real value through equity? If your employees want backpay then you probably have the wrong people for your stage of company. It is a tough proposition for us to fund a $3mm round and have $500k get paid out as salary. This is easy for me to say as a VC, and it may sound self-serving, but it is true.