Category Archives: Venture Capital

The Mythical World-Class Manager

Posted on September 5, 2010 | 8 Comments

If I had a dollar for every time a venture capitalist said “world-class,” I could start my own venture fund.

But rather than dismissing world-class as a tired cliché, in this post I’ll spend a few minutes trying to understand what VCs mean when they say world-class and why they say it so often. As always, I’ll add my personal take on the issue along the way.

First, let’s start with a definition: world-class, quite literally, means among the best in the world.

World-class chess players come from all over the world to play each other at events like the World Chess Championship. World-class tennis players come from all over the world to play each other at events like the US Open. Once in a while someone who’s very, very good — but not quite world-class — gets into a world-class competition and receives a quick reminder about what world-class really means. Think: yesterday’s 6-0, 6-0 routing of amateur teenager Beatrice Capra, ranked 371st in the world, by Maria Sharapova.

So how does world-class apply to Silicon Valley managers?

There are world-class companies at which one may have been formerly employed. Oracle in enterprise software, Google in Internet search, SAP in enterprise applications, PayPal in Internet services, IBM in databases, VMware in virtualization, Salesforce in SaaS-delivered CRM, or — let’s not forget — BusinessObjects in BI.

There are world-class universities from which one may have graduated. Favorites in Silicon Valley including Stanford, MIT, Berkeley, Carnegie Mellon, and Harvard.

There are world-class exits. VCs are in the business of generating returns for their limited partners. Operational managers are in the business of building companies. Often, these two goals are aligned; sometimes, they are not. I world argue, for example, that YouTube at $1.7B and Bebo at $850M were world-class exits. I don’t believe either were world-class companies. Google is still struggling to make an operating profit off YouTube, let alone get an return on the $1.7B invested. AOL shut down Bebo just two years after buying it.

I believe that when VCs say world-class they mean primarily two things:

Fits the part. You can think of Silicon Valley recruiting agencies as central casting: “somebody call central casting and get two Nerds and a Bimbo.” Think: “somebody call Heidrick and get two sales RVPs and a marketing guy.” Fitting the part often entails having attended the right universities and worked at the right companies. For certain jobs, it entails personality traits — the room should hush when the world-class sales VP enters. The world-class corporate development VP should be as inscrutable as destiny. I’d dare say it might also tacitly include being the right age or gender, which I believe is one major problem in the Silicon Valley system that I otherwise admire.

Has been part of a team that delivered a world-class (or at least regional-class) exit. That is, someone who’s made somebody — preferably me — some money.

I believe that as a result you end up with two types of “world-class” managers: drivers and passengers. To get into the club, you need to have attended great school X, worked at great company Y, and been on a team that delivered great results Z. But, once in the club, you find two types of people: those who were key to driving those great results and those who — despite being very good in many respects — were just along for the ride.

This is not lost on all VCs. I remember when interviewing at MarkLogic that a well known and very smart VC kept probing me in certain areas during the interview. The prodding continued to the point where I exclaimed: “oh, you’re trying to figure out if I was a driver or a passenger on the BusinessObjects bus!” While purely spontaneous, the exclamation was probably worth its weight in gold. Mere awareness of the dividing line is a good indicator as to which side of it you’re on.

Strategically and operationally, I think there is a huge difference between drivers and passengers that comes out when they are placed in a new situation. When placed in their next company:

Drivers assess the situation and develop strategies and tactics appropriate for the new reality.
Passengers do what worked last time.

Due to some smart choices (Berkeley), some work (an MBA), and some luck (a battlefield promotion at Versant), I have been an e-staff level executive in enterprise software since 1993. In those 17 years, I have seen a lot of world-class managers come and go. And I am repeatedly stunned by the number of otherwise very intelligent people who show up and do what worked last time. Often with the very same cohort / entourage with whom they did it.

Now, for passengers, to the extent that this-time is situationally similar to last-time, things are actually quite good. However, disaster strikes when it is not.

I’d say there are three key traits for recognizing passengers:

Ego. Ironically, drivers tend to be more humble about their past successes than passengers. Drivers understand that role that teamwork and luck (i.e., right place at the right time) played in their success. Passengers, on the other hand, tend to give themselves undue credit for just about everything, ignoring the possibility of Fooled by Randomness effects.

Showing up with all the answers. When you ask drivers “what are you going to do?” at new company X, they will say something like: “I have no idea. I need a few months to assess the situation and then make a plan.” Passengers, on the other hand, will quickly bark off a list of 10 things that need to happen in the first 100 days.

Job hopping. I think passengers end up job hopping as a result of their desire to repeat the formula. When it works, they stay and often succeed. When it does not, they bail. In fact, quick bailing is a key success strategy for passengers: you can/want to do X, so go find situations where X is what’s indicated. Drivers will tend to do longer gigs with different strategies and tactics. Passengers will tend to do in-and-outs repeating the same strategies and tactics.

I think for some VCs the world-class manager is actually a form of hope, a silver bullet in which they want to believe: “if we could just get someone world-class in here, then everything would be better.” I’m sure that sometimes works out, but I wonder if it wouldn’t work out just as well substituting the word “competent” for “world-class.” As in: “if we could just get someone competent in here, then everything would be better.”

In my 17 years watching lots of e-staff-level execs come and go — all of them “world-class” on their start dates — I have to say I’m a skeptic. I’ll go for people who are drivers, people who reason, and people with low egos any day over the alternative.

That’s not to say that I don’t believe in excellence: Steve Jobs is world-class. Larry Ellison is world-class. Hewlett and Packard were world-class. Marc Benioff is world-class. Tom Siebel is world-class. Bernard Liautaud, while lesser known, is also world-class. World-class does exist. But just as Maria Sharapova doesn’t give tennis lessons, none of the aforementioned proven world-class managers is going to work at a startup.

I suppose you could introduce a concept like weight-class, as a surrogate for corporate size, to the equation in order to add a dimension: she’s a world-class, welter-weight marketing VP or he’s a world-class, bantam-weight CFO. While there is certainly some truth to the idea that different executives prefer different size ranges, this just piles subjectivity on subjectivity.

That’s what I think about world-class. What do you think?

(Revised 9/7/10.)

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Posted in management, Venture Capital

Highlights from the Fenwick & West Venture Trends Report

Posted on August 14, 2010 | Leave a comment

Just a quick post to highlight some interesting facts from Fenwick & West’s (F&W’s) quarterly Silicon Valley venture capital survey.

Valuations are up. Up-rounds beat down rounds 55% to 27%, with flat rounds making up the difference. F&W’s venture capital barometer showed an average price increase of 30%.
DowJones VentureSource reported that $7.7B of VC was invested in the US in 2Q10 across 744 deals.
VentureSource reported 79 acquisitions of VC-backed firms, for a total value of $4.3B
There were 17 VC-backed firms that executed an IPO in 2Q10, compared to 9 in 1Q10
Fundraising by VCs declined in 2Q10, with 38 firms raising $1.9B, compared to 38 firms raising $3.7B in 1Q10
90% of VCs surveyed expect the number of venture firms to decrease between now and 2015. (I suppose they all think it’s the “other guys” who are going to fold.) Reasons cited include: difficultly in achieving successful exits, unfavorable tax policy, and an unstable regulatory environment
The Silicon Valley Venture Capitalist Confidence Index produced by USF professor Mark Cannice declined to 3.28 in 2Q10 from 3.65 in 1Q10, breaking a five-quarter streak of increases. The drop was attributed to shocks from the macro economy and shocks to the venture industry itself.
18% of rounds in 2Q10 were A rounds
27% of rounds were up rounds
Of down rounds, D rounds led by series at 36% of down rounds
Software had 34 financings with 73% up and a barometer increase of 51%
Internet and digital media had 23 financings with 52% up and a barometer increase of 43%
40% of rounds had liquidation preferences
17% of those rounds with preference had multiple liquidation preferences, 71% of those were in the half-closed interval (1,2]x
35% of rounds had participating preferences

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Posted in Venture Capital

Highlights from the 2Q10 Software Industry Equity Report

Posted on August 12, 2010 | 2 Comments

It’s a been a while since I’ve done one of these posts, so I thought I’d take a minute and pull some highlights from the very useful quarterly report done by the Software Equity Group.

Following IT spending increases of 9% in 2007 and 6% in 2008, IT spending declined 10% in 2009
Goldman Sachs forecasts IT spending to increase 7% in 2010
Web conferencing and email top CIO SaaS adoption at 27% and 21% respectively
BI and data warehousing are at the bottom of CIO SaaS adoption at 1% each. BI-as-a-service still seems to have trouble taking off; while I hear good things about Birst, one cannot forget LucidEra

Median enterprise value (EV) to revenue (R) ratio of public software companies was 2.1x
$1B+ companies have a median EV/R ratio of 3.1x
<$100M companies have a median EV/R of 1.1x. This means the size arbitrage lives on; big players can buy revenue at 1.1x and sell it at 3.1x
The median public software company (in the SEG Index) has an EV/R of 2.1x, EV/EBITDA of 12.8x, EBITDA margin of 16%, TTM revenue growth of 0%, and TTM revenues of $218M
SuccessFactors, Concur, and Salesforce are high flyers on the EV/R ratio at 7.6x, 7.5x, and 7.5x respectively
SaaS companies have a median EV/R of 3.4x, EV/EBITDA of 32.3x, EBITDA margins of 9.2%, and TTM revenue growth of 11%
SaaS companies with above-average growth had an EV/R of 4.2x while those with below-average growth were at 2.2x

There were 5 IPOs in 1H10: SS&C, SPS Commerce, Convio, Broadsoft, and Motricity
The median offering amount was $58.7M
The median enterprise value was $203M
The median EV/R was 3.8x
The median EV/EBITDA was 42.5x
The median first-day return was 1.4%

7 software companies filed S-1′s in 2Q10: Qlik Technologies (about whom I blogged here), IntraLinks, Tangoe, RealPage, Ellie Mae, Tripwire, and AutoNavi
4 of those 7 are on the SaaS model
The median proposed offering is $86M
The median annual revenues is $73M
The median net income is $10M
The median TTM revenue growth is 20%
This suggests a shift from the 50/50/0 IPO bar that I have previously discussed based on these reports (i.e., $50M+ in revenues, 50%+ growth, and 0% EBITDA). These medians suggest a higher bar in terms of both revenue and profit, but a lower bar on growth. Note that the bar is inherently a flexible concept (e.g., smaller size can be offset by higher growth) and one that most definitely changes over time.

There were 507 software M&A deals in 2Q10
Total value of the M&A deals was $17.5B, up dramatically from $4.3B in 1Q10 and $3.3B in 2Q09
The high dollar volume was boosted by mega-deals including SAP/Sybase ($5.4B), TPG/Vertafore ($1.4B), IBM/Sterling ($1.4B) and Allscript/Eclipsys ($1.2B)
The median M&A deal was done at a EV/R of 2.1x and EV/EBITDA of 12.0x
By category, development tools and IT asset management topped the M&A EV/R ratio at 3.5x, with healthcare in second at 2.7x, and BI/GRC at 2.6x. ERP and messaging/communication were at the bottom with EV/R of 1.0x and 0.9x.

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Posted in Venture Capital

Beware the Spectacular B-Round Valuation

Posted on June 26, 2010 | 18 Comments

Visualization tools startup Palantir announced a follow-on financing round yesterday, raising $90M at a claimed $735M valuation. Since most people aren’t familiar with either finance or VC math, this can generate confusion so I thought I’d do a post explaining a few things.

The first is simple: do not confuse valuation with revenue. Valuation (or for public companies, market capitalization) is an implied metric based on per-share price and number of shares outstanding. For example, a public company with 50M shares and a $20 share price has a valuation of $1B. That alone says nothing about its revenue. TechCrunch makes this mistake three times in the story, calling Palantir “the next billion-dollar company” in the headline, saying they’re a “near-billion dollar company” in the middle, and at the end, saying they are close:

It’s hard to imagine a billion-dollar company without a sales team, but then again Palantir is getting pretty darn close.

This is simply not true. By my guess, Palantir is doing somewhere between $25M and $50M in GAAP revenues — nowhere near $1B. Furthermore, while I hate to be technical, I could easily believe they are doing less: as I understand their model, recognizing GAAP revenues should be a nightmare — e.g., calling all field staff engineers and claiming no services business implies field-based R&D implying the need to defer revenues until product completion for a given customer.

The second confusion is more subtle and relates to a quirk in VC math that makes an early round investor, who believes in the company and has cash to put to work, valuation neutral on subsequent financing rounds. In fact, you could argue that they’re not valuation neutral, but positively biased because they mark their existing shares to the new valuation when reporting back to their limited partners.

Reminder: I am no longer talking about Palantir in specific because their capital structure is both private and presumably more complicated than I describe here. I am trying to show, in general terms, how some quirks result in early-round investors liking higher subsequent-round valuations — even when they’re buying shares at those higher prices.

For a quick primer on VC math and terminology, go here. Now, let’s examine a spreadsheet I built to concretely demonstrate the mechanics of what I’m talking about.

In my example, a hot company manages to raise a $24M A-round at a pre-money valuation of $36M. This is unattainable for most entrepreneurs, but let’s say you made a lot of money on your last gig and thus have some friends in the venture capital community who believe in you. Note that as part of this round, VC1 has invariably negotiated himself the right to avoid dilution in subsequent rounds. Since he owned 40% of the company after the A-round, he thus has the right to purchase 40% of any new shares sold by the company going forward. This is called exercising his pro rata.

Now it comes time to do the B-round. Let’s say that things are going well and that the company somehow thinks it should be able to raise $30M at a $180M pre-money valuation. That’s scenario I in my spreadsheet. Let’s see what happens. (Click to enlarge.)

In the B-round, the company sells 5M new shares at $6/share for $30M.
VC1 chooses to fully exercise his pro rata and thus buys 2M shares for $12M.
That leaves 3M shares for the new investor, VC2, who pays $18M.

Seems like a pretty good deal, but wait. If you’re executing the go-big-or-go-home strategy which both you and VC1 agree is appropriate, then $30M isn’t enough. You decide you need $90M. That’s scenario II in my sheet:

You issue 15M shares at $6/share to get $90M.
VC1 exercises his pro rata and buys 6M shares for $36M.
VC2 buys 9M shares for $54M.

Everybody’s happy, but then you look at founders and employees whose ownership has dropped from 60% before the round to only 40% after. Most people would call this a 33% dilution (20 divided by 60), though some would call it a 20% dilution (60 minus 40). Either way, while this scenario raises the money needed, the team loses a lot of ownership in the process and doesn’t like that one bit.

Then, the creative type on the team says: “I can solve the problem.” See scenario III:

Why sell 15M shares at $6 when we can sell about 4.3M shares at $21 to get the same amount of money? We’re better off, keeping 52% ownership for ourselves, and the great part is VC1 doesn’t care. No matter the valuation, if we’re raising $90M and if VC1 is exercising his pro rata, then he’s in for $36M– see the boxed cells on the spreadsheet. All we need to do is to get together with VC1 and find some dumb money willing to pay $54M for 8% of the company. There’s plenty of dumb money out there these days and if we can’t get it in one investor, then maybe we can build a little consortium of a few.

And while we might view VC1 as valuation-neutral from one perspective, we shouldn’t forget that he has a boss, too. He reports back a few times / year to his limited partners. If we do the deal at $630M pre-money, then he can mark up his A-round shares from $24M to $252M in value, showing a 10x paper return to his investors.

I am not saying this has or has not happened with any given company. I would like to make the important note that the whole notion of “dumb money” is at odds with free market theory. I’ll also add that I know some quality VCs advise limited partners to ignore investment marks-to-market, but I doubt they all do. Nevertheless, I hope this story shows that there’s potentially more than meets the eye in the world of venture financing, driven largely by the dual role (owner and seller) played by the existing VCs and founders/employees.

So what do I think it really means when a company announces a big round at a high valuation? I think it means that:

The company is trying to build and/or sustain a hype bubble and wants to be seen as hot. Most VC-backed companies do not disclose valuations.

The company is executing a “go big or go home” strategy that I’d argue increases the risk for its customers. Remember, Amazon went big. Webvan went home. See the Fit or Fat Startup Debate launched by Ben Horowitz and countered by Fred Wilson for an examination of such strategies from the VC point of view. In my estimation, sometimes they produce a great result, often a great crater, and rarely a great business. Ironically, you can get nice exit valuations off such strategies but not great multiples.

The company has a supportive A-round investor willing to invest real money and who believes in the go-big strategy.

The company intends to spend the money, either because it must in order to sustain the current burn rate or because it wishes to expand into other areas. The former signals unsustainable situation, the latter signals a potential loss of focus.

If things don’t go as the company plans, the dumb-money will put constant pressure on management to be aggressive, reminding everyone of the expectations they bought into. This can make it hard to back off and change direction in the event of bumps along the way.

The company could have trouble exiting at otherwise reasonable valuations, especially if the dumb-money controls a class of stock. Think: “I need at least a 2-3x on this investment.”

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Posted in Palantir, Venture Capital

The Fit or Fat Startup

Posted on April 7, 2010 | 2 Comments

As I sit here at Palantir’s Govcon 5 conference at the lavish Ritz Carlton in Tyson’s Corner (Virgina), I can’t help but think about the recent “fit or fat” startup debate that hit the blogosphere a few weeks back. The debate started with a post by VC Ben Horowitz of Andreessen Horowitz entitled The Case for the Fat Startup. Excerpts:

The [Sequoia RIP Good Times] presentation catalyzed a movement. Startups everywhere adopted a lean, low-burn, low-investment model. To this day, companies seeking funding at our venture firm, Andreessen Horowitz, proudly proclaim in their pitch decks that they are raising tiny amounts of capital so they can run lean.

Here is my central argument. There are only two priorities for a startup: (1) winning the market and (2) not running out of cash.

Running lean is not an end. For that matter, neither is running fat. Both are tactics that you use to win the market and not run out of cash before you do so. By making “running lean” an end, you may lose your opportunity to win the market, either because you fail to fund the R&D necessary to find product/market fit or you let a competitor out-execute you in taking the market. Sometimes running fat is the right thing to do.

The part of his argument with which I agree is the “sometimes.” The simple fact is that strategy must be a function of situation and there are indeed some situations (e.g., landgrabs) where the run-fat model is required. By landgrabs, I mean the early days of new, destined-to-be-large markets with sufficient switching costs so as to realistically justify losing lots of money in the quest to establish market leadership. Examples include Amazon in online retail and PayPal (which raised $194M) in online payments. Remember these strategies do not always end happily: WebVan consumed $1.2B in venture capital before it went bankrupt in 2001. Hence my two key criteria:

A destined-to-be-large market (WebVan missed here, the market for web-ordered groceries today is still non-existent)
Sufficient switching costs to justify the years of major losses (many online retailers who “sold dollars for ninety cents” were surprised to find their customers disappeared when they tried to sell them for $1.05)

When you “go big or go home,” sometimes you go home. I’d argue that the media biases us by looking primarily at successes, not failures, artificially reducing the perceived risk in such strategies. It’s a bit like saying inner-city youth can escape the inner city through athletic scholarships. Yes, it does happen. And yes those athletes sometimes become rich and famous. But simply because it sometimes works, you cannot argue it’s a good strategy.

I was going to use Oracle as example because they played the landgrab game superbly in the early days of the RDBMS market. But I think they only raised $10M or so before their IPO in 1986. (Vent: I just wasted 30 minutes trying to find a precise answer). So unlike the go-big VC burners, Oracle largely self-funded its ten-year journey to $50M. My prior employer, Business Objects, raised a total of less than $5M in VC.

The debate picked up steam when fellow VC Fred Wilson of Union Square Ventures responded with a post entitled Being Fat Is Not Healthy. Excerpt:

In short, since I started investing in the web in ’93/’94, I have invested in about 100 software-based web companies. And the success rate of fat companies versus lean companies is stark. I have never, not once, been successful with an investment in a company that raised a boatload of money before it found traction and product market fit with its primary product.

Boatload is a subjective term. So is traction. So is product market fit. And so is successful. So let me try to define them in the way that I think about them. A boatload of cash is more than $20mm of invested capital. A boatload of cash is monthly burn rates of tens of millions of dollars. Traction and product market fit are customers or users buying or using your product in droves. It is the realization that you’ve found the sweet spot of the market you were going for. And successful is an investment that pays out multiples of the dollars we invested in it. Getting our money back is not successful in my book. Getting three times our money back is good. More than that is great.

Let me say it again. I have never been involved in a successful software-based web service that raised and spent boatloads of money before it found it’s sweet spot. But it has happened. The Loudcloud story that Ben lived and tells in the All Things D post is proof that it can happen.

You can also win the lottery. The odds aren’t great that you will. But millions of people play it every day. I don’t.

Basically, I agree with Fred, with the sole exception of those Amazon- and PayPal-like landgrabs that really are one-shot opportunities that someone is going to win. The problem is that entrepreneurs, being rabid and optimistic, assume they are in that 1-in-1000 situation about 95% of the time.

Back to Palantir, I think they’re pretty clearly playing the “fat” strategy. That’s logical because the founders are from PayPal and are undoubtedly applying some rewind/play logic from those days and should certainly have some survivor bias because — well — it worked last time. (Try convincing a lottery winner that buying lottery tickets is, on average, a very bad idea.) While they’ve raised $35M to-date, I suspect they’ll be raising another round soon, especially if they are to grow from 250 to 400 employees by December 31st as CEO Alex Karp said this morning.

My issue for Palantir is that I don’t see a landgrab market opportunity which they (see prior points) most certainly do. The technology looks like a set of nice data visualization and graph analysis tools; kind of a nice suite of graph-centered BI tools for tracking entities, relationships, events, and documents across collections of unstructured and structured data tapped from various repositories. While the front-ends are sexy, and most likely easier to use than what they’re replacing, if you think using traditional BI tools is tough, I think these tools are harder. Search meets BI this ain’t.

Visualization companies have had a checkered history in enterprise software, with the most successful being vertical and application specific (e.g., Spotfire), so I think Palantir’s vertical focus on government is a good one. They seem also to make an effort in finance, but my gut feel is that they’re 90% government. The company is good at PR, has some creative and interesting management philosophies (e.g., 210 of the 250 employees are supposedly “engineers”), and has a professorial and clearly very intelligent CEO.

Operationally, I think they’d be an excellent partner for Mark Logic because we specialize in back-end heavy lifting and (whether they’d freely admit it or not) everything I saw today strikes me as front-end and/or data aggregation, as opposed to data management, technology. I know we have some partners in common and I believe some customers may have integrated the systems.

Could Palantir be BusinessObjects for unstructured data? I don’t think so — the technology seems too specialized and too hard for the average user; it’s clearly made for analysts. On the other hand, could they be MicroStrategy? Maybe.

Either way, they’re one of very few enterprise software startups these days playing it fat. If I’m right, they’ll be raising another round in the next few quarters, probably at a nice valuation, and basically playing Horowitz’s playbook. On verra.

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Posted in strategy, Uncategorized, Venture Capital

Veterans vs. Up-and-Comers in Startups

Posted on March 21, 2010 | 2 Comments

The conventional Silicon Valley / venture capital (VC) wisdom is that startups should not bet on first-time managers in just about any position, but particularly at the executive team level. It’s best captured by the statement: a high-growth startup is not the place to learn how to do your job.

This is the conventional wisdom because, while counter-intuitive to some, VCs are not actually risk-takers, they are risk-isolators. A typical VC is trying to isolate risk down to one thing: the unique value proposition behind the startup. Those value propositions can vary considerably:

Sometimes, it’s about the technology. Mark Logic, for example, is a technology disruptor.
More in vogue these days, it’s about the business model. Salesforce disrupted the on-premises, perpetual license business model with SaaS. MySQL disrupted the traditional license model with open source.
Sometimes, it’s about both. My friends at Clearwell will rent you an appliance that includes an innovative e-discovery application.

But the point is that VCs are trying to isolate risk down to the one key value proposition. They do that by setting every other lever in the business to standard. For example, per the conventional wisdom, a SaaS BI business model disruptor should:

Hire standard managers with experience in big BI companies, and use equity to lure them from their cozy jobs.
Develop a standard BI application/product that contains the features users expect.
Build a standard enterprise sales force, hiring salespeople from the established BI vendors
Implement a standard BI partnering strategy, with the usual suspect technology and systems integration partners
Devise a standard marketing strategy, typical of those used by other BI companies but with a key emphasis on the unique value proposition.

Like most VC wisdom, at the first order the approach makes a lot of sense. At the second order, however, it presents some problems.

It encourages cronyism, where the first such experienced manager knows a whole clan of other folks who also are looking for jobs, often for the same reason he or she was (e.g., recent of acquisition by Oracle, a new CEO, a strategy shift). While one of the benefits of hiring experienced managers is undoubtedly their networks, I’ve seen this work out both quite well and spectacularly badly. The key issue boils down to whether you are hiring drivers or passengers. Was the company from which you’re hiring successful because of these people, regardless of these people, or indeed in spite of them? Are you hiring real results drivers or people who, Fooled by Randomness, have great resumes and think very highly of themselves, but who are incapable of solving your company’s problems?

This cronyism often creates a divisive environment that drives out your top existing talent. As the “Company X” mafia takes over, they typically show insufficient respect for those who got the company where it is, ridicule some past practices, and talk boisterously how easy it’s going to be to fix all this. While problems in operational practices are easy to spot and fix, this approach overlooks the startup’s need for process maturity (e.g., size relative to Company X) and the startup’s strategic position in its market. I remember when the experienced (manufacturing-oriented) managers from ASK took over Ingres (then a ~$200M company) and decided that implementing a heavyweight quality process was the answer to our problems. In reality, our problem was strategic: in a land-grab market we’d made some poor technology choices (e.g., Quel vs. SQL) that hampered sales and we had been too conservative about grabbing land. Just as the Ingres executive team’s only hammer was technology, the ASK executive team’s only hammer was process. Neither, unfortunately, was called for given the company’s situation.

It limits career growth for talented up-and-comers within the company: either individuals with management potential or existing managers with executive staff potential. If every new management job will be filled by an experienced outsider, then insiders quickly feel trapped and unable to advance in their careers, making them — particularly the more ambitious ones — more likely to leave the company.

The answer to managing all this is, of course, balance. Both the CEO and the executive team need to take some calculated risks in betting on up-and-comers in a number of posts. This generally will cost the CEO some political capital (debited at promotion time and never credited back, even if the up-and-comer is highly successful), but will help him or her retain both institutional memory and some key people for the future of the company.

Having a stronger-than-usual preference for up-and-comers, I’ve developed a few rules for managing this process.

Always do a external search. You can turn the dial on how hard — from a check-the-network or calling a few contingency recruiters all the way up to a retained search — but you should always expend energy to see “who’s out there” so you have a sense of the market in making the veteran vs. up-and-comer decision. You owe this to yourself, your board, and your shareholders.

Run up-and-comers through the same process as the external candidates. The only exception here is when you are restructuring in which case many people may be changing roles without following an interview process.

Keep a mental balance of how many up-and-comer chits you have used and how many you think you have left. You need to view them as a scare resource, because they are.

Ensure the up-and-comer is “all in.” If you are going to bet political capital on someone they can’t either be [1] telling you what you think you want to hear or [2] be unsure of whether they can do the job. You should only bet on up-and-comers who are certain they can be successful, and so certain that they will probably quit in the not-too-distant future if not offered opportunities.

Limit up-and-comers’ ability to bet on other up-and-comers. Force them to prove they merit their posts by demonstrating how they can bring in veterans. This is a both a solid practice and a great test. The worst outcome is that your up-and-comer hires no veterans for his team and you end up with a whole multi-level hierarchy of inexperienced people. (I’ve seen this happen, too, though happily not in my department and it’s one heck of a mess because there is typically no organizational awareness that anything’s even wrong! )

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Posted in management, Silicon Valley, startups, Uncategorized, Venture Capital

Mark Logic Highlighted in San Jose Mercury News Story on Venture Capital

Posted on November 23, 2009 | Leave a comment

I’m pleased to report that Mark Logic was highlighted in a San Jose Mercury News story published yesterday about the resurgence of VC-backed startups one year after the famous Sequoia Rest in Peace Good Times meeting.

The story was published as part of the Mercury New’s quarterly venture capital survey.

The story begins:

When Dave Kellogg arrived at Sequoia Capital on that day in early October 2008, “the last chair in the room was in the front row,” he recalled. “My penance for being a little bit late.”

Kellogg is the CEO of Mark Logic, a startup that helps business clients make sense of the chaos of unstructured data. He wound up with an excellent seat for an auspicious moment in Silicon Valley lore — the “R.I.P. Good Times” briefing that drove home the severity of the financial industry crisis for the startup economy. Initially intended exclusively for leaders of companies backed by Sequoia’s investments, it would be inadvertently leaked by one CEO and sail around the Web like an early Halloween ghoul.

Not only has the story received great visibility in Silicon Valley, a quote of mine from it was picked up by the Wall Street Journal’s Venture Capital Dispatch blog, here.

The full story is available here. The Mercury News quarterly venture capital survey is here. Another recent piece of Mark Logic business press coverage, from the San Jose Buisness Journal, is here.

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Posted in Mark Logic, Sequoia Capital, Venture Capital

Highlights from 2Q09 Software Equity Group Report

Posted on August 4, 2009 | Leave a comment

I’m not sure which better explains my recent decrease in blog post frequency: bit.ly or being out of the office. Either way, I wasn’t kidding a few weeks ago when I said I’m changing my sharing pattern. Much as popular business authors take one good idea and inflate it into a book, I now realize (thanks to bit.ly) that I have been taking what could have been one good tweet and inflating it into a blog post. While I’ve not drawn any definitive conclusions, thus far I’d say I’m sharing many more articles with significantly less effort than before.

Going forward, my guess is that steady state will be ~2 posts/week (instead of ~5), but those posts will supplemented by 5-10 tweets/day (RSS feed here). Because of this, I’ve added the Tweet Blender widget to my home page, made it quite large, and have set it up to include not only my direct tweets (@ramblingman) but all tweets that include the word ramblingman to catch re-tweets and such. This will probably result in the inclusion of odd items from time to time — apologies if anything offensive comes up — and if this becomes a problem I’ll change the setup.

I’ve re-enabled Zemanta after turning it off for several quarters because I found it too slow to justify its value. They’ve put out a new release, and since I’m interested in all things vaguely semantic web, I figured I’d give it another try. Finally, I’m still considering renaming the blog to either Kellblog or Kellogic, but doing so is a daunting project (think of all the links that break) which I’m not yet ready to tackle at present. So, watch this space.

The purpose of this post, however is to present highlights from the Software Equity Group’s 2Q09 Software Industry Equity Report. Here they are:

Consensus IT spending forecasts for 2009 predict 8% decrease in overall spending
Top five CTO spending priorities from the Goldman Sachs 3/09 survey: cost reduction, diaster recovery, server virtualization, server consolidation, data center consolidation
The SEG software index had a 23.7% positive return, bouncing back from a decline in 1Q09
Median enterprise value (EV) / sales = 1.4x, up from 1.2x the prior quarter
Median EV/EBITDA = 9.4x, up from 7.7x the prior quarter
Median EBITDA margin = 14.9%
Median net income margin = 3.9%
Median TTM revenue growth = 5.2%
Baidu and SolarWinds topped the EV/sales charts with values of 16.2x and 10.0x revenues, respectively
The great software arbitrage continues with companies >$1B in revenues having a median EV/sales of 2.2x while those <$100M have a mean of 0.7x. This theoretically means that the median big company can buy a median small one and triple its value overnight.
Database companies median EV/sales was 1.8x
Document/content management companies median EV/sales was 2.4x
Median SaaS vendor EV/sales was 2.6x, suggesting that $1 of SaaS revenue is worth $1.70 of perpetual revneue. (Though I worry the overall average includes SaaS so this could be understating it.)
Four software companies went public in 2Q09 raising, on median, $182M with an EV of $814M, an EV/revenue of 3.6x, and a first-day return of 17.3%
Five companies remain in the IPO pipeline with median revenues of $58.7M, net income of -$2.2M, and growth of 46.4%
285 software M&A deals were done on the quarter with $3.1B in total value. This was down from 296 deals in the prior quarter worth $7.3B. (The lowest total value in the past 13 quarters.)

Kedrosky: VC Will Be Cut in Half

Posted on June 28, 2009 | Leave a comment

I just finished reading Right-Sizing the US Venture Capital Industry by Paul Kedrosky, author of the Infectious Greed blog and wanted to share some thoughts on it here.

He starts with an interesting swipe at two of the more popular claims of venture industry marketing: (1) the citation of great successes such as Google, Microsoft, Starbucks, and Cisco, and (2) the NVCA claim that venture-backed companies represent about 17% of US GDP:

… noting that venture capital played a role in the early days of these storied companies is not the same as saying the venture industry deserves full credit for these companies any more than does, say, Pacific Gas & Electric …

Merely being the provider of a service to a company is separate from having demonstrated that the company could not have obtained that service elsewhere. There are many providers of risk capital … and a smaller venture industry (or a larger one) might well have had as much success, or more, at funding the same companies.

He moves on to analyze venture capital performance, noting that historical annual returns were about 20% and arguing that the ten-year numbers are about to go negative because the bubble exits of 1999 will soon be excluded:

Having argued convincingly that venture capital has a performance problem, he then offers up three possible explanations. Perhaps, Kedrosky says:

Too much capital is allocated to VC, driving higher valuations and lower exit multiples
Shrinking exit markets (e.g., the decline in IPOs) are damping returns
VC itself is suffering from structural flaws, for example, a habitual over-reliance on the relatively mature IT and telecommunications markets

Excerpt related to the last point:

The computer and enterprise software and networking markets are long past the peak of innovation in terms of being places for profitably investing significant early-stage money. At the same time, most IT entrepreneurs say today that it costs a fraction of what it did a decade ago to start a company [due to open source software, Internet distribution, and cheap hardware and bandwidth].

On reduced start-up cost, I largely agree. On being long past the peak of innovation, I disagree. I believe that technology innovation is largely stalled in IT with business model disruption (e.g., open source, SaaS, cloud) in vogue and dominating new investments. I doubt that a new, technology-disruptive enterprise software company that is not SaaS or open source could even get first-round funding today. I think this means real opportunity in mid-term for technology disruptors and (happily) fewer competitors for Mark Logic while so doing. Yeah!

Kedrosky continues, making some interesting statements on IPO window closure:

There is no question that the number of venture-backed IPOs has declined [to a little more than half] the pre-bubble number … but it did not decline to levels completely out of line with [the pre-bubble] period … what has changed is that the market has become less accepting of young, money-losing companies than it briefly was in the late 1990s …

It is a mistake to say that the problem is the exit market — it would be more correct to say there is a problem with what VCs once were able to bring to market, but no longer can.

At this point, I’m thinking this guy is one heck of a conventional wisdom challenger and a fine analyst, but again I have to disagree:

If the IPO window were open, there were no SOX tax, early-stage public company valuations were weak, and thus VCs would not take companies public that they heretofore would, then I’d agree

But there is a SOX tax that makes marginally profitable companies unprofitable and the IPO window is basically closed so we don’t know if the market valuations are good or bad because there is no public market for the stock of these companies.

As I’ve often mentioned, $30M high-growth, break-even companies could go public and get reasonable valuations in the pre-bubble era (e.g., Business Objects in 1994). Today, I know of $100M+, growth companies that can’t go public due to some combination of IPO window closure and SOX compliance and process / timing costs.

Kedrosky then proceeds to some interesting ROI arguments on VC as a category. This chart, for example, shows how the flood of capital into VC in the 2000 era has resulted in depressed returns thereafter.

Kedrosky then does a little “right-sizing” math, showing two different ways why he believes that VC should be about half the size it is today.

I should note that the Kedrosky’s conclusions are very similar those reached by Fred Wilson, author of the A VC blog, in his post The Venture Capital Math Problem which looks at the same issue but in a more bottom-up, back-of-the-envelope way. Wilson, with some quick math of his own, calculates that the exit rate can’t generate enough returns on the current investment rate of about $25B/year.

Excerpt:

So here’s the venture capital math problem. We need $150bn per year in exits and we are getting about $100bn. That $100bn produces roughly $50bn in proceeds for venture firms per year. After fees and carry, that $50bn is around $40bn. Which is only 1.6x on the investor’s capital if $25bn per year is going into venture funds. If you assume the investors capital is tied up for an average of 5 years (venture funds call capital over a five year period and distribute it back over a five year period, on average), then the annual return is around 10%.

If you’re really interested in this topic go read the 250+ comments on Wilson’s post (and his follow-up).

One of my favorite comments was this one:

Put all of this together and the conclusion is crystal clear. The VC class does not scale for one simple reason: dearth of good VCs.

To be successful in this class you need to have capabilities that far exceed the “random selection” approach, and very few have them. The source of pitches is practically unlimited, even if you are good at sieving out 90%, you are still drowned out in low-quality pitches. You need to be able to dismiss 99.9% or better of the low-quality pitches. Only few can do that, and they have limited bandwidth, that’s why the class does not scale.

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Posted in IPO, Venture Capital