VC Returns through 12/31/06

Today, the NVCA released venture capital returns performance data through year-end 2006.

The data suggest an early, if not yet sustained, recovery in venture performance.

While Keynes famously said, "In the long run, we are all dead;" retrospectively the long-term investment returns are excellent.

The key question is whether the current structural reality - i.e. # of funds, amount of committed capital - of the venture industry will support like returns over the next 10-20 years.

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 idiosyncratic returns. In the bubble, random investments looked genius. The systematic returns (returns for the asset category at large) were simply amazing, thereby creating great wealth 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 idiosyncratic returns. Are funds' returns systematic (an index of the market) or extraordinary? 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 success 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 asymmetries. Certain private investors simply enjoy access to information, ideas, and talent that are not generally available to others. For example, 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 access 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 corollary, 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.

Limiting H-1Bs: Economic Suicide

In a prior post, H1-B Aliens and the Myth of Free Labor Markets, I wrote,:

"In my daily meetings with founding teams and start-ups, there is not a single company that does not have an emigre as a key member. The contribution of Indian, Chinese, Russian, Bulgarian and other nationals to our economy is beyond question and a vital source of our success. From professors, to engineers, senior managers, company founders, and venture capitalists, our current success and prosperity is very positively influenced by our ability to attract the best and brightest to work and study in our country.Unfortunately, America, while often a champion of free trade, is not a practioner of free labor markets. While technology talent is perhaps the most important input in Silicon Valley's decades of innovation, the US government artificially caps and limits the number of ambitious immigrants to our economy ."

This week's Economist includes an article titled Deportation Order.

Since 2003, the US government has reduced the number of H1-B visas by 66%; from 195,000 in 2003 to a measley 65,000 this year. Within hours of the application deadline, 150,000 applicants submitted visa requests; a frightening 85,000 on-time applicants lost out to a random number generator that selected the lucky winners.

The article quotes the Harvard Crimson commenting that "many of the foreigners in its class of 2007 have received their deportation orders."

The valley's position as the leading cluster for technology innonvation is contingent on the seamless flow of ideas, capital, and talent. Artifical limits on the ability to source talent will have profound downstream consequences, reducing the quality of innovation, wealth creation, and utility.

If you feel so moved, please reach out to your Congressperson and Senators; for how to contact your House representative click here; for your senator click here. Ask them to eliminate ariticial limits that are keeping the next Sergey Brin's of the world from joining us.

Large Companies - New Equation of Big Company Behavior

Start-up time is to dog years as enterprise time is to human years. Start-ups move 7x faster as the urgency of the next fund raising, competitive threat, cash position, etc... drive Herculean efforts.

A familiar start-up complaint is that the contrast in cadence (btwn small and nimble and big and slow) is incredibly frustrating. The time it takes to negotiate on OEM deal, partner with, sell to...large companies is often maddening.

Yesterday, over coffee with a great entrepreneur I heard the frustration summed up in a moment of brilliant wit.

The entrepreneur argued that:

an individual's competency x company size = a constant

In essence, the bigger the company, the less competent the people.

Now, we all know that there are many smart and hard-working people at large companies. There is, however, also a common malaise that somehow limits the ability of large companies to make decisions, to move quickly, and to be productive.

Many of my friends work at large tech companies and frequently complain of the siloed thinking, the blackbox decision making, the inability to make decisions, and the frustrating inability of the company to harness the collective energy and initiative of the group.

Why?

What is it about size that limits effectiveness? Why do people feel so powerless in large company settings and so frustrated?

While there many reasons, I see three core drivers

1. incentives
1. the incremental compensation that accrues from initiative is not worth the risks and costs of fighting the corporate inertia
   
2. politics
1. a preponderance of energy is invested in internal battles
   
2. companies and individuals have finite stocks of energy
1. employees of large companies spend more energy on internal issues than on external customer facing and value-creating issues
   
3. dead wood
1. large companies become safe harbors for mediocrity
2. middle management gluts the system and limits the ability of the young and the restless to advance
3. the Wall St "up or out" culture ensures the young hard chargers always have room to advance and that seniority and tenure are no guarantee of protection

While the "constant" above is certainly extreme and unfounded - it underscores the failing of many large companies to provide exciting career choices to younger go-getters and a suboptimal use of talent, resources, and energy.

VC Interviewing Best Practices

VC firms hire infrequently. Given the slow cadence of new hires, it is critically important to hire well.

Two years ago, when I interviewed at Hummer Winblad, I went through the traditional in-person interviews where partners probed my educational, operating, technology, and investing background.

The last step in the hiring process, however, proved to be the most challenging and most rewarding. After having met all the partners, I received a call saying that things were looking good. There was one more step, however, that they wanted to me to pass. I remember thinking, okay...what now?

The request...come in two days from now and present your thoughts on the future of the software industry to the full partnership. The guidance...don't mess it up as things were looking good.

I presented the embedded deck to the HWVP team. Since then, I have been asked many times about the process of interviewing at venture firms and what to expect. I believe that a "best practice" is to give the candidate a platform to share their thoughts and analytical skills. One should be prepared to white board or present a deck that lays out an investment thesis, sample company of interest, etc; thereby providing a window into how you think.

The key point is not the deck itself, but rather a "candidate pitch" moves the process from conversation pleasantries to structured information exchange.

The file can be downloaded from here.

The Value of Scenario Planning

A standard part of the investment process is to identify a business model's key variables and to generate scenarios that test their impact on revenue and cash.

Sure signs of a thoughtful management team are:

1. the ability of the management team to articulate the material business drivers in the model
2. to test the impact of the variables on material financial metrics
3. to sanity check the assumptions with market comps - i.e. not to base the business on a black swan outcome
   
4. to focus the management team and company KPIs on the identified variables.
5. the inclusion of scenario analyses in investor presentations
   

A very effective means of testing variables is the data table, which allows one to test how different input variables affect the results of a given formula.

The attached example illustrates the value of data tables in analyzing

• the impact of CPM rates and
  
• revenue share on an ad network.
  

The analysis takes the company's forecast and key assumptions and calculates the required page views to hit the plan. The requried page views are then compared to known market comps to test for "black swan" risk. Finally, with CPM rates and revenue share the key variables, a data table tests the the impact of a range of CPM rates and revenue share splits on the page views required to hit projected 2008 revenue.

For example, the analysis illustrates that for the company to hit 2008 revenue

• at a $5 cpm, 20% revenue share
• the company needs to grow monthly impressions to
  
• 333.33m PVS/month
• 6.67x current traffic
• 56% of MSNBC's current monthly traffic
• However, at a $2 CPM and 10% revenue share
• the company needs to grow monthly impressions to
• 1.666bn PVS/month
• 33.33x current traffic
• 282% of MSNBC's tarffic
• Ie, the model begins to look precarious and "black swan-like, ie possible but highly improbable"
  

In summary, the effective modeling of scenarios helps to highlight the impact of key variables on the business, helps communicate the maturity of the management team's thinking, and frames the sanity (relative to market) of the plan in question.

Board of Directors

Corporate America is intensely focused on corporate governance and on the duties of Directors. Whether CEO compensation, corporate performance, ethics, financial statement integrity... boards are increasingly subject to exacting standards and accountability.

Students of finance are familiar with the principal-agent dilemma; management, agents of the principals, often fail to act in the best interests of the principals, shareholders. The degree to which directors are truly independent speaks to their ability to ensure agents maximize shareholder and not agent wealth.

Warren Buffet believes there are four key requirements for board members:

1. owner-orientation
2. business-savvy
3. interest
4. true independence
   

Private equity and venture capital structures eliminate large measures of principal-agent issues.

How? Ownership is concentrated into the hands of a few firms who have direct board level representation. By definition, VC board members are owner-oriented and interested. Whether they are business savvy is subject to a case by case analysis, while independence is not possible.

The question for venture capital boards, therefore, centers not on how best to represent owners, but rather on how best to create a productive board that maximizes the probability for company success.

On Wednesday, I am speaking at the LA VC 2007 Investor Conference. My panel is focused on "Building Boards." Since, my specialty is early stage venture, my thoughts on an ideal board follow (modeled on Buffet's four criteria.)

For aspiring entrepreneurs, I would seek a board with the following characteristics

1. small and nimble
1. 3-5 total directors (CEO, 1-2 VCs, 0-1 independent)
2. start-ups are fast paced and iterative; often board issues are event driven and pre-scheduled meetings often fail to coincide with the natural cycle of progress
3. being held hostage to scheduling logistics drives CEOs nuts and delays the time to decision and action
   
2. economically aligned
1. if the economic incentives of the board are different, consensus regarding financings, M&A events will become more complicated
2. if people make money at very different exit outcomes...
   
3. empowered
1. ensure the VC board member is well established at their firm and has "juice."
2. the start-up road is long and bumpy, VCs with limited internal power are often more proxies than decision makers and their limited internal power may unfairly taint the credibility of the company
3. their political weakness will limit their ability to support the company in times of peril
4. value-added
1. VCs must be able to accelerate the cycle time to success and understand the business
2. The best VCs truly understand the human, financial, and market dynamics of their companies
   
5. effective CEO-board and director-director communication
   
1. CEOs must share information - both good and bad
   
2. Directors need to work well together in executive session issues: compensation, audit, financing and other core issues
3. Failure to act quickly on compensation/bonus programs and other executive session issues impacts morale and limits the effectiveness of company management
   
6. informed directors
1. Early stage companies need to begin to track, measure and report on relevant and timely data. Good board packages make for good board meetings.
2. This is normally an iterative process but data and KPIs enable informed decision making and analysis
7. productive processes and meetings
1. Develop well structured meetings with adequate frequency and cadence
2. Focus the meetings on critical path issues
   

As companies grow, the size, make-up, and roles of the Board change with it. This post reflects my observations of the critical success factors for healthy, functionining Series A boards.

For a more in depth analysis, please read "The Basic Responsibilities of VC-Backed Company Directors."

Mulecon 2007

Today, Mulesource, the leading open source integration software provider, held its inaugural Mule developer conference. The event proved to be a smashing success.

See my prior post on Mule here.

Over 100 developers flew in from around the world to share their expereinces, use cases and passion for the Mule project. For a company less than a year old, the size, diversity, and evangelical nature of the audience was simply remarkable to observe.

The best companies create ecosystems of customers, partners, and developers who realize their own economic interests and dreams via the given company's platform and technology. For example, both eBay and Microsoft benefited from the energy, investment, and activity of the thousands of companies in their ecosystems. The leverage possible when you are the fulcrum by which third parties leverage their businesses is powerful indeed.

Typically, creating vibrant ecosystems takes years to accomplish and material investments in developer, partner, and customer acquisition and development programs. Mulesource, riding the momentum of an authentically grassroots open source project, hit the ecosystem milestone within 9 months of incorporation.

Today, Walmart.com, H&R Block, Fimat, MLB.com, etc...presented use cases, reference architectures, lessons learned, competitors considered, and endorsements of Mule. For those interested in Mule, Eugene Ciurana's very detailed Mulesource case study from The Serverside is definitely worth reading.

For the prospects in the audience, hearing first hand why the largest mission critical applications in e-commerce, trade processing, tax form processing, etc chose Mule over competitive open and closed source vendors, many of which already had enterprise license agreements with competitors in place, proved invaluable.

Watching the developers share best practices and their genuine appreciation for Mule's flexibility, ease of use, and value helped me realize that the company is in the enviable position of having a fully functioning ecosystem where the interests of the ecosystem and the company are becoming fundamentally intertwined. Historically, that proved to be a very good thing!

Congratulations to the Mulesource team and to the many third party customers and developers who are driving the project and company forward.

Shift in the on-line video landscape

While the world focuses on Youtube's battles with mainline media, Move Networks is quietly altering the underlying infrastructure landscape powering on-line video.

The investment community and media are largely focused on the battle between copyright holders and Google, however, an equally important shift in on-line video transport is underway. While the battle for copyright, traffic, and the on-line ad dollar is raging, another battle is underway; that is, how best to stream live and archived television to web audiences.

Today, Youtube, NBC, CBS, etc use Flash Video and Flash Media Servers to deliver their content. Many pundits are also pushing the merits of P2P....

As of yesterday, however, ABC.com moved away from Flash and is now streaming full episode content via the Move Networks player. Full episodes of Lost, Desperate Housewives, etc are available via Move.

ABC joins Fox, Televisa, the CW, and other major content ownders who see five core reasons to move away from Flash:

1. quality
   
1. Move provides continuous play video with no buffering or jitter
   
2. Improved quality ensures 8-10x longer viewing times
   
2. increased revenue
   
1. longer viewing times naturally create more ad avails and higher revenue
3. reduced cost
   
1. Move rides on HTTP and leverages the economics of commodity HTTP transport rather than proprietary RTP transport
2. Flash Media Servers are materially more expensive than commodity web servers and web caches
4. DRM
1. Flash does not support DRM
   
5. scale
1. Move scales to an order of magnitude larger number of simultaneous streams
2. Why? Move scales with the web not via deployments of proprietary media servers in CDN fabrics
   

Move is the only video delivery system that allows customers to deliver both live and on-demand content, supports continuous play, utilizes least-cost CDN pricing and routing, leverages commodity web infrastructure, provides full support for PVR features, and provides per stream, per user reporting and tracking.

The net results of Move’s solution is a 10x increase in average view times versus alternative technologies, a 10x reduction in delivery costs, and a 10x increase in the possible audience size. At $25 CPM rates, content owners enjoy 95% gross margins, or 1.5x more than broadcast economics, and the Web moves from a marketing vehicle for broadcast programming to a profit center in its own right.

With $55bn of TV ad spend at risk, the stakes have never been higher and the race is on to monetize video content on the web.

Disney's move (pun intended) to Move represents a remarkable shift in the on-line video infrastructure landscape. Two of the big four networks are now streaming via Move's protocol, and the era of jerky, unwatchable on-line video is coming to a close.

Check out the abc.com site and watch full-screen video - who knew web video could look so good?

See prior posts here
Move Networks
24 is on the Web!

How do you plan for M&A?

Happy St. Patrick's Day. Please find below my guest post on start-up company M&A from Ask the VC.

Question: How do you plan for M&A? Trying to build our company, thus far we went the regular path – market research, sales projection models, expenditure / P&L models, potential products/product lines and the like (text book?), but many people we met told us ("shouted") that we should plan for a strategic partnership/ M&A, how do you do that? Should there be a special business plan?How does a P&L look in that case? How do you plan the selling of your IP to a large company? Selling after you have a finished product? Selling the company after initial sales? Letting the company grow a bit more? Is it good practice / healthy to plan your business on somebody buying you? Will it be acceptable to prospective investors/ VCs?

Plan for Independence. There is a famous VC saying, "companies are bought and not sold." Accordingly, the best "plan" is to plan for success as an independent company.

The company’s operating plan, technology road map, and executive team should not focus on unnatural acts, in the hopes of attracting a buyer, but rather on building a company with the potential for independence. Companies built to "flip" often flop. They often flop due to the fact the team is not truly committed but, instead, looking for a quick buck. Bad motives drive bad behavior.

A fundamental concept that helps focus management on building to independence is optionality, or BATNA – which is MBA-speak for "best alternative to a negotiated agreement." BATNA is a fundamental tool for understanding negotiating leverage and strategy. If you work to ensure you have a BATNA – for example continued independence or a higher offer – the company is able to negotiate from a position of strength. If no BATNA exists (i.e. the choice is between a fire sale or running out of cash), the company is at the mercy of the buyer and the negotiation becomes an exercise in Russian roulette. Always have a BATNA.

Be Prepared for Acquisition: Sourcefire ("FIRE") went public this week. Since the last security company went public – NetScreen – there have been over 250 security M&A transactions.

So what?

While the security software market is an extreme example, it is far more probable that a successful tech company will be bought rather than go public. Accordingly, while no special plan for sale should be developed, it is highly logical to expect M&A to emerge as the path to liquidity.

While VCs believe "companies are bought and not sold," acquirers tend to believe that "successful partners make the best acquisition targets." Successful partnerships are characterized by

• a history of successful joint customer engagements,
• successful technical integrations and co-deployments,
• a joint roadmap,
• co-marketing and sales traction, and
• management teams and team members with a track record of collaborating to reach shared objectives.

A great example of the partner-to-buy model is SAP and Virsa, although there are many such examples.

Keep Good Records: Finally, M&A is a diligence driven exercise. The final cliché is that "good record keeping makes for good diligence and good diligence makes for expedited outcomes." Good records include:

• Articles of Incorporation/company charter
• all Board minutes, contracts, signed employee assignment of IP forms
• capitalization table
• option plan records
• prior financing documents
• audited financials
• patent filings
• documentation relating to litigation, assessments, or claims

Any material gap in records will either 1) delay the sale process and/or 2) will lead to a higher escrow to offset potential liabilities that may "appear" post-close.

In summary, all clichés are common sense and the M&A related clichés noted in this post are no different:

• build companies for independence (always have multiple BATNAs),
• partner well,
• keep good records

Hedge Funds and Venture Capital

Brad Feld and Jason Mendelson kindly asked me to serve as a guest blogger on Ask the VC.

Today's question and my response follow. The original post can be found here.

Question: As the alternative asset classes continue to converge, there has been growing evidence of hedge funds looking to be more involved in venture (both passively and actively). As an early stage venture capitalist, what are your thoughts on this? Are you seeing the trend? Have you considered partnering with any hedge funds, and if so do you view hedgies as primarily a source of passive capital or are they demanding/receiving strategic places at the table?

Economic theory can be used to explain the phenomena described above. The theory in question, "economies of scope," states that a reduction in per-unit costs is possible via the production of a wider variety of goods or services. For platform funds, the incremental cost of the nth fund is significantly less than the cost of establishing and managing the first.

Accordingly, alternative asset platform funds – Carlyle, Bain Capital, Pequot Capital, Blackstone - are aggressively pursuing economies of scope in raising funds that leverage their LP relationships, back office systems, strategic relationships, etc Platform funds are aggregating assets in ways that maximize their resource base and economic interests. Whether the interests of LPs and the platform fund’s principals are aligned remains a more complicated question.

See my earlier post on alternative asset platform companies here. In short, I am not a big fan.

The center of gravity for platform players largely falls into two camps- private equity firms and hedge funds. The question above accurately reflects the fact that hedge funds are increasingly showing up in later stage deals. As an example, see $60m Brightcove financing led by Maverick Capital.

First, this is reminiscent of the late 1990s when the mezzanine market proved to very lucrative. Hedge funds piled into pre-IPO rounds in hopes of buying six to twelve months ahead of the IPO.

Second, one needs to separate the strategic vs. opportunistic players. Carlyle and Pequot, for example, have made long-term commitments to the venture category. The two firms built dedicated venture teams investing dedicated venture funds; not hedge fund managers investing "cross over" funds in one-off private deals. The opportunistic players’ presence in the market is tied to the economic cycle rather than to a secular commitment to the asset class – ie. fast money in, fast money out.

Finally, the decision to consider an investment from a hedge fund needs to be context sensitive. If the company is looking for mezzanine financing, a passive hedge fund investment makes perfect sense. The goal of the round is to raise expansion capital at the highest valuation and most company-favorable terms possible.

If the company is several years away from a liquidity event the decision is more complicated – I would suggest weighing the following variables in evaluating a hedge fun investor– will the investment be made from a dedicated venture fund, is there a dedicated venture team, does the fund keep adequate reserves for follow on rounds, does the company need an active net new board member, if so, could the partner in question add value, do they have referenceable portfolio companies and CEOs that can speak to their strengths…? The investor must be judged on their merits as value-added private company investors, not as easy sources of capital.

We would absolutely consider working with a hedge fund in a later stage round, however, we prefer to syndicate A round deals with likeminded investors with a successful history of A round investing and a long term commitment to the early stage venture asset class.

You Can Multi-task But Your Company Cannot

Yesterday, Verne Harnish, a start-up growth guru, visited Hummer Winblad.

Verne, founder of Gazelles Inc, is a thought-leader in start-up growth management and the author of a must-read book, Mastering the Rockefeller Habits. Please see my detailed post on the book here.

Verne's book is based on the management style of John D Rockefeller, whose management style centered on three key areas:

• priorities
  
• define the 1-5 most important organizational objectives
  
• data
  
• identify and manage to the key metrics and leading indicators, and
  
• rhythm
  
• run a well-organized set of daily, weekly, monthly, and quarterly meetings that keep everyone aligned and accountable

The core premise is that success is the sum total of all decisions being made in an organization. Leaders/managers influence decisions, and hence success, and need a framework regarding how best to do so.

Verne led eight Humwin CEOs through a presentation on how best to master, manage, and benefit from growth.

While the session proved rich in content, one lesson struck me as particularly profound.

"You Can Multi-task, but remember that your company cannot."

Entrepreneurs are by definition multi-taskers - they can juggle five to six balls at once and switch gears with no loss of momentum . Too often entrepreneurs ascribe to their companies those same capabilities and are amazed when people and organizations complain about being whipsawed and of being uncertain as to priorities and direction.

How best can a leader ensure a company moves quickly and as one? A leader must strive to harness the collective energy of an organization by defining common objectives and a common cadence.

Changing focus leads to energy diffusion, loss of momentum, plunging moral, and organizational confusion.

Think about crew...a boat with eight oars pulling to the same rhythm almost leaps out of the water...if the cadence is out of synch the boat wallows...

Organizations that shine channel energy towards common goals and benefit from the cumulative leverage of many brains and hearts focusing on the same objectives. An entrepreneur simply cannot run a company the way he runs his day.

The challenge for start-ups often lies in how quickly the market, product, and opportunity changes.

The great leaders, however, insulate their companies from the pernicious effects of course correction and shifting objectives and see the benefits of harnessing energy rather than unintentionally diffussing it.

Ernest Gallo: Passing of a Giant

Ernest Gallo, a true giant in Californian business and entrepreneurship, passed away yesterday.

Mr Gallo, who co-founded E&J Gallo Winery with his brother Julio 70 years ago, passed away at age 97.

Starting with $6,000 dollars and book on wine making from the local library he built the world's largest winery, which today produces over 62 million cases of wine each year.

Along the way, he pioneered many of today's standard business practices:

• vendor managed inventory,
  
• end cap product placement,
  
• national sales forces;
  
• brand advertising,
• brand extensions;
  
• modern distribution systems,
  
• and, perhaps, most significantly, introduced wine to a country that only drank beer and hard liquor.

I once asked his son, the current CEO, why they use the Gallo name in their premium wines. He asked me, "how long do you think it will take consumers to see us a premium wine brand name?" I told him, "ten to twenty years." His response was telling - he said, "fine, we are not going anywhere."

In a valley that thinks in terms of months not decades and works to minimize time to exit, the Gallos are an amazing example of resiliency, vision, and multi-generational commitment to the business.

Mr Gallo was a great entrepreneur, pioneer, and Californian who will be sorely missed.

Updated Link for Introduction to Presentation Venture Capital Pitch

Apologies for the incorrect link to the presentation.

Please click here for the slides.

Introduction to Venture Capital

Today, I guest lectured at Stanford University.

The class, the Entrepreneurial Engineer, is a graduate course for engineers interested in starting their own companies.

The professor, Roger Melen, asked that I provide an overview of the venture capital industry, insights into the venture process, and a suggested play book for entrepreneurs looking to raise venture capital.

While a well-covered subject, I attach my slides for review and discussion. Also, if widget fails to load visit:

HWVP in the FT

The FT recently profiled John Hummer and Hummer Winblad.

The article, titled "Think boring is the tip from Silicon Valley," highlights conclusions from a review of Hummer Winblad's 18 year investment history.

In the spirit of George Santayana's quote, "those who cannot learn from history are doomed to repeat it...."the article reviews some of John's conclusions on the "model" that works best for HWVP and, equally as important, the model that doesn't work.

Chief among the conclusions are 1) a focus on capital efficiency with small A rounds, 2) a bias towards infrastructure companies, and 3) the importance of investing in disruptive platform shifts/waves.

While the above is not a universal recipe for success, I believe that introspection is fundamental to defining strategy and securing consensus and focus.

One thing I can vouch for is the leverage and productivity possible when the full team subscribes to a common model and measures investment opportunities along a common curve.

The Mathematics of Energy: Have We Reached a Tipping Point?

The VC industry profits from secular disruptions. In IT, platform transitions – mainframe to client/server to web, etc – create massive disruptions, new companies, and fantastic returns to investors.

In a absolute sense, disruptive companies initially operate on the margin of major industries. GOOG, for example, is the leader in the online ad market, a market which represents less than 6% of the total advertising market.

It is often not the absolute levels of market share that drive market capitalization but rather the rate of relative change in new technology platform adoption. The rate of change is a function of the economics and value of the emerging technology platform.

GOOG’s market cap reflects the market consensus that the online market’s share of total advertising will grow from 6% to 10% to 20% and that GOOG will disproportionately benefit from the reallocation of spend.

Okay, online advertising is 6% of the total.

Anyone care to hazard a guess as to clean energy’s share of the US energy market?

Clean energy, a new vc darling, is 2.3% of the US electricity market.

The 2.3% breaks down the following way:
1.5% from bio-mass
0.44% from wind
0.36% for geothermal
0.01% for solar power.

The other 97.7%?
49.7% coal-fired
19.3% nuclear
19.1% natural gas
6.5% hydro
3% oil-fired

Wow. 97.7% is non-renewable, with 50% carbon spewing coal.

Now, the environmental benefits of clean energy aside, is clean energy economically competitive?

Caveat….the environmental impact/cost of traditional energy is not captured by market prices. Non-price costs are referred to as externalities and, ultimately, serve to understate the costs of traditional energy. Pricing externalities remains beyond the scope of the market – ie. What is the cost of Greenland’s melting ice sheets, who should pay for it, how should it be imputed into the market price for energy?

The DOE provides interesting answers as to price competitiveness. For a plant coming on-line in 2015, the per kilowatt hour prices, by energy source, are forecast to be:

Coal $0.0531 per kwh
Wind $0.0558 per kwh, or 1.051x coal
Natural Gas $0.0525 per kwh, or .98x coal
Nuclear $0.0593 per kwh, or 1.12x coal
Solar $0.30 per kwh, or 5.65x coal
Biomass $0.075 per kwh, or 1.41x coal
Geothermal $0.075 per kwh, or 1.41x coal

In essence, the DOE believes that, independent of subsidies, that only natural gas will be cheaper than coal. Importantly, wind, nuclear, biomass, and geo-thermal are approaching the cost of coal.

The sad fact is that in the absence of either 1) subsidies, 2) innovations in pricing models that can capture the costs of externalities, or 3) a material breakthrough in technology, that the importance of coal will be undiminished. This is reflected in TXU’s plan to build monster coal fired plants in TX – they are economic actors.

For the clean energy sector, the math does not yet work. In order for the 2.3% to become 5% then 10% then 20%, we appear to need two things

1) the analog of Black-Scholes pricing models to emerge. We need to develop a pricing model, that the market will accept, that can capture the externalities and hidden costs of non-renewable energy production.
2) A breakthrough not only in the cost of alternative energy production, but also an ability to scale. Wind today can serve 20m homes – we need massive increases in scale.

Monster companies emerge not when they own 20% of a market but when the market realizes that the economic advantages of the new platform will create massive dislocations in the market. When we see clean energy reach 5%, it will be interesting to see if a GOOG type company is leading the reallocation of capital with an economic value proposition that leaves coal, thankfully, in the dust…

See WSJ.com/reports for an excellent analysis of the topic above

Framing: Creating the Right Mental Impression

George Lakoff, a professor at Berkeley, is a renowned expert in cognitive linguistics. His particular expertise lies in applying linguistics to the study of public political debate.

His core thesis is that metaphors and concepts are the building blocks of thought and the mechanism by which we process reality. He says, "Our ordinary conceptual system, in terms of which we both think and act, is fundamentally metaphorical in nature."

In Lakoff's vernacular, we think in "frames." He writes," Every word, like elephant, evokes a frame, which can be an image or other kinds of knowledge. Elephants are large, have floppy ears and a trunk, and are associated with circuses, and so on. The word is defined relative to that frame." When I say "elephant," you cannot help but think of the characteristics noted above.

This is very important as it argues that every word we choose to use carries with it related associations, emotions, imagery, correlated ideas, values, etc. He argues that we can control the way people think and relate to our positions by the words we use and the frames (ie. related meta-associations) that we choose to employ.

In politics, he credits the Republicans with a mastery of framing - for example, the concept of "tax relief" implicitly suggests that taxes are a burden and any opposing position would be pro-tax and pro-burden.

Why is this important? How is it relevant to start-ups and the venture process?

VC is fundamentally a patter recognition and classification exercise. Every time you pitch a VC, they are, in real-time, classifying the company and opportunity into a master taxonomy. VC is an exercise in decision making by metaphor - this company is Salesforce.com for X, Youtube for Y. The evaluation process involves first classifying the opportunity into a conceptual bucket and then quickly associating the company with the attributes of the given bucket.

If you can indeed control the associations, both positive and negative, that are an inherently part of any frame, then it is vital that we choose our words very carefully. Entrepreneurs must carefully consider the frames and buckets they choose to use to describe their businesses recognizing that each chosen word carries with it either "positive" or "negative" connotations and baggage. It should be the goal of every CEO to ensure "positive" categorization.

In the VC lexicon, there are certain buckets that are minefields or "third rails." It is important to control the categorization exercise and preemptively "frame" the discussion in your favor.

Example "third rails" or "negative frames" can be either failed markets (ASP, P2P file sharing, egovernment), business models ($50m to break even), or team dynamics (husband and wife team, 15 founders, etc). These frames all evoke negative emotions, memories of capital loss, and a desire to quickly end the meeting.

When you describe your business, unconsciously the words you employ are raising a set of memories, emotions, inclinations...in the mind of your listener. Be mindful how best to control the reaction of your audience by anchoring off positive tailwinds, successful companies, and other anchors that ensure your name evokes a smile not a smirk.

Isolating Causality: Bad Market or Bad Company

Cervantes famously once said that, "proverbs are short sentences drawn from long experience." In venture capital, one often hears industry veterans say something like, "bad markets make for bad investments."

The importance of the growth, health, and timing of a market to a start-up's postive outcome is both vital and well-known. Cliched and yet, as with many proverbs, true.

When a company is behind plan, an investor must ask is it the market or is it the company? A frequent challenge for an investor is to isolate causality in a given investment. Isolating market (exogenous) or company (endogenous) causality is vital with respect to the appropriate remedial action. If it is the market, there is little chance that more money or new management will change the outcome. If it is the company, additional resources (both capital and human) may indeed impact the outcome and be reasonable.

I have seen some of the smartest people work the longest hours, code round the clock, make the most sales calls, and reap no reward. When the market does not care about your solution, or, worse yet, does not exist, no amount of management talent, hard work, or capital can remedy the situation.

If the market is the challenge, additional investment is a dangerous example of escalation of commitment that will result in capital loss. Often the signals as to the health of the market are ambiguous - are the data points in question indicative of the market's development and health or more random and indeterminant?

I have observed several key indicators that help identify market failure and that suggest further investment is a challenge:

1. 3 VP sales...
   
1. when the plan is missed, the favorite scape goat is the VP Sales.
   
2. A single misfire may be legitimate, but every time that I have seen multiple VP Sales fired in a short amount of time the core problem is not sales management but the fact the market does not care nor exist.
1. VP Sales turnover is a classic red herring.
2. no competitors
1. company's operating in non-existent markets are often unable to point to direct competitiors.
   
2. While competitors may exist on the margin, the names vary from account to account and no clear enemy, or set of enemies, emerges. Lack of competition is a sure sign the market does not care.
3. no RFPs
1. no customers are soliciting the company and there is a dearth of inbound requests for proposals.
4. no repeatability in customer deployments
1. while good teams can generally get 2-3 customers, an early warning sign of a bad market is that there is no consistency in customer need, no common abstraction of use case, and no way to build a repeatable marketing, sales, and product positioning against a common set of needs.
5. no partners
1. companies in dead markets cannot explain where they sit in the market ecosystem and are characterized by no legitimate partner activity
6. no energy
1. the company culture begins to calcify and visitors can feel the lack of energy and nothing appears to change month to month - ie it's like groundhog day...
   
7. no one knows what the company does
   
1. companies that suffer from the above challenges are often the ones that cannot simply and clearly explain what they do. after 45-60 seconds of buzzwords, the listener is left bereft of any sense of clarity and their eyes begin to glaze over.
   
2. when i first started in vc, i remember thinking..."wow, these guys are so smart, i have no idea what they just said." after a few years, i began to realize that if i have had no idea, then i could be damn sure the customers wouldn't either.
8. thrashing
1. the company begins to thrash, with constant changes to the positioning, core problem being solved, and the productand there is no longer a core mission or center of gravity
2. tempers fray as the lack of common mission leads to each executive articulating their own and failing to agree on a direction
   
9. companies that are in healthy markets close enough business to:
1. develop a clear value proposition
2. build repeatable marketing, sales, and delivery models around common uses cases
3. know their top 2-3 competitors cold and see them in every account
4. are solicited for business
5. have real, active partners engaged in common customer accounts
6. have highly energetic cultures where the changes month to month are signficant
   
7. can explain what they do so that almost anyone can understand
8. share a common mission that everyone in the company can articulate
   

If the market is dead, there is no hope. More money, yet another VP sales...will accomplish very little save to ensure further capital loss and wasted effort.

If the market is healthy, then there may in deed be logic in additional funding and new management. Understanding which of the two situations exists can help avoid unnecessary pain and capital loss.

All start-ups iterate their product and value proposition as they hone in on the eventual mission...the challenge is when to know if the challenges are part of the natural evolution or a symptom of operating in a market vacuum.

Krillion Launches

What do you get when you marry local search, an $18bn consumer durables market, and major off-line retailers? Krillion.

Krillion, backed by Hummer Winblad, provides a Localization Engine™ that scours the Web to find, integrate and present actionable local search results for the ready-to-buy consumer. As of this week's launch, Krillion has over 275 million pages of relevant local search results displaying local product information for major appliances in over 40,000 U.S. cities and towns.

For example, if you are looking for a white GE refrigerators within 10 miles of Mountain View, the query returns the following page. A landing page for each query result is dynamically generated, optimized for SEO, and placed into the indexes of the major search engines. By product, by location landing pages provide consumers with actionable information regarding where to buy the product in question and the price ranges across various retailers. See this page as an example result of a discrete SKU.

Why is this important?
Despite the fact that 75% of those who buy big-ticket items do all their research online and make over 90% of their purchases offline, today’s search engines typically are unable to find and deliver results pinpointing specific local stores with specific products. Krillion provides a bridge between the two worlds and helps drive big-ticket consumers into local big box stores.

Krillion delivers search results category-by-category and the first category to be covered is the $18 billion major appliance category: refrigerators, ovens, ranges, washers and dryers, and dishwashers. Moving forward, Krillion will deliver search results for additional categories such as consumer electronics, lawn and garden, seasonal appliances and others.

Congratulations to the team and please see Search Engine Watch's coverage of the Krillion launch here.

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