Enterprise Start-up Strategy

Today, I attended Software 2006, an enterprise software conference organized by the Sand Hill Group. The conference highlighted several important strategy concepts related to how to architect a next-generation enterprise software start-up. Keynote speakers included Ray Lane, a McKinsey & Co partner, and Dave DeWalt. The following were my take-aways on salient points.

First, enterprise software start-ups must be designed cognizant of current marketplace realities. While much has been written on the subject, Ray Lane summed up the startup vendor challenges well:

• challenge of access to buyers
• long evaluation cycles and committee based buying
• integration requirements
• customization requirements
• installability
• ROI analysis and business case/spend justification development
• business model and licensing
• renewals

Second, vendors cognizant of the challenges above need to architect solutions that foot to the following McKinsey equation:

• software success = customer need x offering innovation x sales and delivery model.
• What is the need? What is the product's advantage over the current state of the art? How is the product sold and deployed?

Third, speakers highlighted certain key characteristics for success; the need to identify whitespace, build products that install quickly and easily, a linear value realized/cost relationship, an entry strategy that adds value to single users (immediate value and short and distributed decision cycles) while scaling organically to hundreds, and a total enterprise value that grows with the cumulative user count.

There was significant discussion with regards to how Web 2.0 will impact the enterprise. McKinsey posits four key areas of opportunity:

• Timely access to information and content (ex Google and Flickr)
• Improved decision making via better use of data and presentation of relevant information (ex. Zillow)
• Enhanced communication (ex. Skype, Yahoo! IM)
• Better collaboration (ex. Socialtext, Jotspot, and Typepad)

Finally, Greg Gianforte, Rightnow's CEO and founder, offered some useful insights into enterprise go-to-market strategies for SaaS companies. His key point is that large customers require choice and levels of parameterization not required by the SMB market. He laid out five types of choice to consider:

• Deployment choice (on-premise and hosted)
• Payment choice (monthly term, term net thirty, and perpetual). He made the interesting point that payment choice allows vendors to tap both capital and operating budgets.
• Upgrade choice. He believes that forced upgrades are rejected by large companies, accordingly, upgrade customization is important. This demands a competency in multi-tenant, multi-version support, with customer driven elections to upgrade from version to version.
• Integration choice. If a system of record is hosted, think through integration options and ensure pooling of relevant data is possible.
• Customization choice. Push configuration but be prepared to allow for presentation layer customization

All in all, a good day and one full of important ideas to consider when building and designing enterprise start-ups.

Marketing Best Practices

Capital efficiency and return on invested capital are the hallmarks of successful companies. Venture capital is a milestone driven investment model and companies benefit, with respect to dilution, by being able to achieve milestones and value creation on as little capital as practical.

A major area of potential inefficiency and burn is marketing. This post passes on a few marketing performance indicators that are worth tracking to ensure return on the marketing dollar. At scale, software companies spend 20-30% of revenues on sales and marketing, while start-ups, typically spend 50-60%+. Marketing, when done well, can be a critical driver of sales leads and growth. The goal must be to avoid being in a company where you feel like paraphrasing John Wannamaker, who famously observed, "I know I am wasting 50% of my marketing budget -- my trouble is that I don't know which 50%."

The goal of a start-up's marketing plan should be to drive leads into the sales process. Ultimately, management needs to track the cost per lead and the cost per close. My suggestions are to track the following

• Programs
• advertising (home page ads, newsletter sponsorships, banner sponsorships, search engine key words)
• direct email
• outbound telemarketing
• events
• Costs per program
• ex $2,000 to sponsor a newsletter geared to the target demographic
  
• Reach
• ex newsletter reaches 12,000 readers
  
• Expected response rates
• ex .5%
  
• Actual response rates
• ex .75%
  
• Costs/lead = cost per program/leads from program
• expected cost per lead = $2,000/60 = $33.33
• actual cost per lead = $2,000/90 = $22.22
  
• Leads/quarter from all programs
• Average cost per lead/quarter
• Total programmatic spend/total leads generated

Metric-driven management helps a young company quickly triangulate on what is working and what is not. Tracking costs, response rates, and the contribution of marketing to the success of the business helps make marketing more scientific and its contributions more tangible to the overall goal of reaching the next milestone as efficiently as possible.

Looking for a job in VC

In the last month, I have had the good fortune to speak to numerous graduate students regarding finding a job in venture capital. While much has been said about the process already, it appears the demand for guidance is undiminished. This post summarizes some of the advice I am giving people.

First, asking for how to get into VC is akin to asking how to get into medicine. Adam Smith famously stated that specialization is a function of market size. The VC market, while not as large as the health care industry, enjoys broad specialization and focus. As with medicine where one can be in internal medicine, orthopedics, pediatrics, etc, there are many flavors of funds with each flavor requiring and looking for different skill sets. VC firms differ by location, stage of investment, and industry focus. Later stage firms typically value financial analysis, deal structuring, and deal execution skills. Early stage firms typically value technology and market expertise combined with operating experience.

Second, the world is intensely competitive. To succeed you will need not only good fortune, but also a deep passion for the domain in which you operate. Accordingly, pick the stage, focus, and investment philosophy that maps to your skills and interests. There are simply too many smart people in the world who will run you over if you enter their market without the commensurate passion and commitment that comes from doing something you truly love.

Finally, if want to get into the early stage space, I believe the best path is the Zen approach. Ie. the harder you try the worse you will do and the more frustrated you will become. Focus not on getting into a VC firm right after graduate school, but instead on a market, company, and operating role that will provide the expertise, sets of relationships, and experiences that will prove valuable to a prospective VC firm employer. This is generally not a one year commitment but rather a multi-year investment that pays dividends in making you a more suitable candidate for hire and also provides the option value of discovering a joy for the operating side that may keep you in the executive ranks.

Larry Sonsini

Last night, I attended an HBS dinner honoring Larry Sonsini as the Bay Area's 205 business person of the year.

In his acceptance speech, Larry reminisced on a 40 year career working with growth companies. Larry's career serves as witness to the many industry changing companies started here in the valley and to his role in advising many of them along the way. By decade he rattled off a list of clients - Bob Noyce, TJ Rogers, Steve Jobs, Larry Page, Jim Clark, etc - and the pioneering vcs - Arthur Rock, Tom Perkins, Don Valentine, etc - who funded them.

He closed with a comment on three traits the great entrepreneurs all share:

• passion,
  
• adaptability,
  
• and not taking themselves too seriously.

Finally, he remains very bullish on the future of the valley. He took the audience back to the 1980s and to the fears that the Japanese would decimate the US tech industry. While he acknowledged challenges - education, burdensome regulation, etc - he remains confident that the next 40 years will be as bright if we continue to embrace change, reward innovation, promote meritocracy, and accept failure as a sign of trying something new.

Innovation Happens Elsewhere

I spent the last two days at pcforum 2006. Check out Technorati's tag page on the event for more detail. A highlight of the event for me was Bill Joy's talk. Bill discussed areas of opportunity. He commented on the threats endemic today from pandemics and of the drivers that led KPCB to raise a Pandemic and Bio Defense fund. Quick case in point - vaccination technology is still premised on 100 year old models based on using chicken eggs to grow vaccines. He also made a comment that I found very interesting, "Innovation Happens Elsewhere."

Bill's premise is that no company owns a monopoly on talent and innovation. As such, businesses need to be architected to leverage the innovation of others. Certainly the multiple benefits - cost, innovation, wealth - standards and open-systems have made possible speak to the value of building businesses that are premised on the axiom of distributed innovation. It turns out the quote comes from work done by Richard Gabriel, a distinguished engineer at Sun (Ron Goldman, Dick's co-author, pinged me to say the quote is from Bill and that they borrowed it from him. FYI). Dick Gabriel wrote a book titled Innovation Happens Elsewhere that focuses on open source software models. He has made the book freely available on his web site. I am certainly seeing the fruits of models based on the idea - open-source commerical derivatives, web 2.0 models that leverage 3rd party web services and components, and the rise and power of end-user content surpassing. As entrepreneurs design their businesses, it pays to think through how company and customers will leverage the undeniable fact that innovation will happen elsewhere.

Will Your Grandchildren See Dow 2,000,000?

Warren Buffet's recent letter to shareholder contains a few gems. In reading the letter, I am struck by his ability to simply and clearly articulate highly complex and challenging subjects - like insurance, derivatives, and signal rather than noise.

While the letter is full of interesting comments, one really struck me.

To paraphrase, from Dec 31 1899 to Dec 31 1999, the Dow Jones rose from 66 to 11,497. While a rise of 174x over the 100 years, the return to shareholders, a powerful illustration of the power of compound interest, was only 5.3%.

If we extrapolate the 5.3% rate of return over the next 100 years, the Dow Jones will close on Dec 31, 2099 at 2,011,011.23, or 11,497*(1.053)^100. The begging question is will the next 100 years see the same level of corporate wealth creation. Also, how many of you think the equity rate of return will not be higher than 5.3%? If the rate of return is 10%, for example, the Dow will hit 158,435,700 on Dec 31 2099.

Mr Buffet suggests that the replication of the past century's performance will be challenging. He argues that, "For investors as a whole, returns decrease as motion increases." His core premise and criticism is that shareholder wealth is a zero sum game. He argues that transactions (ie motion), transaction fees, and transaction agents (bankers, LBO funds, consultants) are transferring wealth from shareholders to service providers and threatening the future value of shareholder holdings. I suppose the key is to focus on true wealth creation rather than wealth transfer.

Y Combinator

Today, I had the pleasure of attending Y Combinator's Winter Founders Program Angel Day.

Angel Day is a show-case events for the eight companies currently in the Y Combinator Program. Twice a year, the Y Combinator team selects 8-10 teams and provides them intense coaching, $6k in seed money per person, and the opportunity to build a company and product. While cynics may associate Y Combinator with the now pejorative synonym - incubator - I left struck by the incredible energy, creativity, and productivity of the current crop of companies. It is simply remarkable what 3-4 very smart and very dedicated engineers can build in 10 weeks. Read the NY Times article for more on the model. In brief, in return for the micro-seed investment, Y Combinator takes a ~6% stake in the company. The plan is to be very Darwinian - companies either take hold and flourish or go the way of all flesh. The Summer program is full but start thinking about applying for the winter program.

While I will not jump ahead of today's companies launch plans, a few public Y Incubator companies include Reddit, Textpayme, and Kiko.com.


Thanks to Paul, Trevor, and Jessica for a great event.

In Honor of National Proscrastination Week

Cassandra

Bill Gross, Chief Investment Officer of PIMCO, writes a monthly essay, the Investment Outlook. PIMCO is a large fixed income investor and Bill's essays are wonderful reviews of economic, fiscal, and public policy.

His current essay - The Gang Who Could Not Talk Straight - is a highly critical review of the President's annual Economic Report.

In short, he argues that America's competitive position is being undermined by a collapse in our educational systems, sky rocketing health care costs, the lowest national savings rates in the developed world, and an addiction to foreign investment to cover for our inability to save. His conclusion is that these macro failings demand that investors begin to ship capital offshore to more attractive markets. His warnings, however, are important for all to hear. Hopefully, he and others like him, see Pete Peterson, will not be seen as Cassandras, but as concerned patriots helping us wake up to our daunting realities.

As investors, entrepreneurs, and technologists, we have a vital interest in functioning educational systems, health care markets, and positive net savings rates that allow for investment in the future rather than debt service payments to cover historical obligations and spending. If Gross Domestic Investment = Private Saving + Government Saving + Foreign Saving, then the low rate of private and government savings demands that we import capital. The key concerns are 1) that the debt service associated with the current borrowings drowns out the ability for net new investment or 2) foreigners stop providing us cheap capital and dollars available for investment (and hence growth) are limited.

A couple of his charts help tell the story.

Broadcast versus Subscription Business Models

At Hummer Winblad, we are seeing a tremendous number of innovative consumer-facing subscription services. Be it on-line storage, photo sharing, social networking, or other creative ideas, there appear to be a myriad of businesses emerging that are dependent on subscription-based business models. A major challenge looms for these young companies in that the major Internet companies' business models - Yahoo, Google, AOL, and MSN, are based on broadcast economics. Their revenues are are tied to page views and ad impressions rather than recurring application revenues. Accordingly, many of the consumer companies we meet with boast great teams and compelling technology, however, their business models are orthogonal to the business models of the dominant Internet companies, whose models allow them to aggregate and provide compelling services and content for free.

Broadcast companies are incented to provide the best content and services possible to draw in more users, more page views, and more ad impressions. Broadcast businesses seek to maximize revenue per impression/costs per impression, and the wonderful scale these models have achieved with respect to ads sales, affiliate models, and infrastructure costs provide for rich marginal profit margins. Scale allows for economics of scope, whereby they can offer great services - for free - knowing that their costs to offer the service are far lower than competing pure-plays and that their ad businesses will reward incremental users and page views.

Subscription companies require a certain level of free to paid conversions to make sense. The challenge is that to compete with the free versions, vendors get caught in a feature battle, where each incremental feature is valued by an increasingly smaller pool of people. Google and Yahoo are able to hollow out subscription businesses, if and when they choose to enter a given market, and stand-alone companies without ad network revenues and dependent on subscription services suffer the consequences.

Subscription models are, in general, driven by four key areas: cost per acquisition, monthly average revenue per user (ARPU), free cash flow (EBITDA), and churn (cancellations/average users per period). Subscription models require a clear focus on acquisition costs, strategies to drive ever higher ARPU, and customer retention strategies. I meet with many companies who are well-versed in subscription economics, however, their business plans often do not sufficiently factor in the power of broadcast/ad models to challenge their revenue models.

Internet broadcast models appear to be dominant on today's Internet. Unlike a focus on ARPU and churn, broadcast models seek to optimize their ability to profile their user base and to serve increasingly relevant adverstisements to their users. Competition centers not on conversion ratios, churn, and subscription revenues, but rather on powerful analytics, user segmentation, and behavioral analysis that allows for "perfect" ad targeting.

Each model relies on a different set of competencies and different set of goals. Consumer subscription models seek to entice free trial users to move to paid services, while broadcast models seek to maximize users and monetize them via advertising.

IMHO, when designing a model today, start-ups should focus on the type of model most likely to succeed - broadcast or subscription - knowing full well that the major players will continue to add functionality and services in a quest for more page views and ad opportunities.

PS. What is interesting to me is that on cable and radio, we are seeing the rise of subscription services challenging broadcast media - eg. HBO and XM Radio. This may be a function of FCC restrictions on broadcast content but is an interesting contrast to the current consumer Internet.

Stanford Panel on Software Trends and New Company Formation

This Thursday at Stanford, Hummer Winblad and BASES are hosting a panel on software trends and new company formation.

Please see the above flier for details. We are lucky to have a wonderful group of panelists committed to the event. Please feel free to attend if you are in the area.

The Kiss of Death

Venture capital is often described as a business of pattern recognition - experienced investors pick up on market patterns, management team dynamics, and seemingly random data points to draw powerful insights. While I am still relatively new to the industry, I am struck by a few capital structure patterns that are generally bad omens.

The Too Large "A" Round
Ideal company formation reminds me of agile programming - small teams driving quick, iterative cycles that allow for the most insights, appropriate changes in strategy, and, ultimately, the highest quality "product."

I often say that genius is a function of context, and until a company is fully immersed in the context of the given problem set the best insights and strategies are often not apparent.

Too much money too early and too many people too early interferes with the productive process of iteration. Large teams with lots of resources and a very uncertain sense of direction or purpose are a bad combination.

Too High "A" Round Post-Money Valuations
While a self-serving argument, an equally challenging problem is a too high "A" round post-money. High "A" round valuations are often Pyrrhic victories. High posts and middling execution often leaves a company in a grey zone whereby objective value creating milestones have not been clearly met, yet some qualitative progress has been made. A common result of such a financing is a bridge round that extends the runway and is designed to allow the company a quarter or two to "grow" into its post-money "A" round valuation. More often than not, the bridge becomes a pier and the company and founders suffer from a post-money that proved you can win the battle and lose the war because of it.

"A" round financing strategies should be tied to discrete logic tests and proofs and the goal should be to optimize the validation/dollars ratio. Can we validate the technology and business model on as little as capital as possible? The ratio forces founders to think through the material questions that need to be answered with the use of proceeds. Will the product work? Will customers buy it? Can we sell it? If so, how? How much do we need, with a slight cushion, to answer these questions? Given all the noise in a start-up, what are the real issues and risks we need to manage? The validation/dollars ratio is a measure of efficiency and a quasi measure of return on equity. Start-ups that maximize the ratio are generally rewarded for it.

A reasonable Series "A" raise and post-money combined with realized value-creating milestones generally leaves a company in an enviable position when raising the Series " B". The key hypotheses have been validated and a reasonable mark-up is possible.

To that end, Cooley Goodward's recent report on trends in venture capital reported that the median Q305 valuations for A-D rounds were $5m, $12m, $23.5m, and $41.71m respectively.

Patterns and data suggest that for software companies an $8-10m "A" post appears to maximize the probability of a healthy B round and good optics and pattern recognition.

DEMO

I will be at Demo next week in Phoenix. Given all the dynamic activity in the start-up world, I expect to see some great new companies emerge from stealth in AZ.

To set up a time to meet or grab a drink, please ping me (wprice@humwin.com).

Superbowl Index

As the pundits debate next Sunday's Superbowl, my friend Dave Cotter's company, Mpire, developed a Superbowl Index based on eBay's listings of Seahawk and Steeler paraphernalia. On average, Seahawk items sell for ~$50 more.

The Index is a clever means of showcasing Mprie's Researcher product and is probably as accurate as any TV pundit when it comes to forecasting a winner. It looks like whoever wins, eBay will take a cut along the way:)

1 (800) 411-METRO

Matt Marshall recently wrote an article on the $8bn directory services market and other emerging mobile information models. Matt profiles a recent addition to the HWVP portfolio, Infreeda.

Infreeda provides nation-wide, human operator, ad supported 411 calls. Very simply, dial 1 800 411 METRO the next time you are looking for a listing and stop paying high fees (~$1.75 per call) for information.

Let us know your feedback.

Instant Gratification

Last night, Hummer Winblad hosted a dinner at Stanford for GSB, CS, and EE students. Stanford students are remarkably entrepreneurial and the energy around new company formation is impressive.

Over dinner, several questions were raised with respect to design considerations for new enterprise software companies. In thinking through an answer, the following thoughts came to mind.

What is the time to value quotient? How long does it take for the customer to realize value from your product? Compare and contrast clicking on a URL to self-provision versus a two-month on-premise proof of concept.

What is the customization to value quotient? How much customization is required before the customer sees relevance and value?

How much manual labor is required to realize value? How many sales engineering and professional services hours are required to both explain the merits of the solution and have it running successfully in the customer's environment? The common element of MySQL or Salesforce.com appears to be that customers self-validate through low-risk experimentation without the need for vendor sales engineers.

What is the risk of experimentation? Does the customer need to pay for a proof of concept? Does the customer need to requisition IT resource (new servers, open up a firewall port, etc) to enable your product to showcase its benefit? As with the MySQL comment above, can the customer experiment and test the value proposition without material risk or expense?

What is the time to integration? Can the product provide standalone value that obviates the need for day one systems integration, a la SFA? To the extent integration is required, how standardized are the interfaces to relevant up and downstream systems that add value to the solution?

The consumer internet offers useful lessons and direction for the enterprise space. Customers self-provision, self-validate, self-integrate, and self-configure.

The dinner offered some great ideas and insights, and I look forward to seeing the great new companies that are currently being hatched on campus.

Share of Revenue and Profits

The NYT recently published an interesting article on the occasion of Google's market cap matching that of Warren Buffet's Berkshire Hathaway.

See the attached chart. The analysis looks at the relative claims of $10,000 worth of IBM, Google, Yhoo today, Yhoo peak valuation, and Berkshire Hathaway shares on respective revenues and net profits .

The analysis illustrates that a company's improvement in fundamentals may not be matched by a corresponding improvement in stock price. YHOO is down 66% from its peak while $10,000 of YHOO stock now has claim to 17.5x more revenue, 68x more net profit, and 14.5x more book value than at its peak valuation.

The separation from fundamentals and valuation, realistic forecasts and market cap, etc become particularly problematic when market sentiment changes. The questions of where is the floor and what is the intrinsic value are begged by the separation. With GOOG swinging $15 in a given day, it may pay to think about the analysis and YHOO's recent history.

RSS Ad Stats

With RSS traffic and RSS reader adoption booming, ad impressions on traditional sites will inevitably go down. Web publishers will need to work out how to make money off of the RSS r/evolution via embedding ads in RSS.

For some very useful statistics on RSS advertising click-through-rates and RSS reader behavior, check out Pheedo's blog - Pheed Read #1 and # 2.

The feeds are instructive and suggest that RSS ads significantly outperform traditional web advertising wrt CTRs. Furthermore, given RSS subscriptions allow for more effective targeting and segmentation it is likely that the CPCs will be higher than with traditional on-line ads. Web publishers may find that driving RSS usage increases ad-related revenues despite a decline in "home site" web-site page views.

I would love to talk with people working actively in this area. Thanks to Pheedo for the data.

Living History - Sun Founders Panel

Tonight, the Computer History Museum in Mountain View hosted a fabulous event with the four founders of Sun - Vinod Kholsa, Scott McNealy, Andy Bechtolsheim, and Bill Joy. If you enjoy history and technology, I encourage you to come to future events and to support the only museum in the world dedicated to the collection and preservation of the software, documentation, hardware, images, and personal histories that represent the innovation and advances in IT.

The wonderful reality about the technology industry is that a significant number of IT industry pioneers and innovators are not only still with us (Jobs, Joy, Bechtolsheim, etc), but also remain vibrant participants in the economy they helped to create. Tonight really was living history with the people on stage recounting the founding of Sun in 1982 and the adoption of open systems, Unix, RISC, Java, network based computing, the constant ying and yang of fat vs thin clients, and the MSFT vs Sun world views.

Sun's sales in the first six years - $8.5m to $1bn- testify to its force as disrupter, and yet I have to tip my hat to the company and founder's staying power. Here we are 24 years later and 50% of the founders remain employees and Sun remains a force in the market place.

WRT disruption, it is instructive to note that open systems were lightly regarded by the investment community in 1982, which is very similar to Marc Benioff's experience raising money for SaaS-based CRM in the late 1990s. The common elements in both examples appear to be a price/performance ratio improvement and an alignment to the customers' interests that the competition's business model did not allow for. Yet the investment community, in both instances, reflected the incumbent's world view. It seems to be a truism that large companies in technology can innovate (Xerox Parc being the poster child) but that they remain vulnerable with respect to brittle cost structures, business models, and organizational dynamics that make it difficult to use the very technologies their research labs are innovating. Perhaps the best answer to "why can't a large company do what you do Mr Start-up," is to say they probably can but they can't afford to - history, that is living history, says that's true.

Personal Equity

Steve Bird of Focus Ventures wrote an interesting paper on what drives venture capital returns.

The paper looks at two investment cycles: the PC era of 1983-1987 and the Internet boom of 1997-2001. In the former era, the top 50 firms represented 13% of the industry and captured 44% of the value created. In the latter era, the top 50 firms represented 4% of the industry and captured 66% of the value created.

The moral of the tale to LPs is that if you cannot get your money in a top firm then don't invest in the asset class.

Click above to get the PDF.