Tuesday, May 31, 2005

Search: The Rise of Specialization

Adam Smith once said that specialization is a function of market size.

It is no surprise then that the search market, as it grows, is seeing the emergence of specialized, vertically-oriented search algorithms and companies. Searching for good answers wrt the types of search companies starting today and how an investor might want to participate in Adam Smith's prophesy of specialization, I attended today's Under the Radar conference in Mountain View. Under the Radar is a showcase for emerging search and mobile application companies and is targeted at the press and venture investors.

The common abstraction across all the presenting search companies is that while generalized, web-searching is useful, certain classes of queries demand a move from page-link analysis to algorithms more germane to the query at hand. Categories of specialized search include
  • Mobile search (optimized for handset form-factors, location-based services, and carriers): Medio Systems
  • Product search (optimized for product reviews and comparison shopping): Fatlens and Become
  • Rich media search (optimized for video and audio): Blinkx, GoFish, and Meevee
  • Travel: Kayak
Wrt product search, an example helps to make the point. If you search on Google for "Red Sox," the first listing is, appropriately, redsox.com. If you search on FatLens for Red Sox, you get a listing of available tickets to buy for Redsox games. Fatlens is an example of a company optimized to solve a problem ( help find tickets to events), rather than generic information about a category/topic (help me find the Red Sox home page).

The elephant in the room is obviously, what about GOOG, YHOO, and MSN? The major giants are investing heavily in search and extensions to web search. Will consumers seek results optimized for specific queries - travel, rich media, product shopping, event tickets, etc? Will the very models of analysis that make GOOG so powerful on the web (link analysis) leave room for specialists to enter with algorithms with limited general value but strong, vertically specific search results? Will the search start-ups be destination sites or will they syndicate their specialized search results to aggregators of queries (today's big three)?

A further observation is that the business models of various search companies are coalescing around a few key variables:
  • Advertising (Ex. Google Adsense as a partner, direct sales to advertisers)
  • Lead generation or referrals (revenue per click, revenue per customer acquisition, etc)
How does a search site generate revenue? A breakdown of revenue per search helps to understand.

At a high level, Revenue Per Search = Coverage x Click-through rate x Price Per Click

  • Coverage (#searches that show ads/total # searches)
  • Click-through rate (total # clicks on ads/# searches that show ads)
  • Price per Click (total amount received from advertisers/total # of clicks)
  • or total amount received from advertisers/total # searches
The specialized search vendors' business models presume that specialization will lead to higher value to consumers (greater relevancy) and hence more qualified leads to advertisers. Sounds reasonable.

WRT verticalization, a few thoughts:
1. Future revenue f(revenue per search or "RPS")

2. RPS f(domain specific problem resolution)

3. Domain specific problem resolution f(verticalization and specialization)

4. Verticalization f(investment in domain specific search algorithms)

5. However, venture returns are a f(scale and market size)

6. Focus limits scale

7. Therefore, future scale must be f(indirect sales and extensible product platform)

Accordingly, I buy that all queries are not created equal. A search for Red sox tickets, Red Sox jerseys, Red Sox highlight clips, and Red Sox pitchers may all require search engines optimized for the nature of each request. I do not buy, however, that consumers will want to visit N number of search companies to answer N number of queries. Nor do I believe that it is capital efficient to raise money to compete to become a destination site.

Rather, I believe the vertical search space will only see scale and success to the extent that major content or web properties see sufficient value in specialized search that they syndicate results from specialist search engines and play the role of aggregator of traffic and integrator of best of breed search function.

The key bet for a vertical search vendor today, in my mind, is that will engineering driven cultures, like GOOG and MSFT, overcome their not-invented-here bias and grant that specialized vendors produce better results than they are capable of producing through incremental hiring of specialists and tweaks to their search engines. If the answer is no, then I think the specialists lose. If the answer is yes, then MSFT and GOOG may morph from technology innovation companies (the best search innovators) to integrators of best of breed function and ad networks that drive queries across underlying and optimally suited third-party search engines. As a user/consumer, I clearly believe we will "win" if GOOG, MSFT, and YHOO aggregate specliazed search on our behalf rather than force us to alt-tab across N search engines to get us our much needed N answers!

GOOG's market cap and traction is clearly heralding in a new golden era of search innovation - will it pay off for venture investors?


Friday, May 27, 2005

Sales Management

My prior post provides a model for how to create a revenue plan for the year. Another classic start-up conundrum is how to forecast revenue for this quarter.

Sales forecasting is a notoriously difficult problem and start-ups generally learn the hard way that sales meetings, prospect interest, and apparent momentum do not translate into purchase orders in any where near the time and speed one would hope. Professional sales management forecasting techniques can help eliminate emotion and excitement ("We had such a good meeting, I know they are going to buy!") out of the process. Missing a sales forecast really hurts no matter what size company you are. However, given that most start-ups are not profitable, missing a topline revenue number can have disastrous impacts on cash burn, employee morale ("we are working so hard and getting nowhere"), and shareholder confidence.

While there are many different models out there, I will share one with you that works well for the companies that I work with in conjunction with an investment in a CRM system, like Salesforce.

As a first time CEO or manager, a managing a sales pipeline by sales stage can improve forecast accuracy. A key, however, is that the whole sales team buy into the process and be religious wrt its application. Top leaders must constantly evaluate where an opportunity is relative to the key sales milestones and if sales reps are realistically categorizing various opportunities.

Sample Pipeline by Sales Stage
  • Prospect New (10% probability - telemarketing lead or tradeshow follow-up)
  • Prospect Engaged (20% probability - webex, phone contact, early requirements discovery)
  • Technical Evaluation (30% probability - demo/presentation completed, NDA executed)
  • Budget Qualification (40% probability - major discovery requirements phase)
  • Proposal Submitted (50% probability - confirm budget, test commitment)
  • Technically Selected (60% probability - building ROI analysis with customer)
  • Contract Negotiations (70% probability - reviewing proposals, technically selected)
  • Getting Final Signatures (80% probability - selected, budget confirmed)
  • In Purchasing (90% probability - waiting for fax to ring!)
  • Closed (100% - purchase order in house!)

When forecasting revenue, try to match each sales engagement against the milestones/stages listed above. The forecast is then equal to the sum of the dollar weighted opportunities by stage.

While a rigorous process is not sufficient to hit the number, I believe it is a necessary condition to doing so in a predictable and repeatable manner.

Sales Forecasting

This post addresses a key question for start-ups, how do you model and forecast sales?

Forecasting Revenue
A key mistake start-ups make in raising money relates to how they model future revenues. This post explains a bottoms-up approach to forecasting revenue. My favorite bottoms-up forecasting method is the productive sales rep model. In this model, future bookings are NOT a function of market share, size, and penetration rates ($500m market x .005 penetration, or $2.5m) but rather of how many mature sales reps are in the company and the expected sales rep quota and productivity. A top-down approach is simply too hard to handicap and fails to ensure that a company matches an investment in sales resources with projected bookings and revenue.

First Model Bookings
Bookings = mature reps x quota per rep x productivity
Bookings = purchase orders
Mature reps = the number of reps with sufficient market and product experience to be effective (typically six months with the company)
Quota = bookings quota per year (typically $1-2m per rep in a start-up, and $2+m per rep in a mature company)
Productivity = percent of total quota achieved, on average, by the sales force

Therefore, for a start-up, with two mature reps entering the year, one rep joining in January, a $1.5m quota, and an expectation of 75% productivity, bookings would equal:

2.5 (mature reps) x $1.5m (quota) x 75% (average productivity as % of quota), or $2.8125m.

Then Assume Bookings Mix and Revenue Recognition Policy
To get to revenue, we then need to assume 1) a revenue recognition policy and 2) a bookings mix across license, maintenance, and professional services. This mix is typically 70% license, 15% maintenance, and 15% professional services.

Wrt revenue recognition, license revenue is recognized at the time of sale, while maintenance and professional services revenues are recognized pro-rata over the course of the year/project. For example, assuming the bookings mix above a $1m purchase order (booking) on April 1 would contribute the following revenue in the year:

License revenues: $1m x 70%, or $700k
Maintenance revenues: $1m x 15% x 9/12, or $112.5k
Services revenues: $1m x 15% x 9/12, or $112.5k.

While there were $1m in bookings, revenues would be $925k, with the $75k difference on the balance sheet at year-end as deferred revenue.

I have a good worksheet I am happy to share if people are interested. The key issue is make sure that sales projections are tied to tangible investments in sales resources and are based on reasonable assumptions of sales rep productivity, time to maturity, and quota. Finally, think through how bookings translate to revenue. A sophisticated approach to the problem will go along way in gaining credibility with a prospective investor.

Term sheet review

Brad Feld and the Mobius team put together a very insightful set of posts on term sheets.

For entrepreneurs looking to raise money for the first time, I highly suggest reading the posts.

Subjects covered include: liquidation preferences, stock vesting, conversion ratios, redemption rights, and other material elements of most vc firms term sheets.

Click this link to read on.

Thursday, May 26, 2005

Company Culture and Politics

Business school alums often come back to campus and tell students that Organizational behavior proved to be the most valuable course(s) they took. When I studied at Kellogg, I never understood why.

I often meet with people who ruefully state, "my company is too political;" "there is no transparency where I work, things happen, people come and go, and no one knows why;" "I don't understand how decisions get made, things seem so random."

Politics, as we all know, is not something that just happens in Washington DC. All companies, be they start-ups or GM, are political. Politics are informal, unofficial, and sometimes behind-the-scenes efforts to sell ideas, influence an organization, increase power, and achieve other targeted objectives.

Politics have a truly pejorative connotation and being accused of being a political animal is most often meant to be an insult. Since I left business school in 1999, however, I have come to appreciate the fact that to ignore the realities of organizational life and decision making is certain to reduce your effectiveness and influence at work. I believe people often join start-ups to escape the crushing politics of large companies. The reality is that organizational polictics are a constant, while start-ups may be lower on the political spectrum/continuum than larger companies, they remain organizations populated by people.

I recently read a book that provided a model with respect to understanding the organizational political continuum. The book argues there are two contrasting styles and hence models of people and companies.

The first model is idea-centric. Idea-centric people and companies are driven by the power of an idea. They view power as residing in facts, logic, analysis, and innovation. These companies are often flat, meritocracies where the best ideas win and the way to win is to make the most cogent, objectively correct arguments. These people believe in substance, in doing the right (logically speaking) thing, open agendas and transparency, and the belief that ideas speak for themselves. Ie, if the ideas are well stated, why wouldn't someone agree? I fall into this camp and often believe that if I make a logically consistent argument (ie axiomatic) then it should be clear what to do.

The second model is person-centric. Person-centric people and companies are driven by the power of hierarchy. The merit of an idea is not driven by the cogency of the logic but by the power, position, and political support for the speaker. In this world, ideas definitely do not speak for themselves, but rather image and the perception of support (who supports this, what does the VP/CEO, etc think about it). In these companies, people often don't do what's right but rather what works. Decisions, given they are not based on logic, are far from transparent and meetings are fait accomplis rather than opportunities for genuine discussion and feedback. Relationships drive support, not ideas and merit appears to lose out to coalitions and sponsorship. Loyalty, alliances, and working the system outweigh doing whats right and trusting the system to pick the "best" outcome.

In my experience, companies land somewhere along a continuum of the two models. The challenge for all of us is to understand the type of company we work in and what style we will need to adopt to be successful, or rather to quit and leave. Often the most frustrated people are idea-centric people working in people-centric companies who simply don't realize it and cannot understand why their brilliant ideas find no support or traction.

We owe it to ourselves to be self-aware. I believe this is the message the alums were bringing to students - don't be naive, calibrate your company's culture and style, and recognize that merit alone, unfortunately, is often not enough to get things done. The key is to always maintain integrity, avoid ugly ethical compromises, while working within the political constraints of your employer.

Any thoughts?

Monday, May 23, 2005

The Golden Age of IT Buying - what does it mean for investors

This could be the golden age of IT buying.

The IT buyer is blessed with commodity hardware, open source infrastructure, a surplus of vendor capacity in both hardware and software, which is in turn driving mammoth discounts, cheap offshore engineering talent, falling telecommunications costs, standardization and open protocols...The fall in the cost of bandwidth, storage capacity, computation, software all are helping IT buyers generate much more with much less. Traditional sources of vendor value - intellectual property, proprietary implementations that raise switching costs, unique product offerings - sufficiently burned IT buyers so that today they are looking for fungible, commodity solutions that reduce vendor lock-in and attendant costs.

The trends are clear - RISC to x86, Solaris to Linux, Boston to Banglore, Websphere to JBoss - mammoth costs are being stripped out of the IT value chain and IT buyers are loving every minute of it.

What does it mean for start-ups, entrepreneurs, and venture capitalists? Low cost markets respond by consolidating capacity and driving volumes, as companies look to get to minimum efficient scale. Certainly the M&A frenzy of the last 18 months supports the view that large companies are realizing that profits will increasingly be a function of market share. Consolidation, while good for exits in the near term, has troubling long-term implications. How will start-ups extract value from customers who by definition are looking to reduce proprietary solutions and lower barriers to entry/substitution? How will start-ups break into companies who are centralizing spend with IBM, MSFT, and CSCO?

Some suggest the answer is increased verticalization - build solutions that create value by solving discrete pain points for given industries. But I think that is what IBM Global Services is trying to do! Others focus on leveraging the trends in open source by funding the next Red Hat variant. This is an explicit recognition that the software model is dead - ie you are willing to trade away license revenues at 85% gross margin for services and maintenance revenues of 40% GM and take 80% of the revenue (ie license revenue) and see it go to 0%.

While both are somewhat valid, the answer has to be innovation. If we cannot innovate and create unique, proprietary products (not in the sense that they do not leverage standards but in the sense that they are unique and defensible) then we will never see healthy returns for all the risk and capital we are deploying. It is expensive to take enterprise products to market and with the current IT mindset, plethora of comparable vendors in the market it is proving to be very challenging to break through the noise and incumbent account control and to get an IT buyer to buy from a small company.

Innovation - we must create products where the value (ROI and strategic) is so compelling that the customer is willing to introduce a product with switching costs into their environment. Unless we can eliminate the pool of ready substitutes through real innovation, the Golden Age of IT buying will continue unabated and we will see feature-based M&A deals (<$100m) where the major consolidators pick up missing functions (and have a choice of 5-6 to choose from). The days of breakout companies that change the enterprise IT game will be gone.

So my sense is that the answer is not a business model (service versus license) or open source (give up license to get maintenance) or verticalization (we know more about this problem than anyone else), but a continued focus on technical innovation combined with strong product management skills that translate engineering achievement into applied value and resonance to the customer problem.


Friday, May 20, 2005

Lessons from Ballmer

Last week, I attended Microsoft's VC Summit in Mountain View. The 4th annual summit offered venture investors the opportunity to meet with Steve Ballmer and varoius senior managers from across Microsoft's product teams. I really enjoyed the day, and the clear highlight for me is the opportunity to ask Ballmer questions on MSFT's strategy and future direction. He is simply a force of nature and a real inspiration - passionate, articulate, and determined as hell to win.

Microsoft is rolling out a variety of tools to support the information worker - video conferencing, improvements to Outlook, IM, new Office features, etc. As all of us can attest, a major challenge for the modern day information worker is the fact that we are always on and that our days are often interupt driven. IM's ping in, followed by email, phone calls, Blackberry messages - all conviences of connectivity and all challenges of sustained thought and focus.

The VC industry is full of crack-berry addicts, people who cannot go a meeting, seemingly a minute, without pulling out there device and reading the latest email. We are trained to be responsive to email and often a day can go by with tens if not hundreds of interuptions.

I asked Steve if MSFT is builiding a policy driven filter that will allow the knowledge worker to dial his availability up or down and filter inbound messages when he simply needs to get sh*t done. I jokingly referred to a recent study that compared IQs of frequent electronic communicators with those who smoke pot daily and found the electronic messengers lacking!

I found Steve's answer very telling. He does not carry a Blackberry, he does not carry a cell phone during the work day. He does not permit meetings where people use laptops or notepads to check and write email. His goal is focused interaction, drive to a solution, and then break up the meeting and move on. He recounted a story of where a major company CEO interupted him in mid-sentence as his Blackberry vibrated, only to tell him after checking that Scott Peterson had been convicted. The CEO then had to ask Steve where they were in the conversation.

The VC industry suffers from very short attention spans, and I pity the CEOs who need to compete with VCs checking random emails and text messages during their pitches. I, guilty as anyone at times, took a lot from Steve's views on self-discipline and respect to other meeting participants.

Rather than join the Luddite crowd rejecting the convenience of mobile email, I simply am trying to ensure that meetings are sacred (as is time with wife and kids!!!). Perhaps, I will recover some IQ points (I need them) and get more done as a result.

As an aside, Steve provided a list of things he is looking for in an M&A situation. I found the list instructive:
  • technical innovation with impact
  • protected IP (patent portfolio)
  • market understanding
  • engineering excellence
  • alignment with sales capacity (can you sell it?, do you know how to sell it?)
  • timing and tenaciousness
  • understanding of value chain and how to partner to win

Thursday, May 19, 2005

The State and Health of the VC Industry - Serendpity or Process

Brad Feld's blog introduced me to an article by Howard Anderson called Good-bye to Venture Capital. The article, written by a founder of Battery Ventures, makes a familiar, yet powerful argument that the venture industry is over-funded, structurally transformed, and doomed to generate returns far lower than what limited partners expect from the asset class and the associated risk profile. As you will read, the article indicts the industry for suffering from too many investors, too much money, and paints a dire picture of the future.

As a recent entrant to the industry, I found the article is powerful food for thought. Is the industry doomed to low double-digit returns? Are there too many of us chasing too few deals funding too many companies selling to customers with finite budgets, abundance of choice, and limited differentiation between vendors? If so, Howard is spot on, returns will fall, capital will leave the industry, and the fees will be significantly lower thereby reducing the number of professional investors in the space.

As an aside, I don't believe that the VC industry is alone is suffering from too much money. The hedge fund industry is simply exploding wrt funds under management, the number of firms, and the number of people entering the space. Capital, itself, appears to be in abundance across the alternative asset management space.

Howard makes one powerful point that resonates with any reader of Fooled by Randomness. Funds invested in the 1994-19998 time frame did extremely well. The cliche rising tides float all boats comes to mind. At a recent offsite, Eric Schoenberg (a Columbia Phd candidate) reminded us that returns are driven by two key components, systematic returns and idiosyncratic returns (see CAPM model). Systematic returns are market returns. Idiosyncratic returns, however, are where professional investors earn their stripes - they are returns in excess of the market. To be a decent investor, one must at least deliver systematic returns. To be a great investor, one must deliver idiosyncractic returns. In the bubble, random investments looked genius. The systematic returns (returns for the asset category at large) were simply amazing, thereby creating great weath and perhaps reputations for genius that were more due to circumstance and timing than investing prowess. The questions for us to ponder is what will be the future systemic returns to the venture capital asset class, and has the inflow of money and people into the venture capital industry made it impossible to generate idiosynctratic returns. Are funds' returns systematic (an index of the market) or extroardinary? Will there be a Vanguard-like vc fund that is a low-fee provider of index funds for the private markets!? What is the basis for extraordinary performance over the market index? Is the succes of vc investors and funds due to serendipity or to process?

These are key questions for investors (both general and limited partners). Can one deliver quality returns in an industry full of capital and people chasing "good" ideas?

One key difference between the public equity markets and the venture capital markets is the degree to which information is transparent. The public markets are by regulation open and transparent with data available to all.

The private markets are marked by imperfect information, proprietary insights, and information asymetries. Certain private investors simply enjoy access to information, ideas, and talent that are not generally available to others. For exmaple, certain leading firms leverage the footprint of their portfolio (talent, ideas, reach) to drive insights that lead to investments that others are not in a position to make. An obvious example, is Sequoia Capital's investment in Yahoo! and Google. With a BOD seat at YHOO, Mike Moritz enjoyed acccess to information relative to GOOG's search technology simply not available to others weighing the decision to invest in GOOG, presuming they even had the chance.

The question for venture capitalists may be as simple as, "what do I know that others don't?" With the corallary, yet vital question begging, "will I be smart enough and sufficiently certain of myself to act on such information?" For as Keynes famously once said, "Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally."

If one knows nothing proprietary, has no unique relationships, access to ideas, and information, then life may be very challenging.

Another thought related to Howard's piece is that he focuses of the decline of traditional enterprise markets - systems management software, enterprise applications, etc. I agree that these markets are challenged. He misses however, the extraordinary growth that earmarks certain emerging markets, many of which were not funded by VCs. With thanks to Mary Meeker, the following statistics suggest that robust growth, value creation, and investment opportunity seem as strong as ever.

Drivers – (MS Internet Report April 2005)
High Level
User growth 10-15%
Usage growth 20-30%
Monetization growth 30%
GOOG net revenue per unique user up from $2 to $9 over 4 years
YHOO net revenue per active user up from $11 to $20 over 4 years
EBAY payments revenue per active account up $12 to $37 over 4 years

5bn global searches per day – up 62% yoy
355m unique visitors per day – up 36% yoy
$63bn market cap

Ad Spend per household
Internet = $128
Newspaper = $898
7x!!!! differential

135m global subscribers – up 51% yoy
39m NA subs
63m Asian subs

917m streaming music sessions per day – up 119% yoy
$49bn market cap

Halo 2 (game) sold $120m in the first weekend alone
180m MSN IM users

Digital music
300m cumulative iTune sales – up 270% yoy, with 100m in Q1 alone

33m Skype users

Paypal has 72m accounts – up 57% yoy – with 22m active users up 52% yoy

Global phenomena
1998 NA = 46% of total users
2004 NA = 26% of total users
India 2% penetrated
China 5% penetrated
S Korea 70% penetrated

Background - Pequot Ventures

I work in the Venture Capital industry for Pequot Ventures, the private equity arm of Pequot Capital Management. Pequot Capital is an alternative asset management company that provides limited partners access to a variety of investment prdoucts. Today, Pequot Capital manges equity hedge funds, debt funds, quantitative trading funds, and private equity funds.

Pequot Ventures manges $1.7bn and invests in three key sectors: information technology, applied technology, and health care. I lead the firm's software investing activities on the West coast, working out of our Sand Hill Road offices. Our hall of fame includes, NetGear, Sycamore, Netegrity, Andrew Corporation, Arrowpoint, and others.

I joined Pequot Venture in early 2002 and have had the good fortune of working with some excellent mangement teams and companies. Investments that I am involved with include, Tectura, Scalent Systems, Klocwork, Kavado, and Securify.

Thursday, May 12, 2005

The First Post

Blogging is an amazing way to share.

My first blog, a family blog, proved so easy and succesful that I have decided to start a personal blog to share my ideas and experiences.

I hope to use this blog to share with friends and colleagues thoughts and ideas on life, the venture capital industry, start-ups, and other fun things worthy of discussion.

The first post will introduce a book that is simply remarkable, Fooled by Randomness, by Nassim Nicholas Taleb. For a good synopsis - see the following blog. The book centers on the "hidden role of chance in life and in the markets." As an investor, it is particularly apropos as one tries to identify systematic methods of creating value via investing. Investors and investees like to believe that the investment world is deterministic with clearly understood cause and effect. Understanding causal drivers of value helps to create repeatable models for investment that scale both across time and inviduals in the firm. Nassim challenges us to be very careful in overascribing reason and logic to an outcome. Too often, investment outcomes are the result of randomness rather than science, ie being lucky rather than good.

He illustrates his point by comparing the world of investors to a large sample of coin-flippers. If you start with a large enough sample, someone will manage to flip heads for many months in a row. While others drop out, the surviving "flipper" will take on magical qualities and others will study his background, methods, and secrets for achiving such success. Then, of couse, he will flip tails one day and "blow up."

Nassim's book instills a deep sense of humility in the reader and a recognition that time and chance are often at the root of success. I strongly recommend reading his book. Let me know what you think.