Soaring on Ridgelift

Venture Capital – time for V3.0

It's impossible to escape the debate of whether Venture Capital is "broken" – tech blogs, national newspapers, even the overheard conversations in my favorite coffee shop (Café Del Doge in Palo Alto and no, I'm not an investor, just a happy patron!) debate the "death" of venture capital.

Like any "system" that has been "enhanced" over decades, the architecture of the venture capital business isn't broken but has fundamental issues that slow or even limit its ability to adapt to new market requirements.

Few companies survive a major architectural overhaul of their main product family.

Years ago I lived through just such a transition at Tandem Computers as the operating system and related system software (small things like the transaction monitor, database, communication products etc.) all had to be overhauled to deal with faster processors and larger memory.

The original system had been designed in the 70's when the idea of more than 255 processes in a CPU was considered a "huge" number – you can probably guess that the process id was encoded in 8 bits. Years later, the CPUs were so much faster that you couldn't run them at 100% utilization because of that process limit. The process id and similar system data had to be made larger – the ramifications were staggering in their impact.

Project EXCEED was the code name for the project to remove operating system limits. It was originally estimated at 300 man years of work – in the end it "exceeded" that by several multiples – consuming a large percentage of the development staff. This was a critical time as the "open system" transition was accelerating. Tandem missed the wave, lost market share as its systems were relevant to a smaller market niche and eventually was acquired, first by Compaq and then by HP.

Venture Capital firms are caught in an architectural transition:

• Too much capital in the aggregate.
  
  The supply of capital into Venture funds isn't balanced by the market exit potential (IPO, M&A) to generate an acceptable rate of return. The same things happened with capital inflows into the LBO funds which I wrote about back in January 2007 (but was my concluding observation about early stage capital off the mark!).
  
  Many Limited Partners believe that Venture Capital isn't an asset class but an ACCESS class – the majority of venture returns have been generated in the past 10 years by a very small subset of firms. If you could get into those firms you were going to make a return – or at least that was the theory…
  
• Too little operating expertise.
  
  The bubble run up resulted in the inflows of two forms of capital into Venture firms… money and people. The expansion in human capital attracted a lot of very smart people but with little operating experience.
  
  You wouldn't want a medical procedure to be performed by someone who had been trained but was about to conduct their 3^rd or 4^th procedure - on YOU. Yet in the VC world this happened with new VCs sitting on the boards of private companies and dispensing guidance and business advice. The rapid growth exceeded the capacity of the experienced VCs to mentor the new folks coming into the business.
  
• The Internet effect.
  

  A little discussed side-effect of the Internet is how it eliminated latency in information flow and flattened access to data. We see this everyday – the speed at news travels approaches the speed of light – Google search makes even obscure data easy to find (you just have to know what to search for!).
  
  But this same improvement means that ideas, concepts, description of problems etc. quickly spread to be known by many people. The time advantage of knowledge has been reduced and places an ever larger premium on being the first mover and flawless execution.

   

• Technology markets are mature
  
  It is much harder for a startup to break into a mature market than one that is emerging. The technology has become mission critical with the target customers and they don't want to take risks on new entrants. Similarly, the scale and performance requirements necessary to make meaningful improvements require much larger amounts of capital.

Like many of the technology companies they funded in the past, few Venture firms will successfully weather this transition.

I wonder if there isn't another factor to consider… as the H1N1 flu pandemic began the question was posed whether Google Trends had provided an early warning of the developing problem (for those who knew to look!). I'd seen Google Trends when it was first released but had forgotten/ignored it for a long time.

I pulled up Google Trends and entered search terms like "startup" and "venture capital" – the results were surprising to me – here's the chart from Google Trends on "startup":

Google Trends (startup) – All regions

Google Trends lets you drill down by region – the results for "startup" are fractal – as you drill down the data looks the same (except for regions like China and India).

A search for "venture capital" looks more pronounced…

Google Trends (venture capital) – All regions

I've debated these trends for several months – it's possible that the trend is a result of knowledge about startups and venture capital becomes increasingly well known and so people don't search for it. That could explain the difference in the regional data for countries like China and India.

To counter this, I look at the number of friends and business professionals returning to work in major corporations. One of my friends remarked that after working for 10 years in 3 startups, all he had to show for it was long work hours, an under market paycheck and weak benefits. He has a point.

Hard to know!

VC 1.0 was the beginning of venture capital where experienced investors carefully nurtured companies with modest capital. Markets were just beginning to emerge as new technology developments provided productivity improvements or solved critical business problems.

VC2.0 was the Internet and resulting bubble.

So what will VC3.0 bring? This architectural re-design is "in play" and uncertain.

While this is underway I think there are two areas that deserve your attention… I characterize these as Fire and Water.

Big problems or unmet needs create a fire – big pain and urgent need. If you decide to play with fire you must execute with perfection and precision. You won't get a second chance and VC investors should quit funding the moment execution becomes flawed or someone else does a better job.

Difficult problems or emerging trends benefit from an approach like the erosion of water. Relentless and slow like a river or getting into the cracks and freezing to break down the problem faster like ice. Build entry barriers with fundamental IP, good execution and careful deployment of capital – together with deep and meaningful strategic relationships with established companies that realize they need your help.

Pick one!

 

Did Oracle buy SUN to stop Cisco getting software?

Startup ideas tend to come in waves.

Generally (but not always! the ultimate winner tends to be one of the early entrants so I'm always alert for emerging trends. One of the latest trends I see is of tighter coupling between application and data - streamlined access to all sources of data whether on the network or storage. This holds true for both virtualized and high performance applications – at least so far!

I'm still connecting the dots to see how the trend matures, but it got me thinking about Oracle's acquisition of Sun Microsystems.

Given Cisco's entry into the server world and with their sights so obviously set on the Data Center, did Oracle acquire SUN to stop Cisco getting it's hands on software like MySQL and Linux?

If the trend for tighter integration between application and data continues, new leaders could emerge in both the virtualized and high performance spaces. The odds favor an incumbent vendor like a Cisco or Oracle moving into an adjacent segment and extending their dominance – however, a startup has a chance assuming it can leverage agility, deliver overwhelming benefits and overcome the enterprise manta of "I don't buy from startups".

For Cisco to extend its dominance, it needs to leverage its ability to develop solutions that benefit from tighter integration with the network – the ultimate source of all data whether from remote locations or storage (memory or disk). It doesn't take too much imagination to see the benefits that could have extended from taking MySQL, a stable Linux implementation plus a lot of networking/high performance know-how to build a killer data center solution.

Ironically, several of the early stage companies I work with have migrated away from MySQL because of changes the SUN made to the license agreement. PostgresSQL emerged as a very viable alternative for many of these companies. Perhaps this is a viable alternative for Cisco – time will tell!

If I'm right about the trend, Oracle will need to extend it solution set by acquiring substantial networking experience – just as Cisco still needs to get higher level software and expertise.

Assuming this is a trend and not a line drawn between two data points, the future M&A market for startups in this space could be very lucrative!

We will see!

[Apologies if you saw an incomplete version of this post earlier! Finger trouble with the iPhone TypePad application on my part!]

Why plan B should be your new plan A

I wrote the original draft of this post over a month ago… and decided to sit on it and see how the first quarter finished off. While there are some signs that the economy is no longer plummeting downwards like an elevator with a broken cable, there is still plenty of cause for concern.

We're heading into the reporting period for Q1 – already you can feel the storm clouds gathering. Remember that many companies chose to give no guidance at all for this quarter so there's no warning flurry of pre-announcements to provide a harbinger of things to come. I don't believe it's going to be an out and out disaster but I don't expect many to outperform.

With that comforting thought in mind, I offer you the following – if you haven't already done what I suggest below, you might want to give it some serious thought. The road out of the current economic wreck is going to be long and slow – a slog if you will.

 

Many companies have two plans…

Plan A – the plan of record (POR) that defines how the company will execute over the next year or so to achieve its goals. The POR acknowledges the assumptions, risks and future capital requirements for the company to continue to expand.

Plan B – the contingency plan that says what the company will do if plan A falls apart due to external factors (the economy? Duh!) or failures in execution, customer demand, external vendor screw ups etc.

 

This is the time to make that plan B your plan A.

Invert the psychology – instead of having a set of assumption that IF NOT MET cause you to take corrective actions (often with not so happy consequences like layoffs, a down round, going into hibernation…), do the opposite.

Put in a base case and then factor in what you would do when you have met or achieved the base case. Meet milestones that give you confidence on the business – spend more money to expand. Remove product or sales risk – move aggressively to the next phase.

In a nutshell, plan based on achieving confidence not having to sweep up the broken glass.

Apart for giving you more stability in your company, it will expand your cash runway and give your investors more confidence to boot.

Take out plan B, put it into action and use the original plan A to expand as your progress.

No plan B? Time to go back and read about Darwin…

Cloud based memory systems

Ever wonder what comes next? We've seen two decades of strong growth in technology fueled by semiconductors and the Internet. The list of game changing innovations is long but the pace of additions has slowed considerably over the last few years.

It's tempting to lay the blame on declining investment as a by-product of the consolidation of hardware, software and communication companies. Certainly most of the larger players seem to have adopted a strategy of incrementalism rather than developing new break through products.

The trend towards cloud computing may look like yet another incremental step in scaling or amortizing the cost of the data center. But wait!... there's more!

Check out this article on the implications of Cloud Based memory…

"Are Cloud Based Memory Architectures the Next Big Thing?"

I think we're seeing the early signs of another step function in system design based on low power processors and massive amounts of distributed memory. The implications of this change will affect everything – power systems, cooling, hardware, software and communications.

It's also going to place a premium of dealing with failure – how do you make the failure of one element transparent – much like Tandem Computer did in the 70's and 80's but without the high price and software complexity? Hadoop?

That's one answer but there will be many others.

Time to remember the King!

It's time to remember the King – no, not Elvis! YOUR CUSTOMER!!!!

In good times when demand is strong and the rising tide raises all ships, it's too easy to become complacent and think that you know best and simply respond to your own perspective of what your customers need.

In times of challenge (ok, let's quit the subtleties – when times suck!) it's critical that you give the customer (or prospect) the respect and consideration they deserve.

Sounds obvious?

You would think so but I see so many people and companies with little clue about the real needs of their customers or how their product/service relates to the customer needs.

Some personal and anonymous examples to illustrate the point from my last couple of weeks "vendor management"…

• The specialty photographic magazine who I called to verify my subscription… sorry, unless you have specific date and method of payment, we can't help you.
  
  Apparently never heard of a subscriber database…
  
  Frustrating? You bet!
  
• The PG&E truck that showed up unexpectedly to "repair a gas leak" which we hadn't reported. When asked for identification and a work order, the field tech responded – "isn't the fact I'm in a PG&E truck enough for you?"
  
  No, it could have been stolen and YOU showed up without prior notice – don't expect me to roll over like man's best friend!
  
• The folks at Expanded Spectrum Solutions who went out of their way to verify a $12 order for some quartz crystals?
  
  Impressive!
  
• The tech support folks at Synergy Systems in San Diego who helped me get a GPS unit back on the air FIFTEEN YEARS after I purchased it from them?
  
  Perfect score on the SAT and the Gold Medal. Think I will do more business with them? You bet – already did!

Ok, criticize in private, praise in public. The last two deserve the public recognition – they were selfless and helpful without question. It illustrates the point way better than the negative cases…

In the early days at Cisco we were maniacally focused on the needs of the customer – a culture driven top down by John Morgridge and John Chambers. Some research into customer behavior that I read back then was very telling – give a customer a great experience and they will tell 2 to 3 other people – give them a bad experience and they will tell 20 to 30 other people!

In other words, good news travels slowly, bad news travels very fast!

During my Cisco experience, we moved mountains to make a customer whole or respond to their needs:

• Need a customer visit to close a sale or combat a competitor? No problem!
• Send an engineer into the field to debug and fix a problem? No problem!
• Customer has unique needs that we need to address? No problem!

It paid back a thousand fold.

In the current financial mess, it's critical to spend even more time with your customers regardless of whether they spend money or not. For sure, you need to prioritize and focus on where you can close revenue but your customers have the best perspective on what you need to do.

So, some suggestions:

1. Go meet your customers on their turf – drink their coffee and understand their problems. Do this when you aren't trying to close new business – either a future prospect of keeping an existing customer aware that they matter to you regardless of the next purchase order.
2. Hold customer focus groups or webinars. Get your customers talking about their problems, what your product does well and what it needs to do.
3. Expose as many people in your company to the customer as you can (and can afford). Engineers, managers, marketing, finance – the works.
4. Give all your senior managers at least one customer to "own the relationship" in conjunction with the sales team. Think executive sponsor. Get to know your customer like you know your best friend.

Time to cozy up to your customers – you won't regret it!

It’s been a while…

Sorry, for the zero volume of posts over the last couple of months.

I've spent a lot of this time trying to understand the impact of the financial mess on companies I work with and help them sort through strategy and action plans. This has been a rewarding process – adversity has a way of amplifying people's characteristics and I've been positively blown away by the creativity and determination I've seen flourish. As the saying goes, we may be down but we're not out!

A note on my posts… I try to keep the content on Soaring on Ridgelift "on topic" and maintain a high signal to noise ratio. As a result, I stay away from posting articles about my outside interests – feedback I get via email or in person about my blog supports this approach so far.

I've starting a parallel blog where I will post on topics that don't fit here – it's called EtherGeist and the URL is linked here. I'll add cross links between the two so you can easily find it and follow if you are so minded.

In the meantime, look for the next few posts to offer some ideas about life in Financial Mess 3.0 and opportunities to take some proactive steps forward.

As a reminder, I am happy to have a 30 minute "No-harm, no foul" meeting or phone call to go over business ideas. If you're interested, drop me an email.

The fallacies of risk management

Imagine the following scenario:

A commercial airline flight takes off for its specified destination. Unfortunately, the weather at the destination is so bad that the pilot is unable to land. As they execute the missed approach, the plane runs out of fuel and crashes – all on board are lost.

Can you imagine the tragedy, law suits, inquiry and resulting government regulations? The public reaction would be (rightly) overwhelming. Fortunately, there are already regulations in place not to mention extensive pilot and dispatcher training that would make this imaginary scenario (thankfully!!) almost impossible.

Every flight should be planned in advance with a set of contingencies designed to cover the unexpected or to recognize that the assumptions made for the flight are not working out. Contingencies include planning an alternate destination, carrying extra fuel and as the ultimate back stop, finding a runway and getting on the ground as soon as practical. Pilots train for these situations and commercial flights also have a high degree of redundancy in systems (engines, power sources, flight controls etc.) designed to minimize the impact of the 1% improbabilities.

The process of building a contingency plan has been drilled into me by every flight instructor and recurrent training session I've had. If I can't build an adequate contingency plan, I don't fly. It's that simple. Not surprisingly, this form of thinking has carried over into other aspects of my life including investing.

Yesterday's New York Times magazine had a great article showing the impact of the 1% improbabilities in investing – Risk Management and how the professional investors got nailed by the Black Swan events of the meltdown. It's well worth a read regardless of whether you are an investor or an entrepreneur.

If you are a CEO of a company (big or small) you need a contingency plan that thinks about the possible 1% events and how you will react to them – fortunately, the US Government thinks about such things too!

Don't fall into the "oh, we'll deal with that if it happens" trap that I've heard so many times in board meetings over the years. There is too much temptation to put aside the really hard issues that may be improbable- they are uncomfortable to deal with and don't have clear cut answers. As a CEO or board member you should make sure that these issues are put on the table and discussed ahead of time.

It may turn out to be unnecessary but when (not if) the improbable occurs, you will be much better prepared and the actions you take will be considered, not reactive. This will help the company better cope and survive the unexpected. Today's environment is so out-of-the-norm that events you think are improbable are much more likely to occur.

Don't find yourself the victim of fear and surprise…

 

2009 – A desert for VC backed IPOs?

As 2008 ends, two different points about the IPO market in 2009 struck me as noteworthy. Both of these appeared as I began to catch up on my reading from a hectic December.

The first arrived late last week in an article I read on SFGate's Tech Chronicles in "Slim picken's for IPOs could yield investor bargins" that quoted Renaissance Capital (an independent research service) with their outlook for the kind of companies that might access the public markets in 2009:

"Looking ahead, Renaissance said the companies lined up to go public in 2009 will have average revenues of $535 million…"

This is consistent with the discussions I've had over the last few months with some of the (remaining!) investment bankers. Public market investors want a growth story but they don't want to take a risk – revenue at the $500M mark, solid growth (>20% per year) and consistent profitability are going to be the hall marks of companies that can successfully IPO once the window re-opens. Renaissance also projects 100 IPOs in 2009 – it will be great to see that number achieved!

The second data point arrived in an email from the Silicon Valley office of the New York Stock Exchange announcing that the NYSE had approved an additional listing standard for emerging growth companies:

"On November 12, 2008, the SEC approved an additional initial listing standard that we put in place to encourage emerging growth companies to list directly on the NYSE.  The following minimum listing requirements are all pro-forma for an associated offering / IPO:

• $150mm market capitalization
• $75mm total assets
• $50mm shareholders equity
• $60mm public float for IPOs, or $100mm public float for transfers
• $4 stock price
• 400 round lot holders"

It's great to see the NYSE make this move but I don't see a $150M market cap company getting much interest – this is almost micro-cap territory these days and isn't going to be very popular with public investors recovering from the worst beating they've had in many decades.

2009 looks like a year to consider mergers that help private companies consolidate a market segment and bulk up on revenue and profitability. Private to private mergers are challenging to say the least but with execution attention to a solid merger plan (and agreement between different investor syndicates), the rewards may finally outweigh the risks.

In any event, 2009 has the makings of a desert for VC backed companies to IPO – there are certainly some VC backed companies that meet the Renaissance Capital profile but not many. The majority of exits in 2009 are going to be via M&A – only time will tell if shareholders will be happy about the valuations!

Venture Debt – Check your security blanket!

Many venture backed companies take on debt at some stage of their life borrowing money from a bank or specialized venture debt lender. This money is far from being "cheap" carrying high interest rates, transaction fees and warrant coverage (usually in the form of a stock option for preferred stock).

Debt can make sense in an environment where customers are buying and next round valuations are expected to be significantly higher than previous rounds. The premise is that venture debt can lengthen the amount of time a company can operate before having to raise a new round of financing. In an "up" environment, more time can translate to a higher valuation and hence less dilution to existing shareholders (especially important for common shareholders who generally don't invest in rounds of financing to protect their ownership).

Debt can also make sense when a company is expanding sales – debt in the form of a line of credit can be used to supply working capital to cover the time from shipment/invoicing to cash collection. The line of credit allows a company to borrow some percentage of its account receivables – generally with a better rate than pure venture debt.

In addition to high interest rates etc., one of the other attributes of venture debt is that it typically requires either a UCC-1 filing (Uniform Commercial Code, article 9 public filing perfecting a security interest in underlying assets) or a Material Adverse Conditions (MAC) clause. Either of these conditions allows the lender to "call" the debt due under certain conditions. The lender also requires that you either place all your funds (existing and borrowed) in their bank (where the lender is a bank) or execute an account agreement that provides the lender with account control over all of your funds.

In todays "down" environment where revenue growth is uncertain and credit is tight, venture debt can give a company a false sense of security about the remaining cash runway it may have before raising the next round.

Remember that the debt lender has an obligation to protect their asset and so keeps a close eye on the company's current cash balance and compares it to what is owed on the loan. As the cash balance gets close to the outstanding loan, the lender will call the CEO and investors in the company to determine the plans for the next round of financing – basically looking for a "guarantee" that the investors will continue to finance the company (thereby insuring the loan doesn't default).

Any hesitation or lack of conviction in the certainty of the "next round" may cause the lender to invoke the UCC-1 or MAC clause and cause the note to come due. The lender then sweeps the accounts to recover their outstanding principle and the company is immediately out of cash.

Given the current climate and challenges facing financial institutions of all kinds, cash is just a much "king" for them as it is for startups. You can pretty much guarantee that lenders will protect their cash as the first priority and worry about business relationships or possible legal challenges later. We saw this exact scenario unfold many times in 2002-2003 as the business environment was challenged by the aftermath of the Dot Com bubble, 9/11 and the pull back in telecommunication capital spending. 2009 is unfortunately shaping up to be worse…

So, if your company has a venture debt line and you forecast your cash balance going below the outstanding amount of the loan, take a long hard look at whether that cash balance is going to be real at the time you need it most. Chances are the cash will be swept.

Confront the issue now while you still have plenty of time – consider the possibility of the accounts being swept and talk the issue through with your investors. Get a contingency plan in place - perhaps getting a small "top-off" round and immediately paying off the loan (thereby saving interest expense) or figuring out other ways to stretch your remaining cash either to the point of break even or getting a new round of financing closed earlier.

Don't hold on to venture debt as a security blanket – you may get caught out in the cold!!!

 

 

The other side of cost cutting

Like me, you've probably had enough with comments from VCs on how to cut costs/plan to weather the deepening recession. For sure, there has been much well-meant advice on the cost-cutting front.

Inevitably, people focus on the cost-cutting front first – it's the foundation for longer survival and sadly has profound impact on people's lives and careers. As I've written in the past, getting to cash flow breakeven places the control of your destiny squarely in your own hands – no longer dependent on infusions of capital for meeting the next payroll.

However, cost cutting is only one of the levers you can pull to reach breakeven. I haven't seen much from VCs on driving the sales front so here's input for the other side of cost cutting – revenue generation.

Sales leverage

Even in a growth market, startups face a headwind in getting their message out and making it heard above the noise. In a down market, it is even harder. It's expensive to knock on doors and find potential customers that a) have the problem only you can solve and b) who are willing to spend money to fix it!

Companies put a lot of effort (and expense) into lead generation programs. Purchasing prospect lists, advertising, trade shows, telemarketing etc. are all tried and tested tools but are still part of a push sell – you want to convert this to a pull.

You have to make it easier for customers to find you.

Simplify the message

When I start working with a company, I listen to how the team describes the problem they are solving and try and put myself in their customers' shoes. Does the customer describe the problem in the way the company does or would they describe it differently? Then I go ask some customers or prospect how they describe the problem.

9 times out of 10, the customer's description of the problem is simpler, more concise and in a phrase suitable for a Google search.

You can guess what I do next… I take that simple phrase and run it through Google to see where (if at all) the company ranks in the search results. Sharing this with the team can be an enlightening experience especially if the marketing folks defined a "new category" to describe themselves; often they are the only occupant of the category and customers give you a blank stare when you describe the category.

So, step 1:

• Make it easy for your customers to find you!
• Describe yourself the way your customer describes YOU
• Use plain language, don't define a complex category

Make it obvious

How many web sites do you look at and instantly "get" what the company does from its home page? Try it for yourself (especially with your own company web site!) – While some sites deliver the message with punch, all too often you have to drill down several levels in the web site to get a plain answer – assuming you can find one at all!

In a world of attention-challenged people, do you think a customer prospect is going to drill down into your site to find out how you can solve their problem? Obviously NOT!!!

Step 2:

• Make sure you have a clear message on your home page
• Match the description of the solution to the customers definition of their problem
• Include an obvious "call to action" (get more information, free trial, demo… etc.)

This isn't just SEO

DO NOT let your marketing folks tell you this is about search engine optimization. Simplifying the message and making it obvious is a critical first step – you want to make sure that your site ranks high in the searches for the RIGHT message – the one that the customer uses to describe their own problem and to which they resonate when visiting your web site. Once you have the message down you can turn it over for SEO.

 

If your sales process is dragging and you're trying to figure out why – start by following the steps above. If the message isn't simple and obvious – FIX IT before you do anything else. Likely, this won't be a simple process because positioning is complex to get right and effects many other things – sales collateral, product specs, and product!

I will leave you with the following food for thought: if you can't deliver a simple and compelling message that resonates with your customer via your web site, how effectively do you think your sales person is going to deliver a value proposition?