BeyondVC

What do I see in venture through 2010???

The Jordan Edmiston Group recently asked me and a few other VCs a few pointed questions about the future for circulation in their July Client Briefing.  As an aside, I worked with JEGI two years ago and they did a fantastic job helping us sell Moreover Technologies to Verisign.  They understand the media and online world, are well connected, and work diligently to get the job done.  Anyway, here are the questions and my response:

Even though there is uncertainty in the credit markets, a stalled IPO market, and few billion-dollar plus M&A transactions, the investment activity level and appetite for quality businesses in the middle-market continues to be vibrant. Venture Capital firms continue to invest in companies that are providing answers to key disruptive market forces and are exiting those investments via M&A. The Jordan, Edmiston Group, Inc. (JEGI) solicited a handful of key VC executives for their responses to the following questions:

1. What are the key market forces you believe will impact your venture activities through 2010?
2. How do you envision capitalizing on or responding to these market forces?
3. How is the environment changing for deal exits (e.g., IPO vs. M&A)?

(My answer is pretty consistent with what I have been blogging about during the last few years.  Here is an excerpt from the briefing and if you are interested in reading more and some of the other VCs responses, you can get it here)

We are continuing to move to a broadband connected world, where everything that we do on a device increasingly lives in the cloud. Our business applications, our music, our videos, pictures, and messaging will be easily accessible from any device, any time, and anywhere. We will continue to see new cloud-based applications and services, and data-driven services will play a larger role in this new world. There will be some great opportunities to invest in companies that take existing data and run algorithms over these streams of data to deliver better and more targeted advertising, personalized recommendations and search, and better overall services for end-users.

One of the next phases of growth and large revenue opportunities will be driven by what is captured every time you click on a page and move from site to site. How companies use this data to improve a user’s online experience is the next game changer. What I love about these kinds of opportunities is that algorithms scale, have high gross margins, and are highly defensible. With our computing world living in the cloud, there will be a whole new generation of mobile applications that leverage the increased computing power and faster broadband speeds that are offered today.

Mobile carrier voice revenue is declining, and data revenue is the next huge growth area for carriers. However, data revenue cannot increase without applications that drive usage. Obviously, there are concerns about carriers’ “walled gardens”, but I see a future where carriers increasingly provide open access to allow innovative apps to drive data growth. In addition, as mobile devices become better, cheaper and faster, we will see an increase in the number of users accessing the web from their wireless devices, as often as they do from their home PCs.

Capitalizing on Disruptive Market Forces
Dawntreader Ventures will capitalize on these disruptions by investing in the entire food chain, from infrastructure layer to the apps and services that touch the end-user. This includes investments in companies like Greenplum, which is powering the back-end data warehousing for a number of high profile Internet companies for targeted advertising; and Peer39, which provides semantic advertising solutions by using natural language processing and machine learning. This technology enables the company to go beyond keywords to understand page meaning and sentiment, to deliver the most effective display and text advertising to end-users.

Exit Strategy

Unfortunately, the market for IPOs is currently “dead”, but it may reopen in 2009. M&A continues to be strong for the right companies that fit a strategic hole in an acquirer’s portfolio. In the end, I continue to tell my portfolio companies that if you focus on what you can control (growing and managing your business), then the external factors (exit strategy) will take care of themselves. However, if you try to force the issue and shop your company, that shows a sign of weakness and more often than not will result in a fire sale. Companies are bought and not sold. For strong, well managed companies, opportunities will always present themselves, as long as you can avoid making desperate decisions.

To read some other VC responses and to get an update on the state of Interactive M&A, I suggest getting the JEGI briefing here.

Data wars heating up - Microsoft buys DATAllegro

As I have written in previous posts, what you do with data will be one of the next battlegrounds on the web.  Knowing that they had some limitations with SQL Server, Microsoft announced its acquisition of DATAllegro (full disclosure: my fund is an investor in competitor Greenplum) to enter the data warehousing market.  Enterprise volumes across the board are ramping up quickly and this clearly gives Microsoft an opportunity to capture that market.  Being an investor in Greenplum, I always like to see healthy exits of competitors as many believe it will trigger further consolidation.  When a competitor is acquired, the first reaction from many is often asking themselves why it wasn't them and fear about competing with a juggernaut, but my perspective is quite different as it usually opens new opportunities.  As I have written before, many acquisitions fail and companies are usually so distracted for the first 6-12 months trying to integrate operationally and technically, that this gives others in the market a nice window to continue executing on their business plan.  So I tip my hat to DATAllegro and look forward to an exciting 12-18 months ahead as the data wars are clearly heating up now. 

Your reputation matters - how to handle reference calls

The world that we live in trades on reputation.  What that means is that eventually whether you are raising capital or landing new customers, your references will matter.  If you are an entrepreneur, a VC will want to do some deep reference checks on you and also on any major customers or partners.  If you are trying to land that big customer, naturally the sales propsect will ask to speak with other customers to get a better understanding of the technology and your service.  How you handle and manage these reference calls is crucial to moving to the next step in a funding round or to closing a sale.  I have seen some entrepreneurs take the nonchalant approach, feeling quite secure in their relationships, and freely passing on contact information for their personal references and partners/customers.  Many times these calls will turn out just fine but there is still a big chance that they might not turn out as planned.

In my opinion, the best way to deal with reference calls is to carefully manage the process.  First, I would identify the 4 or 5 best references (customers/partners/personal) and have a call with them to make sure they are willing and have the right attitude and to pre-screen them with questions to make sure they convey the right information to the interested party.  Secondly, I would make sure that you don't inundate your references with too many calls as they may tire of helping you after awhile.  Finally, I would also set expectations and be quite clear with the VC or potential customer about what to expect from the call.  For example, I was talking to a CEO yesterday, and he mentioned that our strategic partner would take a call from a VC but that the partner was not the most effusive individual and would clearly state the facts but nothing more.  Well, if that is your only reference for that partner, make sure you convey this to the interested party to set expectations (see my earlier post about that). 

As a side note, a couple of my portfolio companies gave pretty big discounts to their first customers but also made sure that as part of the deal they would serve as lead references for other prospective customers and for VCs.  The discounts got the customers to take the leap of faith to buy the portfolio companies' products and also got them quite excited to freely promote our technology to others.  The point is that you should always think about your reputation, who will be your best reference, and then to cultivate them to really make sure that they can help you grow your business.

Raising capital and meeting expectations

What I like to tell portfolio companies is that on average it will take 6 months to raise capital with some cycles being shorter and some being longer. Given that, it is imperative for a company to start thinking about its next round well ahead of time and the milestones it needs to hit to have the right momentum to get potential investors excited. One area that I would like to caution entrepreneurs is being too aggressive on the milestones and revenue forecast, particularly in the near term.

Let me explain. Like any other VC, I love to invest in companies going after big markets with huge revenue potential. That being said, I also like to see plans grounded in reality as well. Rather than get me excited, showing a revenue ramp from $1mm to $17mm to $65mm will actually do the opposite for me, raising more questions and concerns than general excitement. Along those lines, it is also imperative that when you share your plans with investors that you are pretty confident that you will realize your milestones or hit your numbers in the next 6 months as investors like to see if you can deliver on your promises. One cardinal sin is being overly optimistic in the near term and falling flat on your face in the due diligence process. It is much better to position yourself in a way that you can meet and exceed expectations during the due diligence process than the other way around. When this happens the rest of your forecasts become more believable.

The next generation web - scaling and data mining matters (continued)

I had some interesting meetings yesterday and as I reflected on them this morning, one common theme emerged which is that the next generation of the web will be built on data mining and extracting intelligence from the reams of data web services collect on a daily basis.  This reminds me of a post I made in March of 2006 titled "The Next Generation Web - scaling and data mining will matter" where I mention:

I truly believe the next battleground will be based on scaling the back end and more importantly mining all of that clickstream data to offer a better service to users.  Those that can do it cheaply and effectively will win.  The tools are getting more sophisticated, the data sizes are growing exponentially, and companies don't want to break the bank nor wait for Godot to deliver results.

My first meeting was with a well known research analyst covering Internet stocks.  While we discussed the usual topics such as how the Internet was taking share from traditional advertising budgets and how the top brand advertisers have not really embraced the web yet, our most lively discussion centered around next generation advertising technology which all centered around increasingly complex forms of data analysis.  To that end, I mentioned one of the fund's portfolio companies, Peer39, which is using natural language processing and machine learning to create highly precise matching of commercial offers and user generated content.  As you might guess, the secret sauce is the algorithms that the company has created.

Later in the day I had lunch with a friend who we had funded years ago.  What was interesting to hear was how many of the future product lines that we discussed a few years ago were finally starting to emerge as real revenue drivers for the business today.  Years ago the company's first data center cost around $20mm and the latest one which has orders of magniture more customers cost only $3mm.  Clearly, any data-driven opportunities a few years ago were cost prohibitive in the first place and too early for the customer to understand in the second place.  That was the case because many businesses were just worried about not getting Amazoned and today they are all on the web thinking about how to drive better results.  That is why our discussion led to a massive data warehousing project his company was working on to take all of that data across his huge customer base and to help them better monetize their sites.

What I love about these kinds of opportunities is that algorithms scale, have high gross margins, and are proprietary and defensible.  The next generation web is not about what you click and see but what is happening behind the scenes every time you click on a page and move from site to site.

Old school content has value...again

Every day it seems we are reading about the power of social networking to transform the Internet and how we communicate online and also consume and discover new content.  While that is true and clearly changing the consumption habits of online users, today seems like a flashback to the old school Internet days where traditional content was king.  First IAC announced the acquisition of Lexico Corp which owns dictionary.com, thesaurus.com, and reference.com and then CBS announced the acquisition of CNET.  With $400+ million of revenue in 2007, it seems like a good buy for CBS at a little over 4x trailing revenue.  So looking at the fact that people are recognizing that social networks are not as easy to monetize as previously thought and the understanding that old school content can still be monetized, I wonder what other old school content companies may be in play in the future (can anyone say the Knot.com or the thestreet.com - full disclosure, i bought shares of these companies for my own account during the last couple of months).  Given the weakening ad spending environment and the fact that many of these small public Internet companies reported lower guidance for the rest of 2008, it is clear that now is a good time for strategics to buy and expand their uniques and ad inventory.  As I have always said, when it comes to the web, scale matters!  Also see Silicon Alley Insider for some comments from the CBS conference call regarding scale and the value of premium content:

CNET's been very disappointing for past few years. What are your strategy for improving CNET revenue growth, margins?

CFO: We think that they have the asssets to do that, they've revamped a number of the sites. Combining with us is good because there's very little overlap with our advertisers (auto, pharma, etc), but CNET audience demo very attractive to our advertisers. And then they reach advertisers (electronics, etc) that we don't. Other efficiencies: One public co instead of two. Combining some ad platforms, etc.

Given MSFT/YHOO, other consolidation, does this make you big enough on the Web?

Les: We just tripled our digital platform. Are there possibilities to do tuck-ins? But right now, we have taken a major leap forward. We are very happy with the cards we're holding now.

CFO: We're now a top 10 Internet company. Could we be a top 5 over time? Sure. But would be through growth, not acquisition.

Les: Remember! Premium content!

Open vs. closed networks and Facebook chat

As you know, I have always been a believer in open standards (see my post from January 2006).  Being a market leader, it is quite easy for Facebook to create their own standard similar to how every other instant messaging network was started.  And to that end, Facebook started down that path.  But just today, it announced that it was extending its chat and opening up its service by offering XMPP/Jabber support.  Assuming there are no restrictions, this is a huge win for openness.  Maybe one day Skype and MySpace and others will adopt the same strategy and move us to a world where we can IM anyone from any network and have one IM identity rather be forced to live in a world that was similar to the dark ages of email where Prodigy, Compuserve, and AOL users could only communicate with users on the same network.  Once Facebook starts with chat, maybe when and if it ever offers VOIP, it would leverage the open SIP standard as well. Rest assured that the development team at portfolio company Gizmo5 is digging into the details of the Facebook annoucement and in short order can offer seamless connectivity to Facebook chat from your mobile phone.  From the day Gizmo5 was started, it was built to live in a world of open standards leveraging the SIP protocol for VOIP and Jabber/XMPP for IM and Presence.  As you might imagine, the smaller networks who needed users were the ones to adopt open standards first.  Slowly but surely, larger and larger networks have adopted these standard starting with Google Chat in 2006 and now Facebook with its dominant market share in social networking.  It seems as if the floodgates are opening and this is quite exciting.  As I mentioned in my post from 2006:

Whatever happens it will be interesting to see if true open standards will triumph over closed and proprietary and how long that will take. At the end of the day consumers don't care about protocols, they just want it all to work seamlessly and easily, and they do not want to be on their own island for communications.  What I want is one identity or phone number that works on any IM network, VOIP network, or even integrates with my PSTN and cell phone identity?

Nokia-an Internet company???

As I have mentioned before, Nokia is one of the few handset manufacturers to get it (See my post from 2/07 on this).  Nokia understands that hardware margins are eroding and like in many technology businesses the value is in the software and monthly service revenue.  In addition, as time goes by, more and more people will be using their phones and data services to get information and communicate with friends.  Therefore it is no surprise that Nokia announced yesterday that it wants to be more like an Internet company and less like a manufacturing company. 

Our new structure is helping  Nokia to be more integrated as we focus more attention on developing new businesses around Internet services. Over time, it will allow us to be faster and more agile in bringing out new products and services, in serving our operator customers better, and in meeting our customers' needs in different parts of the world.

Our goal is to act less like a traditional manufacturer, and more like an Internet company.

The other piece that Nokia gets is that if they don't start offering services on their devices, Google, Microsoft, and Yahoo will.  The delicate dance that Nokia is playing is how to fend off the traditional Internet guys while also adding value to its carrier partners.  Despite the fact that Nokia is one of the few companies that sells a significant number of phones direct to the consumer, carriers still matter.  To that end, it will be interesting to see how VOIP plays into this delicate balance.  For more on this, take a look at Michael Robertson's latest blog post (full disclosure-Dawntreader is an investor in GIzmo5 and I am on the board) on the world's smallest dual mode wifi phone.  Yes, dual mode wifi means the phone can make VOIP calls over wifi networks.  As MIchael says:

"This is not Nokia's first wifi phone, but it is significant for several reasons:         

It has a street price of $200-300 (vs $400-900 for previous phones)

Power utilization has improved so it can do ~3 hrs VoIP calls and ~4 days WLAN standby (historically wifi phones have had awful battery life) It's Nokia's first s40 wifi phone (the majority of Nokia's phones are built with s40 parts so it will be very easy to create many more wifi models)

From my perspective, what is great is that the price point is falling quickly for dual-mode handsets, the battery usage/life is getting better, and manufacturers like Nokia are willing to offer innovative services on them through partners like Gizmo5.  2008 will surely shape up to be an interesting year in the wireless industry.

Developing your way to success or failure...

During the last month, I have been in board meetings and thinking to myself about what was going well and what wasn't.  And when the discussion came to revenue, one common theme that always seemed to surface was a focus on the next product.  What I mean is that when discussing why our current product wasn't selling as well as it should have or getting as many users as projected, the answer was always focused on the next product or feature.  Granted, I have always believed that one needs an insanely great product or service to generate sustainable revenue and that constant iteration is key to success.  However, it is also important to understand why a current product or service is or isn't doing as well as you thought.  In addition, entrepreneurs must also think about how they are going to get the product to the market and come up with the right messaging.  I have seen a number of situations where entrepreneurs can get too focused about developing and releasing the next product or feature without spending as much or even more time and resources in getting it out to the market.  Then when management and the board sit down to evaluate what went wrong, the answer seems to be that people clearly didn't care.  That can be a huge failing because the product or service may actually be phenomenal but just may have had no marketing or support in reaching potential customers.

So my advice is that before you place all of your bets on the next product or feature, make sure you put enough effort into crafting the right message and value proposition and that you put just as many resources into getting it out to the market.  In other words, give your product a chance to succeed and don't starve it to death.  Constantly developing new technology without having a well-thought out plan to get it to market can spell doom!  Developing your way to success can work only if you realize that it is only part of the battle.   

Direct ad sales and startups

I have recently met a number of startups with interesting consumer applications or services.  As expected, many of these startups have a vision to rely on advertising to pay the bills.  And like many startups, a number of these companies have plans to add a direct ad sales staff over time.  That makes a ton of sense, but what I believe is that many entrepreneurs underestimate the direct capital and management costs necessary to build such a team.  In many ways, building a direct ad sales team is similar to building an enterprise sales team.  These thoughts may seem quite basic to you but here they are nevertheless.  First, don't ramp up your sales team too quickly until you have a product to sell.  That means if you don't have scale or enough eyeballs you are better off using Google Adsense.  If you don't heed this advice you may quickly burn yourself out of business.  Secondly, I know that many startups may not know what kind of ad units to sell but be careful of not having a standard product list or rate sheet when you go out to the market.  Yes, I know you have to be creative if you have a new service and listen to your customers, but at the same time don't base your business on selling one-off ad units for each advertiser because this can be a huge drain on your technical resources over time.  Next, make sure you never forget that what is right for your users is right for your business.  Many times I have seen companies that are trying to meet the advertiser's inventory requirement make the ads much too prominent and sacrifice usability in the long run.  While this may drive some initial short-term results, it may come to bite you in the ass in the future. 

The bottom line is that Google Adsense works well for a reason-it has scale-it has tons of eyeballs, it has a huge customer list of advertisers, and is therefore more likely to get you great pricing and ad targeting.  Yes, I don't disagree that over time you want your own sales team and don't want to solely rely on one partner for your revenue, but just go into this with your eyes wide open and don't ramp up before its time.  The direct costs, management costs, and hidden strains on your infrastructure may be more than you can handle if you ramp up too quickly.  Start slowly, figure out what it is that advertisers love about your service or product, figure out what kind of units deliver the best results, and then ramp.  Here is an earlier post on ramping up an enterprise sales team as there are many similarities to direct ad sales and direct enterprise sales.