Hummer Winblad Venture Partners

Per my prior post on early-stage havens, I am pleased to write that I am putting my hypothesis to work and joining Hummer Winblad Venture Partners.

Starting October 3rd, 2005, I will be part of HWVP and looking for exciting, early-stage software deals.

My contact info will be:

Hummer Winblad Venture Partners
One Lombard Street, Suite 300
San Francisco, CA 94111
w) 415 979 9600
e) wprice@humwin.com

I look forward to working with great entrepreneurs and the experienced HWVP team. Please feel free to send early-stage software deals my way!

Early Stage Haven?

Recent numbers suggest that early stage investing may yet prove to be a bastion of IRR and extraordinary returns. Why? Recent data provides interesting insights into industry dynamics.

In 1H05, VC firms raised roughly $11bn in IT Venture Capital. Over the same period, IT VCs invested roughly $5.5bn, for a ratio of IT$ invested YTD/IT$ raised YTD of .5. Not a sustainable number.

If IT VCs stopped raising money today (which will never happen), it would take ~12 quarters to invest the $32bn of IT VC$ available for new investment at the Q2 run rate of $2.747bn.

As we all know, the surplus capital appears to be a secular rather than a cyclical shift in the fundamentals of the venture industry.

A key question is, where is the capital going? Apparently, not in the early stage. According to VentureOne, the percentage of VC IT $ going into early stage is falling precipitously:

• 2000 Early Stage $/Total $ = 34%
• 2003 Early Stage $/Total $ = 20%
• 2004 Early Stage $/Total $ = 20%
• 1H2005 Early Stage $/Total $ =16%

With a -53% change in the amount of money flowing into early stage investments btwn 2000 and 1H05, it appears that the surplus will continue to flow into later stage deals. In later stage investing, winning is almost always a function of share price. Price discipline is eroded as firms bid deals up to deploy capital and "win."

With fewer dollars chasing early stage deals and meaningful non-share price based differentiators - deal flow, company evaluation in absence of customers/revenue, syndication, post-deal value add, etc - it may be that while extraordinary returns for the industry as a whole look challenging, early stage investing may prove to be a bastion of IRR and extraordinary returns.

I believe that smaller funds, specialized focus areas, and early stage investing are the way to go.

Thoughts?

Scale Free Profitability

Morgan Stanley's high-tech investment banking team present a wonderful chart that examines the effect of scale on software profitability. The chart powerfully illustrates that scale is increasingly necessary to achieve competitive operating leverage in the software industry.

For example, the distribution of LTM operating margin by revenue size is as follows:

• $75-300m in revenue = 7% operating margins
• $300-500m in revenue = 11% operating margins
• $500m-$1bn = 12% operating margins
• $1bn-$5bn = 18% operating margins
• >$5bn = 33% operating margins

The scale effect, as noted by Larry Ellison and Barron's, is driving rapid consolidation of the industry as vendors seeks to consolidate capacity, drive volumes, and get to minimum efficient scale. Consolidation, while good for exits in the near term, has troubling long-term implications wrt the market's expectations for future small cap software company growth, profitability, and viability.

Start-up companies and VCs, by definition, cannot rely on scale to help us achieve profitability. Rather, start-up companies must innovate their business models and strategies in order to reach attractive profitability metrics independent of scale.

As important as technical innovation, successful start-ups must innovate how we do business and prosecute R&D, marketing, sales, and operations.

If we simply innovate technically and rely on traditional business practices, we will suffer from the fate illustrated in the table above.

How we rip costs out of the software model while delivering value will be critical.

I would enjoy hearing from start-ups and investors on novel, optimized business practices that are helping to realize scale-free profitability. While open source software, offshore development, and channel based selling are well-known strategies, any fundamentally novel approaches would be great to share.