Category Archives: Venture Capital

The Right Time To Raise Money At A Startup

Posted on March 2, 2012 | 2 Comments

I’m often asked by entrepreneurs:  when is the right time to raise money at a startup?  I invariably say two things in response:

  • Whenever you can
  • Right now

Whenever You Can
Most startups typically go through ups and downs. Say you’ve just completed 4 consecutive quarters above plan. You growth is high and your burn rate is reasonable. You have enough cash to go three more quarters before you need money. What should you do? Unless you are virtually certain that your quarterly streak will continue, I’d say raise money.

Why? Because the increase in valuation / decrease in dilution from adding 1-2 more quarters to the streak is nothing compared to the decrease in valuation / increase in dilution from tanking a quarter along the way. Whether you’re a subscription or perpetual company, investors will always want to see new sales / new bookings as your primary growth metric. While the SaaS model does damp revenue volatility, that’s precisely why a VC will want to see bookings. And, in my experience, bookings are volatile. During my 24 quarters at MarkLogic, we hit our bookings targets about 90% of the time. But I can say, sometimes when we missed, we missed. I remember one quarter coming in around 50% of target. Right after that quarter is exactly when you do not want to be raising money. And, by the way, it’s usually precisely when you need it.

The fastest way to end up bridge loans – where you lose almost all control of your company and are fed milestone to milestone – is to not raise money when skies are blue and instead try to raise money in a storm. Much as I love them, VCs are not in the business to be nice people:  if you’re coming to them, hat in hand, with 30 days of cash in the bank, I can assure you that you will not raise money on favorable terms. You could have done that 90 days ago. But, if you’ve tanked the quarter, now it’s too late.

To show this in reverse, one trick VCs love is to sneak a peek at an extra quarter. I remember one time when I was raising money, we’d agreed on terms, and the lawyers said it should take 2-3 weeks to close the round. It was June 12th, so if everybody pushed hard we should have been able to close the round before the quarter ended on June 30th. But suddenly everyone disappeared. Hello? Hello? Why aren’t the VCs calling back? How come their lawyers have gone silent and are taking forever to turn paper? Hello? Hello?

We made the quarter and the round closed July 5th. Arguably, I could have gone back and asked for a higher valuation based on having made the quarter – i.e., knowing that 2Q would be successful wasn’t priced into the round. But the VCs are good, they knew I wouldn’t do that – and they wouldn’t have let me if I tried.  So they got a “free peek” at the 2Q results. I’ll bet you $1000 that if we’d tanked that quarter, they’d have come back to me seeking to lower the valuation. The game is neither fair nor symmetric. (So time your round to close before the first day of the last month of the quarter.)

Right Now
Particularly for new companies, I believe the right time to raise VC money is right now. Too many would-be entrepreneurs treat fund-raising like going to the Senior Prom. I need to find a date. I need to book a limo. I need to do my hair. I need to get a dress.

Translation: I couldn’t possibly go talk to VCs about raising money until I have a great slide deck, an advisory board, a CEO, a Beta product, or some customers.

To me, it’s all avoidance. Traditional A-round VCs want to catch you in your dorm room. They are used to talking PhD students (or drop-outs) about their visionary ideas. They are not worried about whether you have a CXO. (In fact, they would be more than happy to help you find a CXO which, by the way, I wouldn’t recommend.)  They are worried primarily about the market opportunity, your idea, and your technology. As Don Valentine always said: great markets make great companies.

What’s more, they want to invest in people they know. One way to get known is to build a relationship over time as you think about raising money for your company. The best way to do this is to find someone in your network who can connect you to a top VC partner and who’s spent time getting to know you and your company (e.g., someone who’s perhaps done some advisory work or an angel investment). Then you want that person to send a top VC an email that looks like:

Dear Joe,

I have been working a bit with Mark Smith who just (ideally, either left great company or completed or ideally dropped out of a great PhD program) and who has a very interesting idea for a company. They are thinking about raising money and thus weighing the pros and cons of bootstrapping, an angel round, or a VC round.

I’d suggest meeting with him.

This way you remove the “prom factor” from your VC meetings because are not going on the big one-shot date. You’re not raising money. You are thinking of raising money. So it’s not awkward for them to not invest – in fact, they never even need to say no. But if they like your idea and your company they’ll be shoving money in your pockets whether you ask for it or not.

Better yet, you can invoke their competitive instincts by noting that you’re chatting with several VCs about whether you should raise money. Best of all, this approach lets you benefit from their wise (and free) feedback as you develop a relationship over time. If they are even moderately interested, they are going to want to track you (i.e., “hey, come back in a month and let’s have a coffee”).  If you continue to make good progress during that time (i.e., accomplish what you say you will in a given timeframe), you not only build credibility but also slowly transform yourself from stranger to interesting person who I’ve been tracking for the past 6 months. That becomes even more helpful when the VC needs to convince his partners to invest in you, as he invariably will.

So, now you know the secret. When’s the right time to raise money in a startup? Either right now or whenever you can depending on your situation. No business ever died from a little extra dilution. But, as the ever-quotable Don Valentine also pointed out: “all companies that go out of business do so for the same reason; they run out of money.”

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Posted in startups, Venture Capital

Thoughts on the Splunk IPO and S-1

Posted on January 20, 2012 | 8 Comments

I like Splunk.  I like Godfrey Sullivan and what he’s done with the company.  Steve Sommer is a great marketing guy and I think he’s done a superb job with Splunk’s marketing, particularly in imbuing the company with a hip, fun, consistent corporate personality, making them the Virgin Americas of log file analysis.

I also like Splunk because many months ago, they let me riff with Godfrey and many members of the e-staff about marketing and strategy.  They were smart and it was fun.  They even gave me a superb bottle of wine for my troubles.

I like Splunk because, unlike Jive, Godfrey hasn’t turned the e-staff into a crony club.  Building great teams is about finding the right people for the right job, not just carrying around an entourage.  Exercise:  search Spunk’s management page for Hyperion and then search Jive’s for Mercury.  (Answer:  2 and 6.)

I also like Splunk because they pivoted.   When I first heard of them, they were positioned as “IT search.”  I had no idea what that was or who would buy it.  When we met for the strategy riff, they were in middle of re-positioning around machine-generated data, a message that I liked.

Most folks make software that analyzes human-generated data; we focus on machine-generated data.

Clear, simple, and true.  Instead of piling on as a YABDW (yet another big data wannabe), Splunk built a message that was sexier than “log file analysis” but still true to their essence and still generalizable to a broader vision of “operational intelligence.”  A+ marketing.  Bien fait.

Finally, I like Splunk because they haven’t burned through lots of cash.  They’ve raised $40M.  They have $23M in the bank.  $17M net burn isn’t bad for what they’ve created.

Splunk’s fact sheet does a great job of telling their story in two pages.

When I heard that Splunk had filed their S-1 to for an initial public offering, it was no surprise.  I’ll spend the rest of this post analyzing it and pulling some highlights.  Those looking for controversy will not be happy.  I’ve read the S-1 over the past few days and found few surprises.  Overall, the company looks pretty clean from where I sit.

Let’s start with the income statement:

  • FY11 revenues of $66M, up 88%
  • Trailing 9 month (T9M) revenues of $77M, up 78% so there’s a slight deceleration in growth
  • FY11 gross margin of 89%, on the high side for an enterprise software company and reflective of the high license revenue mix (75%)
  • S&M expense in FY11 of 60% of sales, which rose to 62% for the T9M period.  They’re not afraid to spend on growth.
  • Healthy R&D expense of 21% of sales in FY11, which stayed roughly constant.
  • Small operating loss of 5% in FY11, rising to 10% for the T9M period, probably due to costs associated with the offering.

In my opinion, this is a VC’s dream income statement (with one notable exception that we’ll cover in a minute).

  • High revenue growth = big opportunity
  • Small operating loss = sustainable, but spending it all on growth.
  • Small net loss = nowhere to go but up in profitability
  • High license mix = software-focused

The only part of that VC formula I dislike is the license mix.  Boards like high license mix because market share is measured in license dollars, license dollars are seen as the engine of a software business, license dollars drag other dollars with them (e.g., maintenance), and finally because boards get tired of companies missing their high-margin license target and covering the gap with low-margin services.  They see it as soybean filler in their hot dog.

I think that view is myopic because it is not customer-oriented.  To the extent your software is truly easy to use and requires few services, then I guess it’s great.  But to the extent you are selling typical enterprise software, it can be hard to use, setup, and configure.  In that case, keeping your services org tiny may win you cheers at the board meeting, but jeers at the user conference.

Personally, I’d like Splunk even better if they had the same license revenue and more service revenue on top, even though it would reduce the license mix and gross margin percentages.  (Note:  not gross profit, both revenue and gross profit would be higher in my ideal company, but the license mix and gross margins would be lower.)

I worry that Splunk could end up in No Man’s Land on the services issue:  too small an opportunity to entice big consultants to build serious practices around the product, but too great a need to be satisfied by a small (6% of sales) professional services organization.  For example, we are customers in my current job, and — far as I can tell — we get some good value from the software, but could probably get a lot more.

Now, if you’ll pardon the pun and the mixed metaphor, let’s find the cloud in the silver lining:  Splunk is not a SaaS company.  OMG.

For example, we typically enter into perpetual license agreements, whereby we generally recognize the license fee portion of the arrangement upfront, assuming all revenue recognition criteria are satisfied.

Personally, I’m OK with it.  In some ways, I admire Splunk for swimming upstream on this issue.  While SaaS is wonderful and has many advantages, not all customers in all categories want to buy on a SaaS basis.  Splunk has evidently decided that in machine-generated data, people primarily want perpetual (yet they also offer term as an alternative).

Splunk’s sales are backloaded:

As is typical in the software industry, we expect a significant portion of our product license orders to be received in the last month of each fiscal quarter.

The combination of this backloading with the more volatile revenue stream associated with perpetual model should make Splunk’s earnings more volatile than its peers.  We’ll see if that turns out to be the case.  (See here for my generic analysis of SaaS vs. perpetual businesses.)  But they do have some ability to manage it:

We typically ship products shortly after the receipt of an order. We may have backlog consisting of product license orders that have not shipped and maintenance, professional and training services that have not been billed and for which the services have not yet been performed. Historically, our backlog has varied from quarter to quarter and has been immaterial to our total revenues.

The astute reader will notice they’re saying that they may choose to not ship all orders at the end of quarter.  This is common in perpetual software businesses both due to order volume and because experienced managers know that if you’ve hit this quarter’s targets it’s time to slow down the order processing desk.  You’ll never know if you’ll need those orders next quarter, so let’s not put them on the midnight truck.  And while a few million dollars here or there may be immaterial to revenues, in the case where expenses approximately equal revenues, these orders can have a big impact on earnings.

I always read but rarely analyze the risk factors.  For Splunk, there are about 25 pages of them, in which the only tidbit I found was this:

We employ a unique pricing model which subjects us to various challenges that could make it difficult for us to derive expected value from our customers.

We charge our customers for their use of our software based on the customers’ estimated daily indexing capacity. As the amount of machine data within our customers’ organizations grows, we may face pressure from our customers regarding our pricing, which could adversely affect our revenues and operating margins.

I wasn’t aware of this, but it makes a lot of sense.  Increasingly, software vendors  want to sell the copier machine priced by the copy.  The desire here is always to hook your pricing to “something that goes up” (e.g., the old MIPS-based pricing model).  Splunk is betting that data volumes will go up and ergo that customers will need to buy more licenses as they do.  This should help offset the volatility argument above — while existing customers aren’t setup on renewable contracts, if they have the perpetual right to analyze only half their data, I suspect they’ll be back ordering more software.

Let’s talk about equity now.

  • It appears to me that there are about 1o2M shares outstanding before the offering based on 79.4M outstanding on 10/31 plus 23.2M shares issuable upon exercise of stock options.
  • If they raise $125M in the IPO with a typical share price of $15, then that’s another 8.3M shares, so that means about 110M shares outstanding after the offer.
  • This implies a target valuation of around $1.6B which I find high, so high, that I’m wondering if I’ve made an error.  This article says the valuation may be $1B.   Either I’ve mangled the math or they will reverse-split their way out of the problem.  Either way, let me assume they’re targeting a ~$1B valuation after the IPO even though I can’t yet see how that pops out from the math.

Here’s a graph of Splunk’s common share price as seen by the strike price of options during the year.

While there are literally pages of math explaining how they calculate the fair market value (FMV) of the stock to me this curve looks a big flat and a bit low.  The point of periodically performing section 409a valuations is to ensure that boards didn’t hand out in-the-money stock right up before the IPO.  If the company goes public at $15 and even just stays flat, I’ll let you explain to the IRS and the SEC how the stock was really worth $4 in October and $15 in February.

The pages on  compensation and the fees paid to compensation consultants always make me ill.  The CEO loses a lot of control in the IPO process, consultants make a lot of money, and executive pay is not constrained in the process because the exercises are based on benchmarking. By the way, despite those general objections my reactions to Splunk executive compensation are:

  • The bases seem reasonable
  • The on-target earnings (OTEs) seem reasonable
  • They have a highly leveraged compensation plan (Godfrey is a salesman, after all.)
  • They blew out their numbers
  • Ergo, they made a lot of cash compensation
Let’s look at the cap table.

The VCs own 70% of the company, which had raised a total of $40M in venture capital.  If the company ends up with a $1B valuation, then the VCs will on average — which is both interesting and misleading because different people bought in at different valuations — get a 17.5x on their money.  Not bad.

Godfrey Sullivan owns a hefty 8.1% of the company — quite a lot for a hired CEO (as opposed to a founder).  This is because Splunk is successfully running what I call the “new VC play.”   Because:

  • Consolidation means there is an oversupply of very senior executives
  • There are relatively few portfolio companies with the potential to go public
  • It now takes 7-10 years as opposed to 3-5 to go public
  • There is ample venture to fund the promising companies through IPOs that now happen closer to the $100M revenue bar than the $30M bar of the 1990s

You then go get the biggest guy you can find, load him up with options so a $1B CEO will run a $20M company, and then fund him for high growth over the long haul to get to the IPO.  This is true of Jive (Zingale) and Splunk (Sullivan).  It is true to a lesser extent at Lithium:  Tarkoff was a billion-dollar GM (which isn’t quite the same league) though the VCs are certainly backing him with money.

Hence, if things go I think, my guess is that Sullivan’s share will be worth $80 to $100M after the IPO.  Nice work if you can find it.  Or, as I believe was the case in this instance, have the vision to see the potential and pick it.

I’m fizzling here about page 120 of what looks to be 175 or so pages.  If you find anything interesting in those pages or have thoughts on what I’ve presented here, please share them.

And, in conclusion, congrats to the Splunk team and best of luck with the IPO.

(Be sure to read my disclaimers.)

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Posted in IPO, Venture Capital

Endeca and The Butterfly Effect

Posted on December 7, 2011 | 4 Comments

Let’s go back to July of 2010.  Imagine you’re having coffee with Endeca’s CEO, Steve Papa, a brilliant guy and someone for whom I have great respect.

But let’s say we’re having a coffee with Steve in July, 2010 and say the following:  ”Here is what’s going to happen over the next 18 or so months.

  • Hurd will expense those dinners.  Someone at HP is going to look into those expense reports and launch an investigation.
  • Hurd will — and I know you’re not going to believe this — basically get fired over those expense reports, which are the monetary equivalent of stealing Post-It notes relative to his salary.
  • HP’s board is going to appoint — and I know you’re really not going to believe this one — former SAP CEO Leo Apotheker to the HP CEO slot.
  • Leo is going to miss financial targets  – OK you can believe that — and then one day he’ll announce that he’s spinning off the the PC business and acquiring Autonomy for an astronomical $10B.  Yes, that’s right $10B for the meaning-based M&A leader.
  • And, as a strategic response to that, Oracle is going to buy Endeca for what I’m guessing will be a very nice multiple as well.”

This purpose of this post isn’t to slight either Endeca or its CEO.  I think Endeca was a fine company, I am a big fan of founder CEOs who build their companies, I have even greater respect for those few who make it work over extended time periods (Endeca was founded in 1999) and with a pivot or two along the way.

But I’d say that the average (largely perpetual) enterprise software company is worth 2-4x revenues and I’m guessing / speculating that Endeca got more like 6.  What accounts for that 50% uplift?  You could say it’s market dynamics and demand.  Or, looking at the above chronology, you could say it’s The Butterfly Effect.

But, either way, timing is everything and I believe Endeca did the right thing at the right time for the right price.  And making the wise decision to say yes wasn’t random.  Well done and congrats.  But remember the butterflies.

“In preparing for battle, I have always found that plans are useless, but planning is indispensable.” — General Dwight Eisenhower.

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Posted in endeca, Venture Capital

Interview by SandHill.com on Big Data, Cloud Computing, and the Future of IT

Posted on August 19, 2011 | 1 Comment

[This is a re-post of a recent interview with me, authored by Darren Cunningham of Informatica.  The post originally appeared on SandHill.com where Darren writes a column on Cloud Computing.]

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The Cloud in Action

Big Data, Cloud Computing and Industry Perspectives with Dave Kellogg

BY Darren Cunningham

I had the pleasure of working with Dave Kellogg early in my marketing career and continue to learn from him as a regular subscriber to his popular blog, Kellblog. A seasoned Silicon Valley executive, Dave has been a board member (Aster Data), CEO (MarkLogic), CMO (Business Objects) and VP of Marketing (Versant and Ingres). I recently sat down with Dave to discuss industry trends. As always, he didn’t hold back.

Dave, you’ve written a lot about “Big Data” on your blog. Why is it such a hot topic in the world of data management?

First I think Big Data is a hot topic because it represents the first time in about 30 years that people are rethinking databases. Literally, since about 1980 people haven’t had to think much about databases. If you were an SMB, you went SQL server; if you were enterprise, you’d go Oracle or IBM depending on your enterprise preferences. But in terms of technology, to paraphrase Henry Ford: any color you want, as long it’s relational.

Overall, I think Big Data is hot for three reasons:

  • Major new innovation is finally happening with databases for the first time in three decades.
  • Hardware architectures have changed — people want to scale horizontally like Google.
  • We are experiencing a serious explosion in the amount of data people are analyzing and managing. Machine-generated data, the exhaust of the Web, is driving a lot of it.

I think Big Data is challenging on many fronts from the cool (e.g., analytics and query optimization), to the practical (e.g., horizontal scaling), to the mundane (e.g., backup and recovery).

What’s the intersection with Cloud Computing?

I think when people say cloud computing, they mean one of several things:

  • SaaS: The use of software applications or platforms as services.
  • Dynamic scaling: My favorite example of this is Britain’s Got Talent, which uses Cassandra. Most of the time they have nothing to do. Then one night half the country is trying to vote for their favorite contestants.
  • Service orientation: The ability to weave together applications by calling various cloud services — in effect using a series of cloud services as a platform on which to build applications.

I think Big Data intersects with cloud in several ways. First, the people running cloud services are dealing with Big Data problems. They are hosting thousands of customers’ databases and generating log records from hundreds of thousands of users. I also think Big Data analytics are very dynamic loads. One minute you want nothing, then suddenly you need to throw 100 servers at a complex problem for several hours.

How do you see these trends changing the role of IT?

I think corporate IT is constantly evolving because smart corporations want their internal resources focused on activities that they can’t buy elsewhere and that generate competitive advantage for the business.

IT used to buy and run computers. Then they used to build and run applications. Then they focused on weaving together packaged applications. Going forward, they will focus on tightly integrating cloud-based services. They will also continue to focus on company-proprietary analytics used to gain competitive advantage.

The other trend driving IT is consumerization. The Web sets expectations for functionality, user interface and quality that corporate IT must meet with internal systems. The bar has gone way up – people won’t tolerate old-school ERP-style interfaces at work when they’re used to Facebook or Yelp.

What does that mean for technology sales and marketing?

If Mr. McGuire in The Graduate were dishing out advice today, instead of saying “plastics,” he’d say “data science.” More and more companies will use data scientists to analyze their business and drive tactical operations. First you need to gather a whole bunch of data about your operations and customers. Then you need to throw world-class data analysts at it to get business value and to be sure you don’t draw false conclusions – e.g., mixing causality with correlation.

Today, most companies have their sales departments on salesforce.com. Leading marketing departments are on Marketo or Eloqua, but most marketers still don’t have much technology backing them. Going forward you will see a whole class of analytics applications vendors providing advanced analytics for Salesforce (e.g., Cloud9, Good Data) and the marketing automation vendors will move beyond lead incubation into providing overall marketing suites. I expect Marekto or Eloqua to try to do for the chief marketing officer what SuccessFactors did for the chief people officer – and if they don’t, then there’s a real opportunity for someone else.

Speaking of all things cloud, you often write about Silicon Valley trends. How would you characterize what’s going on in the market right now?

From my perception, the Silicon Valley innovation engine is running full out. Top VCs are raising new funds. I meet a few new startups every day. Of late, I’ve met fascinating companies in next-generation business intelligence, analytics, Big Data, social media monitoring and exploitation and Web application development. One of the more interesting things I’ve found is a VC fund dedicated to big data - IA Ventures (in New York). When I heard about them, I thought: oh, lots of Big Data infrastructure and platform technologies. Then I spent some time and realized that most of their portfolio is about exploiting new Big Data infrastructure technologies via vertical applications. That was really interesting.

People will debate whether we’re in a mini tech bubble or a social networking-specific bubble. Who knows? I just read an article in the The Wall Street Journal that argues $140B valuation for Facebook is realistic, and it was fairly convincing. So you can debate the bubble issue but you can’t debate that the IPO market has been closed for a long time. Now it is starting to open, and that’s a huge change in Silicon Valley.

Entrepreneurs have historically dreamed of creating $1B independent companies. I’d say for most of the last decade they’ve dreamed of getting bought for 5-10x revenues. Michael Arrington had a great quote a while back saying that “an entire generation of entrepreneurs [has been lost] building dipshit companies that sell to Google for $25M.” I think those days are over. When the IPO window opens, people dream of building stand-alone companies.

What advice do you have for both entrepreneurs and IT veterans?

Don’t build or run things that you can buy or rent. If you follow that mantra, you will follow market trends, and always stay at the right stack-layer to ensure that you are adding value as opposed to leveraging old skill sets. While you may know how to run a Big Data center, you can now rent time in one more cost-effectively. So either go work for a company that runs data centers (e.g., Equinix) if that’s your pleasure, or go leverage the people who do. Put differently, don’t be static. If you’re still using skills you learned 10 years ago, make sure that you’re not teeing yourself up to get left behind.

As always, great advice, Dave! Thank you.

Darren Cunningham is VP of Marketing for Informatica Cloud.

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[Notes:  Minor changes made from the SandHill post.  I added emphasis via bolding and I corrected the attribution of the famous lines "plastics" from The Graduate.  It was not Mr. Robinson, but Mr. McGuire, who said it.]

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Posted in Big Data, cloud computing, Information technology, Initial public offering, Innovation, IPO, NoSQL, Uncategorized, Venture Capital

Highlights from the Fenwick & West 2Q11 Venture Capital Survey

Posted on August 17, 2011 | Leave a comment

Each quarter the legal eagles at Fenwick & West run a great survey on the state of venture capital and write a brief report that rounds-up data from other sources and publishes their survey results.  Here are some quick highlights from the 2Q11 venture capital survey:

  • Total VC investment was $8.0B, a 20% increase compared to the $6.4B invested in 1Q11 per VentureSource.  Of this, $2.9B was invested in Silicon Valley.
  • 14 venture-backed companies went public in 2Q11, raising $1.7B.  In 1Q11 11 companies went public raising $700M, per VentureSource.
  • Venture capitalists raised $2.7B in funding in 2Q11, a 65% decline relative to the $7.6B raised in 1Q11, per Thompson/NCVA.
  • The Silicon Valley Venture Capitalist Confidence Index dropped to 3.66 out of 5.0, a sharp drop from the 3.91 recorded in 1Q11.  I added the red line to chart below which seems to indicate that confidence is about average since 1Q04.

  • 19% of financing rounds were series A, about normal for the past two years, somewhat contradicting the analysis in this recent TechCrunch story, The Series A Squeeze.  (Though it’s unclear how Fenwick handles seed fundings in their study.)
  • 61% of financing rounds were up-rounds, 14% were flat, and 25% were down.
  • The Fenwick & West VC Barometer, a measure of per-share pricing, was up 71%, with the software sector leading the way at 123% and internet / digital media at 115%.
  • 37% of rounds included senior liquidation preferences and, of those, 29% were multiple liquidation preferences.
  • 38% of rounds had participating preferences.
The full survey is available here.

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Posted in startups, Venture Capital

Bobby Fischer Applied to Silicon Valley: Pattern Matching vs. Good Moves

Posted on July 26, 2011 | 4 Comments

When asked why he won so many matches, chess grandmaster Bobby Fischer would reply:  ”all that matters on the chessboard is good moves.”

That is, winning is all about the moves.  And moves, in turn, are all about the situation.  Contrast this to today’s Silicon Valley fashion of “pattern matching” which seems the opposite — all about the players and not so much about the moves.

Consider Blippy, a bad idea if there ever was one, which created a $13M VC sinkhole for a service to share credit card receipts on your social network.  Let’s look at the founders:  two recent Stanford engineering grads and an experienced entrepreneur, Philip Kaplan (most famous for bubble-era website,  F**kedCompany).

How about Cuil?  (Pronounced coo-il.)  Cuil launched in July, 2008 claiming to be the next Google with superior indexing and operational cost advantages.  It seemed clear to me (and the world) that from the start, Cuil wasn’t any better than Google.  They burned $33M in VC and entered theTechCrunch deadpool in Sept, 2010.  Let’s look at the founders:  three ex-Google engineers, two of them PhDs and one from Stanford.

When pattern matching is the rage, when the moves are so obviously bad, and when the players so clearly match the pattern, I’d argue that Blippy and Cuil broke Fischer’s law.  They weren’t about the moves; they were about the players.

I used to joke that if you wanted to raise money in Silicon Valley you should be aware that VCs see people in one of four buckets:

  1. Made me money before.
  2. Made someone money before.
  3. Went to Stanford
  4. Everybody else

Now, make no mistake, the team is has always been a key factor in venture capital investment.  But I think the historical approach was to see the team as de-risking element for the idea.  Put differently, we are investing in a market opportunity and we would like to isolate as much risk as possible to the market opportunity.  How do we do that?  By getting an experienced executive team to reduce execution risk, by hiring experienced engineers to reduce product development risk, etc.  That is, as VC founding father Don Valentine used to say, “great markets make great companies.”

(Asides:  [1] Irony alert in the above video where Don tells a bunch of Stanford graduate students it doesn’t matter where they go to school and [2] note further that Valentine was a pithy quote machine, coming up with such classics as “I am 100% behind my CEOs up until the minute I fire them” and “all companies that go out of business do so for the same reason – they run out of money.”)

Somehow I wonder if things haven’t gotten upside-down of late:  where the players matter more than the moves.  I’d argue that Silicon Valley used to be about the moves (the strategy and market opportunity) and VCs sought experienced players as a risk reduction technique.  Now, it appears to be about the players and the implicit assumption that those who match the player-pattern can win any match, regardless of the moves.

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Posted in strategy, Venture Capital

Why Palantir Makes My Head Hurt

Posted on June 27, 2011 | 22 Comments

While I’ve blogged before about Palantir Technologies (e.g., Beware the Spectacular B-Round Valuation), this will probably be my last post about them because, since leaving MarkLogic, I am no longer terribly involved in the Intelligence Community space nor engaged against them as an indirect competitor.

I initially became interested in Palantir for several reasons:

Part of the marketing was making controversial claims, such as:

  1. We have no sales.  (e.g., at minute 5:40)
  2. We have no marketing.
  3. We have no services.  (Our field technical staff aren’t consultants, they are forward-deployed engineers.)
  4. Positioning as a billion-dollar company when sales were probably in the tens of millions.
  5. Talking about valuation on funding rounds.

Now, as a credibility-is-key marketer, these kinds of claims bug me at two levels:  first, that people would make them and second, that the media would report them.  Here’s my take on these 5 claims:

  1. Whether you want to call it sales or not, someone meets customers, talks about what your software does, discusses how to price it, negotiates and signs a contract.  In the normal world, that is called sales.
  2. Whether you want to call it marketing or not, someone made the website, spent money to sponsor a party, setup the Charlie Rose interview, and designed and paid for the DC subway ads.  In the normal world, that is called marketing.
  3. Whether you want to call it services or forward-deployed engineering, you are sending smart people with engineering and computer science degrees to customers’ sites and helping them solve problems using your software.  In the normal world, those tasks are called pre-sales engineering and consulting, depending on whether they happen before or after a sale.
  4. The standard way, in the real world, to refer to a company’s size is by revenue.  The one and only time I frequently heard people referring to company size by market capitalization (or valuation) was during the Internet bubble.
  5. While this is primarily a style issue, most companies do not disclose valuation on venture funding rounds.  I believe those who do are trying to generate hype.  (And for a company that insists it has no marketing to want to generate hype is doubly irritating.)

At the big picture level, Palantir reminded me of MicroStrategy:  big claims and hype, DC-centricity,  elite school hiring focus, youth focus, a large field technical team, and a work hard / party hard ethos.

At this point I should admit to having some scars from having run marketing at Business Objects during MicroStrategy’s rise.  Let demonstrate what a day in life looked like:

  • Dave, MicroStrategy says their mission is to “purge ignorance from the planet.”  How come we can’t say anything visionary like that in our mission?
  • Dave, Michael Saylor says he’s going to build a modern-day Versailles just outside of DC.  How come our CEO never says stuff like that?
  • Dave, MicroStrategy says they’re building a service where people will wear tiny microphones in their ears and it will notify them if their house catches fire.  How come we don’t have product vision like that?
  • Dave, MicroStrategy just did a $52.5M deal in an industry where average sales prices are $250K and a big deal is a few million.  Why can’t we do huge deals like that?
  • Dave, Michael Saylor says that there will be riots if his software doesn’t work and that this year people will die — literally — because they didn’t buy his software.  How come we’re not mission-critical like that?

To which for several years I had to say “it’s all bullshit, it’s all bullshit, it’s a barter transaction and they’re double counting, and it’s all bullshit.”

It turns out being a naysayer isn’t fun work:  for three years you sound like a whining, doubting-Thomas constantly on the back foot, constantly playing defense and then one day you’re proven right.  But there’s no joy in it.  And the naysaying doesn’t help sell newspapers so you don’t get much press coverage.  And, in the end, all people remember is that “MicroStrategy was pretty cool back in the day” and “Dave’s a grump.”

It was during this period that I got interested in Corporate Cults because MicroStrategy struck me as one.

  • Hire young people with similar profiles from the best schools (e.g., MIT)
  • Work them long hours
  • Isolate them from friends and family
  • Blur distinctions between work life and personal life (e.g., company cruise, work hard / play together)
  • Tell them they’re the best
  • Tell them naysayers don’t get it

Six steps to make MIT engineers cult members.  Thus, in addition to other MicroStrategy parallels, Palantir struck me as a corporate cult.  Kind of a Logan’s Run (where no one is over 30) meets the Apple 1984 commercial (conformism à la the black jackets).

Since I left MarkLogic in January, Palantir got tangled up in the HBGary WikiLeaks mess (proposal here), generated some positive press in Forbes, and raised a $60M round of financing at a valuation rumored to be as high as $3B, bringing the total invested capital to an estimated $175M, a lot of money for an enterprise software company.

This begs the perennial question of “if they’re doing so well, then why do they need so much cash?”  While there are potentially both good and bad answers to that question, my guess is the answer is roughly:

  • Because they can raise it at huge valuations for relatively little dilution.  (Peter Thiel may be a huge help on this front.)
  • Because they intend to spend it to continue hiring and perpetuate the lavish-spending culture and hype machine.
  • Because they are executing a go-big or go-home strategy that is cash intensive and will, they hope, result in a huge exit valuation.

But why does Palantir make my head hurt?

  • Because, despite my general skepticism, I believe they get some things very right.
  • Because, despite their intent, they may have created a new kind of company.

Because I can be perceived as a Palantir detractor, I’ll say it again:  Palantir gets some things very right.  Which things?

  • They hire brilliant people.  They deliver on the hype in this department.
  • They solve hard problems.  I hear customers are generally quite happy.
  • They solve the whole problem.  They don’t just drop software in your driveway and run away.
  • They aren’t afraid to ask for huge checks, order of magnitude in the tens of millions.

Personally, I don’t buy the argument that all field technical staff are “forward-deployed engineers” as opposed to pre- or post-sales consultants.  But I would believe that you can hire better people by telling them they’re engineers as opposed to pre-sales consultants.  And, I could even believe that someone could convince himself — if perhaps not his accountants — that field technical staff are not customizing an application but instead developing a product.

That last point is important.  Why?

  • If field technical staff are engineers, then the associated revenue is presumably license fees and the cost is R&D.
  • If field technical staff are consultants, then the associated revenue is services and the cost is COGS.

Why does this matter?  Because most software company boards and investors see the world in a pretty black-and-white way:

  • License revenue is good.  Services revenue is bad.  (Largely because gross margins run 98% on the former and 20-30% on the latter).
  • R&D expense is investment and ergo good.  Cost of goods sold is bad.

Almost all Silicon Valley boards will want an emerging enterprise software company to run with a consulting business that’s no more than about 20% of total sales.  In practice this means a company can have at most about 1.5 consultants (pre- and post-sales) per salesperson.  Any work that can’t be done either as R&D investment or by that small consulting team needs to get handed off to partners.  This means the vendor loses control over customer success (which customers don’t like) and the vendor doesn’t end up owning all the IP required to solve the whole problem.

Now, my guess is that Palantir’s board doesn’t care about any of the preceding four paragraphs, probably because of cult arrogance:  we don’t care what pedestrian accountants say because we are changing the world and building the ultimate set of products.  Accounting, schmaccoutning.

This works well as a private company, particularly if you don’t plan on going public.  But the constraint on consulting growth hamstrings most enterprise software companies forcing them into a component-orientation, a drive-by license sales model, and a disregard for customer success — the traditional negatives that helped the drive the SaaS movement.

But, regardless of the reason, Palantir is a different type of company.

  • Like a system integrator (SI), they have a small sales force, a large field technical staff, solve whole problems, and ask for big checks.
  • Like a software company, they hire world-class engineers and try to capture everything in product.

Is Palantir an enterprise software company with no sales, marketing, or services (as they would like to believe) or are they the first SI to figure out how to build a world-class software business as most SI’s aspire?

You can argue the difference is just semantics, but I’d argue the latter.

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Posted in intelligence, Intelligence 2.0, management, MicroStrategy, Palantir, United States Intelligence Community, Venture Capital

Startups are Hard, Really Hard: Ergo Seek Mentors and Allies

Posted on June 25, 2011 | Leave a comment

A friend forwarded me a link to this presentation — So You Wanna Do A Startup, Eh?  I liked it so much, I thought I’d do quick post with some brief commentary.

Highlights:

  • Slide 30:  ”Seek Mentors and Allies.  This is the most important point I make in this entire presentation.”  Why it’s listed as bullet 5 on slide 30 is beyond me, but it is nevertheless a key point.  I’m doing some startup advisory work of l ate and I certainly believe that some friends with experience, wisdom, and connections can go a long way towards helping a new venture head down the right path and avoid some obvious mistakes.
  • Slide 11:  Five myths about startups, particularly myth 2 (the average tech startup founder is a 25 year old Ivy league dropout) and myth 5 (location doesn’t matter)
  • Slide 30:  Ask rejectors for feedback.  Critical.
  • Slide 36:  Too funny!
  • Slide 40:  I love the Venn diagram and also note that the delusional aspect that enables founders to do the impossible in starting companies can lead to problems later on.

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Posted in entrepreneurship, startups, Venture Capital

Interest Misalignments in Silicon Valley Startups

Posted on June 8, 2011 | 14 Comments

Everyone’s aligned in a Silicon Valley startup, right?  Give everyone some options so everyone has skin in the game and then everyone wants what’s best for the share price:  one for all and all for one!

Not so fast.

In this post, inspired by a chat with longtime serial entrepreneur Ken Ross, I’ll delve into what I see as the common alignment issues in Silicon Valley startups.  While I am a big believer in broad employee share ownership, one shouldn’t make the mistake of believing that simply because everyone has shares that they are automatically and permanently aligned.

In my estimation, there are four drivers of potential misalignment.

  • Portfolio theory
  • Shareholdings and net worth
  • The “exit” concept
  • Irrational considerations

Portfolio Theory

The most common cause of misalignment is driven by portfolio theory.  VCs typically invest in 10-15 companies and work in partnerships of 5-10 partners.  Thus a VC might get “carry” (i.e., a slice of the investment profits) on 50-80 companies.  A friend once calculated that a VC gets the equivalent of a VP-level (or better) equity stake in each of the portfolio’s companies.

Entrepreneurs and executives, however, have but one life to give and must work at one company at a time.

Divergence can result when VCs want to take more risk than founders and executives because they have placed 80 bets while the executives have placed one.  This can manifest itself in pushing for overly aggressive operating plans or declining “base hit” acquisition offers in favor of “swinging for the fences” each time.   Time can compound this divergence as accumulated sweat equity tends to make the founders and executives more conservative over time.  (Think:  ”I have 8 years of my life in this thing, we can’t take that risk.”)

In addition, VC is increasingly a “hits business” – i.e., a fund that delivered an IRR of 35% might deliver only 15% excluding its top two investments.  Thus, VCs are generally more afraid of selling too early than too late.  While founders often tell tales of VCs declining early acquisition offers that could have earned them a quick $20M, VCs might tell the tale of VMware, which sold for $625M in 2004 and is now worth $41B.

Portfolio theory has other effects that are more subtle.  You might think of a given venture-backed company as in one portfolio.  In reality, the company is in numerous “portfolios” at different levels:

  • The fund level.  The expectations for a company become a function of the performance of the other companies in the fund.  If they are performing poorly, pressure may increase to deliver a big result.  Alternatively, if the fund is old, has lackluster performance, and the VC firm has subsequently launched several high-performing funds, a lack of interest may develop.
  • The partnership level.  Different VC firms set have different investment objectives and reputations.  Some want to quietly deliver great returns.  Some favor operating guys as partners, other favor financial types.  Some like seeing their name in the press; some don’t.    As a general rule, the more early-stage and the more big-name the partnership, the more they will want portfolio companies to swing for the fences across the entire portfolio.
  • The partner level.  Each partner in a fund has his own set of companies.  VC partners track each other’s performance closely and a partner’s fate over time is, in large part, determined by his investment performance.  In addition, since most VC firms are fairly stove-piped, expectations for a given company are probably more shaped by its partner’s portfolio than any other.  Factors that influence the partner’s motivations include the performance his portfolio, his existing status in the firm (e.g., venture partner looking for a big-hit to make general partner, or established leader in the firm, or in-trouble and need of a big-hit to stay in the game), and his future plans (e.g., retirement).
  • The partnership-partnership level.  Suppose early-stage VC firm 1 does a lot of business with late-stage VC firm 3, as is often the case.  You can then think of your company in the “intersection” portfolio between these two partnerships.   Why does this matter?  To the extent that VC3 is dependent on VC1, they may make decisions that optimize the VC1/VC3 relationship over those that they might think best for a given portfolio company.  (Think:  “if Bob ever wants to work with us again, he’d better go along with us on this decision.”)

Shareholdings and Net Worth

The size of someone’s position, particularly relative to net worth, can cause a divergence of interests.  Consider a hypothetical company with 25M shares:

  • The founder owns 5M shares.
  • The total employee option pool is 5M shares.  (Of which Joe Engineer has 20K shares.)
  • VC1 owns 10M shares, having paid an average of $1.60/share across two rounds.
  • VC2 owns 5M shares, having paid $3.00/share in leading the second round.

Let’s consider a proposed $6.00/share offer for this company, for a total exit of $150M.

  • The founder would make $30M and be set for life.  He votes yes.
  • VC1 would receive $60M which does not move the needle relative to the size of his $600M fund.  On a return basis, he makes 3.75x, a poor result for an early-stage VC.  He votes no.
  • VC2 would receive $30M which moves his needle even less.  He makes a 2.0x return, low for a late-stage investor.  He votes no.
  • Neither VC partner will gain any bragging rights because the exit is small in an absolute sense.   This confirms their no votes.
  • Joe Engineer would get $120K pretax or about $60K post-tax.  He can buy nice car, but he still can’t touch a Silicon Valley house.  Joe doesn’t get a vote, but if he did, he’d vote no, too.

The interesting thing here is that Joe Engineer is much more aligned with Winston the VC than he is with the company’s founders and executives.  Joe would vote no for two reasons:  first, $60K after tax doesn’t move the needle for him and odds are (since he chose to work at the startup), Joe is a true believer in the technology and thus thinks of this deal as sell-out.  Amazingly, Winston votes no for the same reason:  $60M doesn’t do much for his fund and he also sees the deal as a sell-out.

Now, the founder would have made $30M and, using typical ratios, the CEO would have made $7.5M, and the key VPs somewhere between $1.5M and $3.0M.   In most cases, they would all vote yes.  (But in reality only the founder and CEO are on the board and actually get a vote.)

The scenario changes dramatically if the founder is already rich.  Imagine the founder made $100M on his previous startup.  Now, a $30M exit is uninteresting because it results in neither a lifestyle upgrade nor a status change.  Now, the founder aligns with Winston and Joe in voting against the deal.  You can analyze the CEO’s vote in a similar fashion.

The “Exit” Concept

Managers want to build great companies; VCs want great exits.

Unfortunately, building a great company is neither a necessary nor sufficient condition to enable a great exit.  At only 3 years old, Bebo sold to AOL for $850M.  A spectacular exit, no doubt, but a little more than 2 years later AOL sold it for less than $10M.  A great company?  Certainly not.  YouTube, while infinitely more ubiquitous, barely makes money but was sold to Google at 18 months old for $1.65B.  A great exit?  Yes — goosebumps quality even.  A great company?  Not.

The best managers tend not to focus on great exits.  They focus on building great companies.  In fact, the “IPO as exit” is almost purely a VC notion.  In reality, an IPO is almost certainly not an exit for the CEO; he or she is de facto bound to the company for at least the next several years and his/her ability to sell shares is highly restricted.

I have always believed that IPOs are like high-school graduations – they are a beginning, not an end.  Godfrey Sullivan, CEO of the red-hot company Splunk, seems to feel similarly, saying “we consider an IPO the 3rd mile of a marathon. The IPO is an early milepost, not the destination.”

In the best-case scenarios, building a great company will indeed lead to an IPO which will be yet another milestone in a long journey of success.  But this is not always the case.  I’ve seen companies (e.g., Versant back in the day) twist into pretzels to make it through the IPO window and provide a reasonable exit for the investors only to end up living-dead zombies thereafter.

Now, I have not found the particular VCs with whom I have worked over the past 20 years particularly exit-focused.  Most are surprisingly patient and indeed want to focus on building great companies.  But, you cannot ignore the possibility of divergence when some of the passengers can exit the bus reasonably quickly post-IPO while others cannot.

The terminology “exit” reflects this pretty clearly.  For employees, customers, staff, and executives, the IPO is not an exit.  Nor, for that matter, are most acquisitions.  Founders, key executives, and key staff are often locked in (through various mechanisms) for 1-3 years after a deal closes.

Irrational Considerations

As humans, we must recognize that we do not always act rationally.  Behavioral economics reminds us that we are subject to a bevy of rules and heuristics that can cause us to make sub-optimal decisions.

Some decisions that appear irrational are rationally motivated  – but by either an unknown personal or non-shared goal.  Others actually are just plain irrational.  For example:

  • Anchoring:  I need to make $50M.  (Because I decided that I need to make $50M.)
  • Benchmarking:  I need to make $50M.  (Because my roommate at Stanford made $50M and I’m smarter than he is.)
  • Fame-seeking:   I need to be famous and will take increasingly risky bets in order to achieve that.  (Arguably this is a rational decision derived from a non-shared goal, but if you are on the board of a company you have a duty to its shareholders so I’d argue it’s irrational from that perspective.)
  • Dreaming:   This technology is going to change the world, despite much evidence to support that contention.  (Because I made it and it’s really cool.)
  • One-more go:  I will take increasingly risky bets because I’m retiring soon and this is my last chance to get one more for my legacy.  Shoot the moon.

The trick here is most founders are, by definition, a little crazy.  The confidence and zeal it takes to quit one’s job, develop a product idea, start a company, and raise venture capital is well beyond that of the average “reasonable” person.  Thus, it can be hard for founders to know when to stop pressing bets.  The same traits that enabled them to be successful as founders present a risk they overplay their hands, and destroy shareholder value in the process, in the long term.

Conclusion

In this post, I’ve tried to highlight some of the common sources of potential misalignment between the various shareholders of a startup enterprise:  founders, venture capitalists, CEOs, executives and rank-and-file staff.  Hopefully, I’ve demonstrated that things aren’t as simple as they might appear and that just because everyone might own shares, doesn’t mean they have aligned goals and motivations.

If you think I’ve missed any good examples, please let me know.

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Posted in management, strategy, Uncategorized, Venture Capital

Highlights from the Jeffries Enterprise Software Update, March 2011

Posted on March 29, 2011 | Leave a comment

Jeffries puts out a very nice enterprise software monthly update (with mile-long disclaimers and which does not seem to be freely distibuted on the Internet so I cannot link to it).

Nevertheless, I thought I’d share some of the salient highlights from this month’s version.

On M&A:

  • 7 M&A deals in February with consideration above $20M, flat year/year and up from 6 quarter/quarter.
  • Median adjusted price/revenue multiple of 2.4x, up from 1.8x year/year and 1.9x quarter/quarter.
  • TTM median adjusted price/revenue multiple of 3.0x, up from 2.3x year/year and flat quarter/quarter.

On public company valuations (enterprise value to TTM revenue multiple) by category:

  • Virtualization:  7.8x
  • SaaS:  5.8x
  • Healthcare IT:  5.1x
  • Human capital mangement:  4.9x
  • Enterprise content management:  4.2x
  • Data mangement: 3.9x
  • Business intelligence:  3.5x
  • Infrastructure software:  3.1x
  • Systems management: 3.0x
  • Security management:  2.2x
  • ERP:  2.1x

On recent IPOs (median of 8 recent, including Smart, QlikTech, IntraLinks, RealPage, SciQuest, ChinaCache, SkyMobi, and Velti):

  • Most recent quarter revenues:  $26.2M
  • Revenues (year of pricing):  $138M
  • Revenues (forward):  $189M
  • Annual estimated revenue growth:  23%
  • Operating margin:  16%
  • Forward net income:  $20.3M

On the IPO pipeline:

  • 34 companies
  • $6.2B in filings (in proceeds raised by the companies)
  • Filing size:  $182M mean, $100M median (amount proposed to be raised)
  • TTM revenues:  $575M mean, $148M median
  • 52 filings in 4Q10, down from 61 in 4Q09, and down from 63 in 3Q10, yet up from the dark days of 4Q08 (6) and 1Q09 (4)

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Posted in IPO, valuations, Venture Capital