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).