Sunday, December 09, 2007

How to Handle Tough Questions

I just finished a book that should be on the reading list of all entrepreneurs, In the Line of Fire, How to Answer Tough Questions When It Counts by Jerry Weissman.

Jerry is a well-known corporate presentations coach and is frequently brought in to help CEOs prepare for their IPO roadshow. The book builds on his first one, Presenting to Win, and is terrific.

Having given and sat through countless presentations, it is often not the subject matter of the presentation but the ability of the presenter to cogently respond to questions and concerns that wins the day. The book's aim is "not so much to show you how to respond with the right answers as it is to show you how to establish a positive perception with your audiences by giving them the confidence that you can manage adversity, stay the course, and stay in control."

There are three classic flawed responses to questions that will haunt the presenter: defensiveness, evasiveness, and contentiousness. The book provides examples of Trent Lott and Ross Perot that bring the damage of these reactions home. After team's present, it is often commented that the CEO seemed evasive, did not address the question, became combative, etc...all reactions that doom the pitch.

Here are some of his suggestions:

  1. actively listen to your questioner - do not rush to answer the question, instead make sure your body and mind are concentrating and listening to the question
  2. identify the key issue at the heart of the question - questions may drag on and ramble, it is your job to work out the key concept driving the questioner's concern - is it market size, competition, pricing model, technology, team dynamics, location....
  3. paraphrase the question to confirm that you understand the key issue being raised
  4. do not answer until you see visual affirmation that the key issue you paraphrased is in fact the questioner's issue
  5. answer all questions with care and confidence - there are no irrelevant questions
  6. anticipate and recognize the universal issues - management - do you have the right people? is your team complete, competition - how will you meet and beat the competition, market - how big is the market, business model - sales, delivery, and pricing model, contingencies, timing, problems, intellectual property....
  7. know your Point B - the audience starts the meeting at Point A, Point B is where you want them to get to - what is your goal
  8. speak to WIIFY - or what's in it for you - people need a reason to act and it must be their reason, not yours
  9. prepare and practice
  10. be agile and respond thoughtfully to questions
  11. never lose control - be slow to answer and slower to anger
Weissman mentored CSCO, YHOO, INTU, MSFT, and many others through their presentations and q&a preparation. The book needs to be on your shelf and the models skills in your arsenal.

Wednesday, December 05, 2007

Panel: Will the VC Market Decline in 2008

I am on an Under the Radar Panel tonight titled: Will VC Market Decline in 08?

This is also the time of year for "what will be hot or not" forecasts. In preparing for the panel, the following jumped out at me.

VC Market
The VC market is already showing signs of decline. How so? In 2006, venture funds raised $24.7bn from limited partners. In the first half of 2007, the fund raising number is $6.4bn, or $12.8bn annualized. $12.8bn represents a -48% decrease in capital invested in the asset class. Moreover, q106 saw LPs invest $8.5bn, while in q107 the number was $3.1bn, or a -63% decline.

What is going on here? See my post on Venture Capital and Emerging Managers for a more detailed answer, however, I believe that LPs are now wise to the Pareto distribution in industry returns, ie less than 20% of the firms drive 80% of the returns. If you cannot get allocation to the top firms, then get out of the asset class.

A few other stats to share: California is consistently taking 40+% of total VC dollars in the US, with the Bay Area taking 30+%. New England, a story of faded glory, now represents only 11%. Other, ie non-TX, CA, New England, NY, is 27%.

To paraphrase, while the world may be flat, it seems that there are two network effects taking place in the industry - 1) the top firms are taking more and more of the returns and, in turn, LP dollars, and 2) the Bay Area is enjoying a virtuous circle of innovation, wealth creation, talent acquisition, large company exits, repeat cycle that is seeing the region take a disproportionate amount of venture and exit dollars. The Bay Area appears ascendant and there are real ecosystem and systematic variables that suggest it will continue to be so.

Moreover, while total dollars into the industry may be falling, as capital leaves the combination of less money chasing deals plus strong fundamentals will result in not a decline in average returns but a rise. Yes, LPs are cutting back allocation, ironically, the top firms in the industry may be on the cusp of great results.

Am I bullish for 2008?
Yes. Why?
1) utility computing is real - cost per computing cycle and cost per gigabyte are no longer stuff of IBM and Sun marketing bs. Start-ups can now leverage the infrastructure assets and operating scale of AMZN, CRM, MSFT, and Google to grow their businesses where costs are now variable and not fixed. The cost of innovation, in essence, is plummeting with respect to non-differentiated infrastructure and there is no longer a need for expensive, bespoke infra build outs that suck dollars without adding customer utility.
2) performance based marketing is real - an economic downturn will accelerate marketing spend on high ROI and performance based ad units. In a consumer spending slowdown, brand advertising, whose value if hard to quantify, will get hammered and the reallocation of dollars from off line to online will accelerate - ie I think CPX Internet advertising will prove counter-cyclical because it is measurable and the spend can be tied directly to leads, orders, and revenue.
3) personal link analysis is real - while google monetized page rank, new companies are emerging to monetize person rank. Social networking will drive derivative investments of value - social networking analysis will become a mainstream marketing practice - ie rather than look at consumers as independent members of a market segment, marketers will now be able to analyze who you know, who matters to you and if they influence you, how well you know them, what groups you belong to, and word of mouth marketing campaigns that target "influencers" in given communities will outperform traditional direct marketing. I just looked at a company with powerful tools in this area - they are able to deconstruct a 3m member community into 17m discrete connections between members and over 300,000 discrete groups - by identifying the key "influencers" and "connecters" in each group, marketers will be better able to launch new products, drive product diffusion, and capitalize on the myriad of connections that now exits between us all, of which we seem to add 5-10 per day.

The lower costs of funding innovation, the speed by which products are diffused in a connected world, the virality possible in mining social networking and exploiting them, and the continued allocation of marketing dollars to performance based ad units should make 2008 one to remember despite the message of the video below - however, amusing it might be.

Friday, November 23, 2007

Confirmation Bias

My first blog post on May 12, 2005 reviewed Nassim Nicholas Taleb's wonderful book, Fooled by Randomness.

I am currently reading his second, The Black Swan, the Impact of the Highly Improbable.

The first book centers on the "hidden role of chance in life and in the markets." As an investor, it is particularly apropos as one tries to identify systematic methods of creating value via investing. Investors and investees like to believe that the investment world is deterministic with clearly understood cause and effect. Understanding causal drivers of value helps to create repeatable models for investment that scale both across time and individuals in the firm. Nassim challenges us to be very careful in over ascribing reason and logic to an outcome. Too often, investment outcomes are the result of randomness rather than science, ie being lucky rather than good.

The second book posits that we expect the world to operate within very narrow bands of probability and tend to discount the possibility of extreme events, or black swans. For example, Wall St uses Value At Risk models that analyze capital at risk with a 95% confidence interval - the models, based on Monte Carlo simulations, create a range of statistically probable outcomes. The savings and loan debacle, the current subprime mortgage mess, Long Term Capital, etc illustrate the fallacy of discounting the highly unlikely.

The book also introduces a key concept that with real application for venture capital - confirmation bias. He writes, "cognitive scientists have studied our natural tendency to look only for corroboration; they call this vulnerability to the corroboration error the confirmation bias." Due diligence is the process by which investors analyze and evaluate investment opportunities. Too often, however, diligence is confirmatory in nature. As Taleb notes, "...subjects supplied mostly questions for which a "yes" answer would support the hypothesis. Disconfirming instances are far more powerful in establishing truth. Yet we tend to not be aware of this property. A series of corroborative facts is not necessarily evidence. We can get closer to the truth by negative instances, not by verification."

In my experience, investors often look for corroboration at the cost of negative empiricism - ie at the cost of looking for non-confirming evidence. Such evidence in itself may not argue against the deal, it will, however, help avoid Pollyannish projections based more on hope than on truth.

Saturday, November 10, 2007

Panel on Investing in Innovation

Last night, I spoke on a SVOD panel discussing investing in innovation.

Invitations to speak always spark new ideas and new frameworks for trying to cogently boil down large and complex ideas into a few key ideas.

The topic of the panel and this post provided a framework for thinking about the issues.

For example, innovation is the science of new possibilities. Investing in innovation, however, centers on the science of consumption.

Innovation in a vacuum leads to failure and the commercialization of innovation is predicated on a ready ecosystem in place to enable the development, delivery, and sale of a product.

Consumption, in the broadest sense, demands the marriage of science with application.

A useful framework for tying technical innovation to consumption follows:

Commercial Success = Customer Need x Offering Innovation x Sales and Delivery Model x Ecosystem Development x Risk-adjusted Return

Customer Need = a clear view of the buyer's problem, identity, motivations, and resources

Offering Innovation = a material, rather than marginal improvement in the state of the art

Sales and Delivery Model = a distribution model that aligns product-market fit and, like Occam's razor, reduces any unnecessary frictions from the buying process

Ecosystem Development = no material exogenous market developments are required for the company to be successful. Rather, the ecosystem is ripe to support the innovation.

  • For example, wimax deployments, RFID reader deployment, etc.
  • Also, like Newton's "on the shoulder of giants," all start-ups require a foundation of enabling conditions to truly be successful. Understanding the cornerstones of the opportunity and how to leverage them is key to commercialization.
  • Also, innovation is largely symbiotic. Bill Joy's quote, "innovation happens elsewhere" is important to keep in mind as product design should benefit from the innovation of others rather than solely on the company's employees.

Risk-Adjusted Return = ROI alone is not sufficient to motivate customer behavior.
  • Like any investor, return must be analyzed with risk and customers, like investors, will seek to maximize their Sharpe Ratios, or return divided by standard deviation.
  • Many start-ups fail to realize the vendor, operational, and product risks they are asking customers to take on. Selling absolute return independent of the risk ignores a major component of customers' product selection. Be conscious of inadvertently creating risk and manage risk out of the sales and deployment model.
The panel agreed that a holistic approach to investing in innovation is required. The maturity of a team's plan depends on moving from the art of what is possible to the science of what is most efficiently consumable.

Friday, November 02, 2007

Top Dealmaker List

AlwaysOn, in partnership with KPMG, just released their inaugural Top Dealmakers List.

The lists include the top LPs, early stage firms, late stage firms, corporate vcs, law firms, investment banks, etc...

As Letterman knows, everyone loves a list. Worth a quick read.

Thursday, November 01, 2007

Venture Capital and Emerging Managers

I recently wrote a post, Portfolio Math, that examined the hit rate and return on invested capital required for the venture capital industry to be viable. The post led to excellent feedback from venture investors, entrepreneurs, and, interestingly, limited partners in various venture capital funds.

The existential question the comments begged appears to be, is it worth investing in the venture asset class?

The current LP position appears to be rather axiomatic:
  1. average venture asset class returns are a nonsensical number
  2. why? less than 20% of the firms drive greater than 80% of the returns
  3. it is borderline impossible to get into the top venture funds
  4. blind allocation to the asset class - ie if Sequoia says no give it to someone who will say yes, is now recognized as very flawed logic
The question then becomes what should LPs do. I see 3 possible choices
  1. leave the asset class
  2. be patient and wait for allocation to top tier funds
  3. sponsor emerging manger funds targeting young GPs at top tier funds
The first two choices imply that an LPs allocation to venture will be materially reduced on both an absolute and relative dollar basis. Less money will enter the system and, like most maturing industries (think ORCL in software), the excess rents in the market will be captured by a diminishing number of firms. The competitive position of the top firms will compound over time as competitors drop out of the market as LPs refuse to fund them.

The last choice is also interesting to consider. In the hedge fund industry, it has long been standard practice for LPs who cannot get into Citadel, SAC, and other top funds to lure away rising stars to start their own firms. If the axioms above continue to hold, I would not be surprised at all to see groups of sophisticated LPs lobbying younger GPs to start new funds in order to ensure allocation to talent who can drive returns in a now well-established Pareto distribution market.

Over the next few years, I expect to see more firms fail as LPs refuse to reup, the total dollar size of the industry shrink, and the birth of several new venture firms run by top-tier alums and backed by LPs committed to the asset class but denied entry by the door keepers at the top firms.

After posting the above, someone sent me the following news story:
California State Teachers' Retirement System may once again be reducing its target allocation to venture capital, this time in favor of debt-related investments such as distressed debt and mezzanine, according to the agenda for its Nov. 1 investment committee meeting.

The pension system is mulling changes to its investment policy that would reduce the target allocation to venture capital to 5% from 15% of its alternatives portfolio and raise the target allocation to distressed debt and mezzanine from 5% to 15%, according to the agenda. The proposal would also reduce the upper end of its venture capital target range from 25% to 15% and increase the upper end of the debt-related target range from 10% to 20%.

Wednesday, October 31, 2007

Rich Price

As some of you know, my brother Rich is a wonderful singer-song writer.

Embedded is one of his new songs, Change, and I love it.

Tuesday, October 23, 2007

DuPont Models and How to Determine KPIs?

Data driven management is a popular concept and with good reason. CEOs, management teams, and board of directors gain tremendous value in defining and managing to key performance indicators (KPIs).


KPIs provide insight into the underlying mechanics of the business model that help teams manage departmental functions and focus the company on the building blocks of future success. The concept of KPIs as powerful intra-period (day, week, month, quarter) barometers of company performance is well understood.

However, traditional mechanisms for financial management, GAAP financials and the operating plan, are necessary, but not sufficient tools for data driven management.

Start-ups are exercises in prospective thinking and both GAAP financials and the operating plan generally fail to provide insight into the upstream metrics that drive financial success.

GAAP financial statements are backward looking records of the past, and they often fail to provide insights into how the company will perform in the future. Start-ups all develop operating plans, however, in my experience 3 year plans, while necessary, are often highly abstracted summaries of a hoped for future that tend to be more academic than operational. They tend to be the product of the CFO's office with little day to day value for the team.

How then should one bridge the gap between GAAP financials and the high level financial projections? As a CEO, VP, director, or individual contributor what data points matter to you? When you come in in the morning, how do you know what to focus on with some sense of certainty that your particular KPI is a key part of the broader company's goals?

In 1919, DuPont's F. Donaldson Brown was tasked with turning around GM after DuPont bought a 23% stake. In order to help drive clarity and transparency into the state of GM's finances, Brown developed a model that broke down the company's ultimate goal, high return on assets, into an easy to visualize set of critical building blocks.

The standard DuPont model follows:
Return on Equity = Net Profit Margin * Total Asset Turnover * Equity Multiplier

Each component can then be broken down into its constituent parts.

For example,
NPM = Net Income/Net Sales
TAT = Net Sales/Total Assets
EM = Total Assets/Common Equity

One can now see that higher profitability, higher asset utilization, and higher debt levels can all lead to higher ROE. Further, each child node can be further analyzed to understand the key levers that drive the parent node.

Net Profit Margin can be influenced by unit volume, unit price, fixed costs, variable costs, and so on.

Now, how does this apply to start-ups?

Well, start-ups can develop a custom version of the DuPont model that 1) transparently states the formula for value creation and 2) makes visible key value-creating levers that are themselves the "Is" in KPIs.

For example, the search business can be defined by the following formula:
Revenue is no longer an abstract concept but a goal with clearly defined indicators that departments can execute against, such as driving more queries per user, maximizing ad attach rates per query, optimizing click through rates, driving higher ecpms....

A team's ability to develop a relevant DuPont model that maps out the key components of revenue and profit is critical in developing material KPIs. To bridge the gap between Quickbooks' financials and Excel operating plans, I suggest that a team whiteboard a model that drives both revenue and costs.

As a planning exercise:
  1. develop DuPont formulas relevant to the business that define the material components of revenue, costs, and profit
  2. drill down on each node until there is no marginal benefit of further granularity
  3. analyze the impact of moving each indicator, or formula argument, on the desired result and identify the most impactful indicators to manage
  4. assign each department indicators, arguments in the equation, they can control, effect, manage, and report against
  5. the formula's arguments are now the organizations KPIs
  6. With the KPIs extracted from the company's DuPont model, data driven management is now possible. The company, departments, and individual contributors now understand how their daily work contributes in the aggregate to the model's efficacy
Are you struggling with identifying material KPIs? Is the operating plan a set of forecasts with seemingly little relevance to day-to-day operations?

If so, take the time to develop a company specific DuPont model and agree as a team on the formula's key arguments; assign each team member a set of arguments to optimize, and come to the team meeting with weekly snapshots and trends of the arguments' execution.

In may ways, laying out a DuPont formula is a precondition to building an operating plan, ie it identifies the key business model drivers. Moreover, aligning strategy with a DuPont model allows for orchestrated execution where the component pieces, ie departmental specific activities, sum to a larger whole.

Monday, October 22, 2007

Aria Systems Raises Series A - Leave the Billing to Us!

The below is a guest post written by Lars Leckie of Hummer Winblad.

Last week, Hummer Winblad Venture Partners announced the Series A funding for Aria Systems, the leading on-demand billing and customer management provider.

HWVP’s investment in Aria is the firm’s fourteenth SaaS investment (others include Omniture, Adforce, Employease – some of which date back to 1998).

The investment in Aria is a double down on the SaaS market – Aria is not only itself a SaaS ISV, but also the company is a core component of any SaaS company trying to efficiently scale. RBC Capital Markets predicts that the SaaS market will grow at 43% CAGR to be $28bn by 2010. That’s a lot of billing.

As the SaaS market grows, the need for ISV’s to make bespoke investments in data center operations, billing infrastructure, and other core, but non-differentiated, functions is lessening by the day. Providers like Aria allow ISV’s to focus 100% of their human and financial capital on differentiated application logic, while using best-of-breed platform vendors for infrastructure services. The company puts it best when it tells customers it will help them, "get customers, get paid, get control."

Why invest in Aria? Simply put, traditional billing solutions, independent of expensive on-premise software, are not well suited to subscription and usage based billing models. New revenue models bring about the need for new billing architectures. Emerging SaaS companies who don’t use Aria can either choose to build a billing system themselves, thereby diverting engineering resources to a non-core engineering function, or they can use existing on-premise solutions with a myriad of spreadsheets and manual accounting. Aria is a solution that can scale and provide the best infrastructure through a strong focus on the billing market.

The Aria solution is a complete turnkey SaaS (single instance, multi-tenant) solution to manage recurring revenue billing. They manage the quote-to-cash system for a company including hosted customer sign-up, customer service, provisioning of service, dunning and all the other components needed for a full billing solution.

Aria is already in the market with strong customer traction and key partnerships in place. The vertical markets that Aria addresses today are SaaS, On-line Gaming and Telco. A few of their partners in these markets are Opsource and GNi but you can see the full list of over 25 partners here.

Congratulations to Ed Sullivan and the rest of the Aria team - Welcome to the Hummer Winblad family.

Friday, October 12, 2007

Burn the Boats

As a venture capitalist, I am fortunate to meet with people brimming with ideas for new products and new companies. You can feel the excitement build as ideas percolate and mature from insights quickly scribbled down in the middle of the night, to application mock ups, late night Starbucks brainstorming sessions, and early team solicitation.

Often, however, the ideas never bear fruit and the excitement subsides and the spark of creativity dies. This week, I met with several good friends who suffer from both the blessing and the curse of a surfeit of choices and options. The blessing is that talented people are always in demand and there are many avenues of opportunity available to them. The curse is that they often sit stalled at the cross-roads of choice - start-up, large company, start my own gig....

Mark Gainey, the founder of Kana, once told me that the hardest step on the road to entrepreneurship is the first one. Once committed, the iterations come fast and furious and the pressure to make it work allows for moments of genius and insight simply not possible before diving in head first.

I continue to regret that so many brilliant people that I know, full of energy and ability, sacrifice their passions on the alter of safety or indecision.

The conquistador Cortes provided a model for all intrepid souls....that is to burn the boats on the shore and ensure no way back and the stark need to make the expedition succeed or go down trying.

In facing choice in a sea of opportunity, I think that Frost's road less taken is inherent in the spirit of the Valley. However, it often requires a moment a bit like sky-diving....i.e. to willingly jump out of a perfectly good plane and make the most of the free fall.

Like Cortes, it is often necessary to burn the safety boats in order to finally realize the promise of late night ideas and the passion that gets you jumping out of bed in the morning.

Investment Models as Risk Acceptance Criteria

In many ways, investing is an exercise in decision making. In order to ensure consistent decisions, firms develop investment models with which to evaluate opportunities.

The models (both qualitative and quantitative) provide a framework for evaluating risk and return. The model defines the strike zone and helps shift investment decisions away from debating the merits of a class of investing, ie. do we want to deals like this, to the merits of a specific investment. The class of investment, what type of deals do we do, is defined by the model, the object, ie discrete investment decision, is the output of the model in action.

Another way to think of a model is as an articulation of the risks the firm is willing to take. For example, Hummer Winblad's model is to invest in Series A, enterprise software start-ups, and to back capital efficient plans at reasonable post-money valuations. Explicitly in the model is a checklist defining our focus, and inherently in the model is a level of risk acceptance, i.e. we are wiling to accept certain risks subject to appropriate pricing, capital investment, and overlap with our expertise.

If a firm's risk asset acceptance terms are well defined, ie what a strike looks like, then the firm can focus on sourcing and executing to the model. Also, to the extent an investment is outside of the model, the exceptions (ie areas of misfit with model) can easily be identified and analyzed. The investor can say, "I recognize that this deal is off our curve in the following dimension, however, the exception and added risk is worth taking for the following reasons."

Defining acceptable risks and a target profile creates consistent decision making and increased productivity. It also helps quickly flag execptions and puts the onus on the deal champion to explain the logic in swinging out of the strike zone.

Models are tools for decision making, but they also provide a logical framework with which a team of individuals can use to maintain a common cadence and definition of risk. The moral is not to never to go off the model, but to always know when you are off the model and to ask if the potential return is worth taking the extra risk.

Wednesday, October 10, 2007

Capital Flows - The Implications of Yale's Asset Allocation

David Swensen, Yale University's Chief Investment Officer, is widely recognized as one of the world's great investors

For Fiscal 2007, Yale reported a return of 28%. Over the last decade Yale's return is 17.8% and assets have grown from $5.8bn to $22.5bn.

For 2008, Yale plans the following asset allocation:
  • real assets (oil, timber, real estate) 28%
  • absolute returns (hedge funds) 23%
  • domestic equity 11%
  • fixed income 4%
  • foreign equity 15%
  • private equity 19%
Read the numbers one more time - domestic equity is only 11% and alternative assets (real, absolute, and private) make up 70% of the portfolio.

Today's NY Times noted that pension fund managers plan to increase asset allocation to alternative investments from 14.4% to 19.4%, a 35% increase, over the next three years. The article cited a survey of 50 of the world's largest pension fund managers and found:

Current Allocation to Alternative Assets: 14.4%
  • 4.5% to real estate, 4.3% to hedge funds, 4% to private equity, 1.6% to other
Planned 3-Year Allocation to Alternative Assets: 19.4%
  • 6% to real estate, 4.6% to hedge funds, 6.3% to private equity, and 2.5% to other.
The incremental 5% allocation is equivalent to $1.2tn dollars flowing into alternative assets over the next three years. This is a staggering sum.

What is more is that the pension fund managers' planned19.4% allocation is still only 27% of Swensen's allocation to alternative assets. Too match Yale's returns, pension fund managers would need to increase their allocation by 3.6x. If a 5% increase is equivalent to $1.2tn, a 50% increase, ie matching Yale's allocation, would represent another $12 trillion dollars of allocation.

Where will this money go?

To compound the capital flow dynamic, Morgan Stanley reports that sovereign funds (gov'ts of China, Russia, Kuwait, Singapore, etc) are sitting on $2.8 trillion and that the figure will grow to $15 trillion by 2015. $12 trillion here and $15 trillion you are talking about real money:)

If the stewards of the world's capital look to Yale as a model there will be a massive flood of capital into non-traditional, alternative vehicles over the next decade. China's investment in Blackstone and Abu Dhabi's investment in Carlyle are harbingers of what is to come.

The chase for returns will continue unabated and Yale's approach suggests that relying on equity and fixed income markets will not suffice.

The recent sub-prime meltdown led many pundits to believe that institutional investors would shy away from private equity and hedge funds. The data above suggests that they will have no choice but to do much more investing with alternative managers, not much less.

Thursday, October 04, 2007

Prescriptions For Guaranteed Misery In Life

As some of you know, I really admire Charles Munger, Warren Buffet's partner. The clarity of his thinking, personal story, and professional success are worthy of study.

I recently read Poor Charlie's Almanac, The Wit and Wisdom of Charles T. Munger. The book is a fabulous collection of his thoughts, speeches, writings, mental models, and commentary on Charlie by Warren Buffet, Bill Gates, Bill Gross (Pimco), and others.

I particularly enjoyed the speech he gave at his son's high school reunion.

The speech borrowed from an earlier commencement address by Johnny Carson. Carson told the students that he could not tell the graduating class how to be happy, but he could them from personal experience how to guarantee misery! Carson's prescriptions for sure misery included:
  1. ingesting chemicals in an effort to alter mood or perception
  2. envy; and
  3. resentment
Munger goes on to add that if you desire misery that Johnny's suggestions were spot on. He adds four more certain ways to guarantee a miserable life to the mix...
  1. be unreliable
    1. do no faithfully do what you have engaged to do.
    2. if you like being distrusted and excluded from the best human contribution and company, this prescription is for you
  2. learn everything you possibly can from your own personal experience, minimizing what you can learn from the good and bad experience of others, living and dead
    1. the idea is to become as non-educated as you reasonably can
    2. do not stand on the shoulders of giants, who needs them
  3. go down and stay down when you get your first, second, and third severe reverse in the battle of life
    1. given the abundance of adversity in life...this will ensure that you will permanently mired in misery
  4. ignore disconforming evidence and remain certain in your views
    1. be one of those people who early achieve and later intensify a tendency to process new and disconforming information so that any original conclusion remains intact
Both Carson and Munger inverted the traditional graduation speech - they pursued the study of how to create X by turning the question backward and instead studying how to create non-X. Munger quotes the algebraist, Jacobi, who said, "invert, always invert." Many hard problems are best solved only when they are addressed backward.

Following all seven prescriptions will help ensure a life of non-felicity and abject misery. "Invert, always invert."

Thursday, September 20, 2007

Portfolio Math

There has been a great deal of discussion about the viability of the venture capital industry.

What types of returns are required to justify the asset class' risk? Are such returns available in today's market? How much risk does an early stage venture capitalist need to take to justify the premise of the business?

To find out, I constructed a simple model of a portfolio with the following characteristics:

  1. # of companies in portfolio
    1. 10

  2. $ per company ($m)
    1. $10

  3. management fee
    1. $0 (to keep this simple:))
  4. Probability of Success
    1. 40%

  5. Probability of Failure
    1. 60%

  6. Definition of Success
    1. 5x money

  7. Definition of Failure
    1. 0x money
The table below illustrates the probability of N successes, the value of the Nth success, and the expected value of the Nth success:

For example, in a portfolio of 10 companies:

  • the probability of 4 successful outcomes is 25%
  • or, 10!/4!6!*(.4)^4*(.6)^6
  • the value of 4 successes is $200m, or 4x5x10
  • the expected value (prob * value) of the fund, the sum of the total distribution of expected values, is also $200m

To 3x a fund, one would need:

  • $300m,
  • given a 40% success rate, and 7.5x your money/success
To 5x a fund, one would need:
  • $500m, or
  • given a 40% hit rate, 12.5x your money/success
To 8x a fund, one would need:
  • $800m, or
  • given a 40% hit rate, 20x your money/success
Now, if the hit rate falls to 20%, to 3x a fund, one would need:
  • $300m, and
  • 15x your money/success
If you hold 5x money/success, each 1% improvement in the hit rate is worth $5m.

If you hold the hit rate constant at 40%, each .5x money/success is worth $20m.

In summary, given that early stage venture capital often experiences binary outcomes, individual firms should look to ensure that deals support the possibility, if not the probability, of a 10x or better outcome.

Furthermore, LPs should diversify across multiple partnerships and look for firms that look to create large winners, not incremental winners. Conventional wisdom holds that 10x returns are required for Series A investors, however, the math exercise helps illustrate why that is the case.

Back to the original question...The early stage very capitalist appears to only be able to justify the risk involved in the asset class if they can either
  • materially increase the hit rate, ie reduce probability of failure per deal
  • create deals with 10x+ returns on invested capital

Are there 10x or greater deals in the market? Of course, however, great funds will need to find quite a few in order to justify their existence.

Hitting doubles or triples, in the face of a high mortality rate, will not cut it.

Note: thank you to Hunter Hancock for his valuable feedback and help on this post.

Tuesday, September 18, 2007

Six Filters for Business Evaluation

I am currently reading, Seeking Wisdom: From Darwin to Munger. The book seeks to provide guidelines for better thinking, explain what influences our thinking, and delves into the psychology of misjudgments. All topics of real interest to investors.

The book leans heavily on the writing and speeches of Warren Buffet and Charlie Munger. It reads like a reference book - with each chapter full of terrific nuggets of wisdom and quotes to remember.

The book includes a useful checklist for business evaluation. All investors, like pilots, need to have a checklist to ensure consistent best practices in decision making. At Hummer Winblad, we put together a checklist for every deal.

The book's checklist follows. While perhaps the book's list is not perfectly suited for early stage many frameworks, the real value lies not in the specific framework itself, but in the consistent application of a mental model that ensures diligent analysis and carefully weighed decision making.

Filter 1: Can I understand the business - predictability?
Reasons for demand - how certain am I that people are likely to buy this type of product or service? why will they buy? what are the benefits?
Return characteristics - Industry and company return characteristics and change over the last five years? Is there a business model comparable that has made real money for its investors and management team and proven the operating model's economic value?
Industry structure - (a la Michael Porter), no of competitors and size? Who dictates terms in this industry? Do I know who is going to make the money in this market and why?
Real customer - who decides what to buy and what are his decision criteria?

Filter 2: Does it look the business has some kind of sustainable competitive advantage?
Competitive advantage - can I explain why the customer is likely to buy from this company as opposed to others in the market? what is the basis of the advantage - market knowledge, execution strength, or technology?
Value - how strong is this advantage, does the advantage benefit from network effects or scale that will make it stronger and more durable over the years?
Profitability - can the advantage be translated into profitability and why?

Filter 3: Able and honest management?
Is the team competent and honest? Do they understand the market and are they focused on value creation for the owners of the business?

Filter 4: Is the price right?
Can I buy at a price that provides a good rate of return with an adequate margin of safety?

Filter 5: Disprove
How can the business get killed?
Who could kill it?
If it failed, what are the likely internal and external causes?

Filter 6: What are the consequences if I am wrong?

At Hummer Winblad, we add:
Filter 7 - what disruption will aid the company is driving growth?
What wave will the company ride that rewrites the operating dynamics of the industry and drives the reallocation of capital away from old models and technologies to new players in the market?

The book is a fun read and one to have on your desk.

Friday, September 14, 2007

Rich Price - Playing on Sept 25th in SF

My brother, Rich, is a wonderfully talented recording artist.

His new band, RGB, will be playing in SF on Sept 25th.

Below is a note from Rich and I hope some of you can make it!

Hi Bay Area friends, I hope all's well. I'm excited to announce I'll be bringing my new trio, RGB (Rich Price/Greg Naughton/Brian Chartrand) to San Francisco a week from this coming Tuesday.

I'm thrilled to be performing with two of my favorite songwriters, and the trio has been great fun. It's like Crosby, Stills and Nash had a one night stand with Paul Simon, The Police, David Gray, Martin Sexton and that short guy from Fantasy Island and somehow managed to produce a three-headed singing beast...that's RGB.

If you're free on Sept 25th, we'd love to see you! Thanks for all the support and for helping to spread the word!! All the best, Rich

RGB (feat. Rich Price)
Tues, Sept 25th at 8pm (sharp)
Red Devil Lounge
1695 Polk St (at Clay)
San Francisco, CA

link to purchase $10 ticket


p.s. I'll be performing in SF in late Oct with my old band. More details to follow.

Friday, September 07, 2007

What is a Brand?

I recently heard a very succinct and compelling answer to the question, "how do you define the concept of a brand?"

The answer, from the CEO of E&J Gallo Winery,...

"A brand is a promise to a customer of quality, image, and differentiation."

The definition elegantly boils down a complex concept to five key elements:
  1. a promise...a commitment from the company.
    1. Employees across the organization need to internalize that promise and live up to the commitment that is at the heart of the company/customer relationship
  2. a customer
    1. the company needs to understand the interests, demographic profile, characteristics, motivations of the customer. What makes them tick? Who are they?
    2. A clear picture of the target customer helps align the product, sales and marketing strategy, and positioning with the customer's interests and needs
  3. quality
    1. a it an experience, physical good, or relationship
  4. an image
    1. a set of mental associations that complement the interests and self-image of the customer
  5. a differentiation
    1. a clearly unique proposition that is effectively communicated to and understood by the customer
I think all five elements are worthy of thought and reflection.
  • what is your brand's promise?
  • who is your brand's customer?
  • what is your brand's quality?
  • what is your brand's image, mental associations, characteristics?
  • what is your brand's differentiation?
Simple questions with surprisingly hard answers.

Friday, August 31, 2007

Chad Ruble, Reuters Vlogger, is Funny

Chad Ruble is funny.

(Full disclosure - Chad is one of my great friends)

Chad hosts a weekly internet video show, And Finally, on highlighting wild and wacky news stories from around the world.

On this week's episode, Chad visits a professional stunt school in NYC.

The show reminds me of Keith Olberman's Countdown segment "Let's Play Oddball" and it is well worth subscribing to via RSS.

Friday, August 24, 2007

The Psychology of SaaS and Web 2.0 Persuasion (and Selling)

One of the cool things about blogging is that it fosters the cross-pollination of ideas. Often, moreover, the derivative idea is much better then its source.

Bob Warfield's post, The Psychology of SaaS and Web 2.0 Persuasion (and Selling), is a great example.

He picked up on my post regarding Cialdini and the psychology of compliance and wrote a very thoughtful piece on how Cialdini's work can be applied to SaaS and Web companies.

It is well worth reading.

Beginner's Mind

"In the beginner's mind there are many possibilities, but in the expert's there are few."

-Shunryo Suzuki-Roshi

I am coming to believe that the comfort to say "I don't know" is fundamental to being a good investor. Intellectual curiosity, being open to new ideas, and the willingness to momentarily suspend disbelief in the face of unorthodox approaches are vital preconditions to being able to reward disruption.

Ideas, opinions, and expertise get in the way of knowing what we don't know. Given that venture is premised on funding innovation, refusal to admit ignorance, unwillingness to ask for clarification, to avoid learning can blind one to the clarity and creativity that exist in a beginner's mind. "Knowing" does not allow us anything new, no surprises, no insights, no discoveries.

When I worked for Art Samberg, a brilliant investor and founder of Pequot Capital, I was consistently impressed by his ability to listen and to learn. He would often ask people for their views; the chance to showcase knowledge to a billionaire investor would drive people into long monologues. When then asked what he thought, he would often say "I don't know enough about it to comment" and walk out of the room. The lesson: there is no shame in admitting you don't know, rather, the real shame lies in making your "intelligence" so much a part of your identity that you are afraid to ask or admit a lack of knowledge.

The concept of beginner's mind is not limited to Buddhism. Frank Herbert said, "The beginning of knowledge is the discovery of something we do not understand.” While Proust wrote, "The real voyage of discovery consists not in seeking new landscapes but in having new eyes.

Our learnings and experiences often help us process a complex world, however, I believe that it is important that we work to maintain beginner's mind over and over again in order to not let "knowledge" trap us from seeing innovation and possibilities.

Wednesday, August 22, 2007

Oracle buys Bridgestream

Oracle's acquisition spree continued this month with the purchase of Bridgestream, the leading provider of business role automation solutions.

Role-based access to systems and information is a well understood security paradigm. Importantly, Bridgestream extended the ability of identity access management (IDAM) solutions to map to the complex, ever-changing business relationships that exist within a department, within a division and across the extended enterprise.

Role based automation enables fast, accurate and real-time information about role-based authorizations and enables organizational changes to seamlessly flow through to production IDAM solutions. Modeling complex, ever-changing enterprises via the Bridgestream solution enhances security, improves compliance, and reduces IT costs. The acquisition complements the earlier purchase of Oblix and further pushes Oracle into the security market.

Hummer Winblad's Mitchell Kertzman co-led Bridgestream's A round and congratulations to Mark Tice, CEO, the Bridgestream team, and the Board on a great outcome.

Starmine Acquired by Reuters

Congratulations to Joe Gatto, CEO and founder, and the Starmine team on their sale to Reuters.

Hummer Winblad led Starmine's A round in 1999 with John Hummer serving on the Board.

Starmine is a powerful example of actionable analytics adding value on top of readily available data- the company's algorithms provide independent ratings of securities analysts around the globe by measuring their stock-picking performance and the accuracy of their earnings forecasts.

StarMine helps professional investors extract more value from broker research and fundamental equity data in less time by identifying the analysts that add value, forecasting potential earnings surprises and shortfalls, evaluating earnings quality, and alerting investors to the most important developments on stocks they follow.

Given the Wall St research shenanigans uncovered in the dot com bust and the recent failing of the credit rating agencies in the sub prime mess, it is more important than ever that effective analytics exist as a check and balance against either incompetence and/or malfeasance.

Congratulations to Reuters and Starmine on a great deal.

Monday, August 20, 2007

Influence - The Psychology of Persuasion

I recently read Robert Cialdini's wonderful book, Influence, The Psychology of Persuasion.

Cialdini is an experimental psychologist who studies the psychology of compliance, or why people say yes. In the book, he identifies six universal principles of influence, the psychology behind their effectiveness, and how we are eerily hardwired to succumb to their effect.

The six principles are:
  1. reciprocation
    1. securing compliance from people can be greatly increased by doing them a "favor," whether they ask for it, like it, etc or not...the simple act of a gift triggers an obligation to comply, within reason, to the gift giver's request
  2. commitment and consistency
    1. we have a nearly obsessive desire to be and to appear to be consistent with what we have already committed to. Once we have taken a stand and made a choice, we behave in ways that justify our earlier decision and commitment.
    2. The desire to be seen as consistent holds even when the cost, value, state of the original commitment evolves or changes
    3. Public verbal or written commitments drive intense desires to comply
  3. social proof
    1. we tend to determine what is correct, or not, by what other people think is correct
    2. this proof is most powerful with people of our own age and background
  4. liking
    1. we tend to say yes to people we like
    2. research shows we say yes to people who are good looking, feed us, who we are friends with, are famous, etc
    3. Tupperware uses friends to sell to other friends --the success rate is amazing as people simply cannot say no to people they are close to
    4. this is also why referrals from friends work - think about the difference in efficacy in trying to set up a sales call or pitch through a friend of the target rather than directly
  5. authority
    1. we feel a deep-seated sense of duty to authority figures
    2. see Milgram's reserach which measured the willingness of study participants to obey an authority figure who instructed them to perform acts that conflicted with their personal conscience
    3. titles, uniforms, clothes, offices reinforce authority and lead to almost universal compliance, even to requests that conflict with our values and conscience
  6. scarcity
    1. opportunities seem more valuable to us when their availability is limited
    2. people appear to be more motivated by the thought of losing something than by the thought of gaining something of equal value - stressing loss versus gain is instrumental in positive response rate and compliance
    3. deadlines, limited supplies, the cost of being left out
A core thesis of the book is that we rely on automated cues and heuristics to make decisions in a world too complex, busy, and fast to ever truly think through every decision.

Smart marketers and con men know that we leverage rules of decision making to streamline our choices and actions - by understanding the core principles of compliance and the psychology that drives automated responses we can vastly improve response rates.

While we all "know" these principles exist and none are radically new, the level of his analysis in understanding why they work is powerful indeed. It is definitely worth reading - both to apply in life and to use in order to defend yourself from marketers and others who are masters in using them to get you to OBEY!

Sunday, August 05, 2007

Company Culture and Politics - Survival of the Savvy

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

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

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

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

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

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

The second model is person-centric. Person-centric people and companies are driven by the power of hierarchy. The merit of an idea is not driven by the cogency of the logic but by the power, position, and political support for the speaker. In this world, ideas definitely do not speak for themselves, but rather image and the perception of support (who supports this, what does the VP/CEO, etc think about it).

In these companies, people often don't do what's right but rather what works. Decisions, given they are not based on logic, are far from transparent and meetings are fait accomplis rather than opportunities for genuine discussion and feedback. Relationships drive support, not ideas and merit appears to lose out to coalitions and sponsorship. Loyalty, alliances, and working the system outweigh doing whats right and trusting the system to pick the "best" outcome.

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

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

Wednesday, July 25, 2007

Star Analytics Raises Series A

Last week, Lightspeed Venture Partners and Hummer Winblad announced the Series A funding of Star Analytics, a provider of financial data management solutions.

Star provides ETL software designed to bridge multi-dimensional and relational data and applications.

The company boasts 16 enterprise customers across key verticals and the A round represents the first paid-in-capital. The team is led by early members of the Hyperion team, also backed by Hummer Winblad.

The investment thesis is clear and the product offering unique relative a large pain point.

Pain Point in Market

1) Fortune 500 companies deploy OLAP-based planning and reporting applications (Hyperion, Cognos, and Business Objects)

2) Data in cubes is A) in proprietary data formats and B) is often largely dynamic (i.e. not persisted)

3) Access to the data requires the use of native client applications from said vendors

4) Corporate America is deploying standard, relational reporting and analytics applications for KPI, BPM, and financial reporting

5) Currently, these applications (Crystal, MicroStrategy, ORCL, SAP, MSFT) are not able to query or view the data trapped in cubes

6) Current solution involves professional services dollars to map OLAP to star schema data structures

Core Product

1) Extracts OLAP data into standard tables (data, metadata, security access controls)

2) Captures dynamic (non persisted) data

3) Manages synchronization – delta’s flagged and continuously exported to maintain consistency between source (OLAP) and target (RDBMS)

As enterprises seek to break data silos and ensure corporate wide access to unified and accurate data, barriers such as data structure, data source, and proprietary interfaces frustrate that goal.

Star breaks the shackles of proprietary data formats, connectivity, and unshared calculations and consolidations and allows for key financial data to by syndicated to business users and processes across the enterprise.

Congratulations to the team.

Competitive Strategy: Play to Your Strengths

Fighting battles that leverage your assets and competitive position rather than your competitors is common sense.

Too often, however, underdogs choose to compete with the market leader on the leader's terms; ie mimicking their strategy and business practices. Rather than seeking to shift the terms of the battle, companies seek to match the products, pricing, and delivery best practices of the industry leader. Think MSFT's current strategy vs Google - ie let's out Google them by focusing on search and text advertising.

The WSJ recently ran a great article on HP's PC business and its battle with Dell.

The article focuses on HP's new PC chief, Todd Bradley, and his decision to change the battlefield and basis of competition.

Prior to Bradley's arrival, HP took on Dell at their own game; HP focused its efforts on battling Dell in direct sales over the Internet and phone.

Bradley's epiphany was to realize that fighting Dell on their terms put HP at a disadvantage and that the HP should instead focus on its core assets, namely the retail channel and retail stores.

A quick inventory found that HP's obsession with Dell's online advantage had left the core retail channel under served and under utilized. Bradley's audit of the channel found HP lacking in on-time shipments to retail, shoddy retail and wholesale account management, and poor supply chain controls.

He actively courted large retailers and committed HP to on-time channel shipments, improved account management, and marketing and product design campaigns to help retailers market the in-store buying experience and custom product offerings.

In one year, HP's market share grew from 14.9% to 17.6%, while Dell from 16.4% to 13.9%. In-store PC purchases went from 54% to 61% over two years.

I found the article compelling and an excellent reminder that head-on competition with market leaders will likely lead to large losses and that it pays to play to your strengths rather than theirs.

Friday, July 13, 2007

You Owe it to Yourself

This summer buy and read Woody Allen's The Insanity Defense: The Complete Prose.

You will laugh out loud at least once a page.

The Insanity Defense: The Complete Prose

Be careful reading it on a plane. The passengers may start to worry.

Wednesday, July 11, 2007

Widgetbox and

Widgetbox, a Humwin portfolio company, announced today a partnership with

Widgetbox will distribute Forbes content and advertising via eight initial widgets all sponsored by Visa.

The atomization of the web is underway and media companies and advertisers are looking to distribute content, application functionality, and advertising to social media and web site end points. The Forbes widgets are a powerful example of a major advertiser, Visa, and content publisher, Forbes, recognizing the power of widgets to reach a distributed audience.

The widgets can be found here and I include an example below.

Congratulations to Widgetbox and on a great launch.

Tuesday, July 10, 2007

3M: Six Sigma vs Innovation

Innovation is the lifeblood of Silicon Valley. Technological and business model disruptions drive the cycle of category, company, and wealth creation.

Innovation often leads to high growth and growth often demands the introduction of processes to ensure quality and scale.

There is, however, an obvious tension between innovation and process, between standardization and disruption. How does a company best manage that tension and avoid the extremes of creative anarchy vs bureaucratic and rigid process?

Companies that optimize for scale often begin to look like eBay - a monolithic app that is always up but still looks the same five years later. While companies that optimize for creativity, like Handspring, stumble with quality and return issues.

BusinessWeek recently profiled the impact of process, via Six Sigma, on innovation in an article on 3M. In 2000, 3M hired Jim McNerney from GE and introduced a total quality management initiative designed to lower costs and drive efficiencies. The company cut 8,000 jobs, operating margins grew from 17 to 23%, and thousands of Six Sigma black belts were trained and turned loose on the company. The short term gains proved popular with Wall St, however, longer term cracks began to appear.

Historically, 3M prided itself of delivering 1/3 of its sales from products introduced over the last five years. Under the Six Sigma regime, however, the ratio of revenue from new products fell to 1/4 and the company lost its creative edge.

The article notes, "while process excellence demands precision, consistency, and repetition, innovation calls for variation, failure, and serendipity."

At Hummer Winblad, we believe that founders are the key creative sparks that drive innovation and vision.

A business school framework defines three classes of company: operational excellence, customer intimacy, and product leadership. VC-backed companies typically succeed via a focus on either customer intimacy or product leadership. Senior executive hires that seek to optimize operational excellence too early in the company's development tend to lead to frustrated engineers and a rigidity that eliminates the chance to innovate. The absence of innovation in a company with few customers or product offerings is an almost certain predictor of failure.

Ideally, our founder-CEOs add a wrapper of operational excellence to their core focus on product leadership and innovation. Rather than move founders to CTO roles and bring in "grey" hair CEOs to drive process-led execution, we would rather see the founder as CEO, infusing the culture and product with their passion and creativity while learning the "tools" of the management trade.

Process, moreover, can be brought in at the VP level to compliment innovation and to help institute best practices that help with visibility and predictability while working to avoid hindering creativity and a culture of trial and iteration.

In summary, it is hard to balance innovation and process, however, in early stage companies innovation is a prerequisite to success. Accordingly, it is often very dangerous to move company founders to staff roles and to hire senior executives with operational depth but little emotional or intrinsic connection to the product market and problem.

Just as it is hard to Six Sigma your way to innovation, it is hard to execute your way to disruption.

Food for Thought: Target Post Money Valuations and Capital Structure

Jeremy and Josh's thoughts on valuation are well worth reading.

Not only should founders be mindful of valuation issues, but also need to be thoughtful about capital structure and shareholder mix.

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, Fewnwick's recent report on trends in venture capital reported that the median 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.

Monday, July 09, 2007

Debtor Nation

This month's Harvard Magazine includes a great article on the implications of America's current account deficit and negative savings rate.

The article addresses a key question - how much longer can the US continue to consume more than it earns? And equally importantly, how much longer will other nations continue to provide the US access to cheap capital by buying US Treasuries and holding US dollar reserves?

The long term fear is that a move away from US dollar reserves, ex. to Euros, will lead to a depreciated dollar, negative impact on US consumer purchasing power, and a rise in interest rates to attract capital back to the US.

The opening paragraph outlines the scope of the problem:

"In 2006, the infusion of foreign cash required to close the gap between American incomes and consumption reached nearly 7 percent of gross domestic product (GDP), leaving the United States with a deficit in its current account (an annual measure of capital flows to and from the rest of the world) of more than $850 billion. In other words, the quantity of goods and services that Americans consumed last year in excess of what we produced was close to the entire annual output of Brazil. “Brazil is the tenth largest economy on the planet,” points out Laura Alfaro, an associate professor of business administration who teaches a class on the current account deficit at Harvard Business School (HBS). “That is what the U.S. is eating up every year—a Brazil or a Mexico.”

As investors, entrepreneurs, and technologists, we have a vital interest in 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. Future growth is conditional on investment in infrastructure, education, and health care. However, we as a nation are no longer saving; thereby forcing us to borrow abroad to fund our consumption and investment.

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.

It will be interesting to see how quickly the current account deficit becomes part of the public policy discourse and how politicians will wrestle with the enormity of the problem and complexity of the issues involved.

Tuesday, June 26, 2007

JavaScript-Enabled Services, SaaS, and Open Source: Friction Free Models that Drive the Reallocation of Capital

What do JavaScript-enabled services, SaaS, and Open Source all have in common?

They are product delivery models that dramatically reduce the cost, time, and resource requirements to test products and their purported value.

The risk to trial is mitigated and individual users can experiment and validate value in isolation of the broader enterprise.

More than ever, companies that focus on reducing the risk and resources required to trial their product or service are outperforming "heavy" footprint product companies.

The capital markets are highly efficient and dollars quickly flow to the highest yielding assets. IT markets, however, are characterized by high degrees of friction that artificially limit capital reallocation and flow.

Typical IT frictions include: required asset requisitions, proprietary interfaces, multi-department decision making, multi-level budget approvals, lack of connectivity, lack of resource and expertise, and behavioral inertia.

It truly pays to ask what are the exogenous barriers that artificially limit value testing and access.

Today's fastest growing companies seek to optimize two core things:

1) friction free adoption and
2) hard "value per unit" analysis; such as price per click, price per CPU, price per seat.

Capital flows to the highest yielding assets.

Once economic actors are able to validate the "value per unit," the dollars will flow:
  • at a rate proportional to the relative increase in yield (value/cost) from product A to product B and
  • at a rate inversely proportionate to the number of barriers that limit the free flow of capital to product B (the higher the # of frictions, the slower the reallocation to the economically advantaged unit of value).
In summary:
  • market are efficient and capital flows to the highest yield assets
  • products that provide a higher yield (value/cost) will attract capital
    • ex. cost per action, cost per seat, cost per CPU
  • product delivery models that reduce frictions will see faster capital allocation
    • efficient product test, validation, and delivery mechanisms stimulate capital flows
  • equity value creation is a function of the amount of total capital at risk and the rate of reallocation from one class of assets to the next
    • ex. total capital at risk = total ad spend market
    • ex. "value unit" = cost per sale
    • ex. "yield" comparison = $100 sale/$2 cost per click= 50x vs $100 sale/$15 per telesales call = 6.66x, or 7.5x differential in yield
    • ex. "friction" = JavaScript implementation of AdSense vs setting up telesales trial
In designing a start-up's strategy, outline:
  • the targeted pool of capital
  • the economic unit of value in question
  • the differential in yield from model A to model B per given unit of value
  • barriers to capital reallocation from model A to model B
  • barriers that protect model B from replication

Monday, June 18, 2007

IRR Multiplication Table

The attached IRR Multiplication Table is a very useful reference tool.

The data table calculates IRR by years (x-axis) and multiple (y-axis).

Dan O'Keefe, who I worked with at Pequot Ventures is the brains behind the spreadsheet. I suggest printing it out and keeping it by your desk.

When you are on the phone you can impress your friends/boss by quickly reeling off the IRR on a 5x over 5 years (38%), 10x over 6 years (46.8%), 3x over 3 years (44.2%) etc.

Start-up Sales Management

My prior post provides a model for how to forecast revenue over the life of an operating plan. Another classic start-up conundrum is how to forecast revenue for this quarter.

Sales forecasting is a notoriously difficult problem and start-ups generally learn the hard way that sales meetings, prospect interest, and apparent momentum do not translate into purchase orders in any where near the time and speed one would hope.

Professional sales management forecasting techniques can help eliminate emotion and excitement ("We had such a good meeting, I know they are going to buy!") out of the process.

Missing a sales forecast really hurts no matter what size company you are. However, given that most start-ups are not profitable, missing a top line revenue number can have disastrous impacts on cash burn, employee morale ("we are working so hard and getting nowhere"), and shareholder confidence.

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

As a first time CEO or manager, a managing a sales pipeline by sales stage can improve forecast accuracy.

A key, however, is that the whole sales team buy into the process and be religious wrt its application. Top leaders must constantly evaluate where an opportunity is relative to the key sales milestones and if sales reps are realistically categorizing various opportunities.

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

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

Another key question is what is the required sales pipeline coverage ratio - ie divide the pipeline by the target and you get the coverage ratio...a typical rule of thumb is that you want $3-4 of pipeline for every $1 of targeted revenue.

The coverage ratio, sales cycle, conversion ratio of prospect to closed...all will help identify the required investment in lead generation/marketing necessary to hit the number.

If the coverage ratio is ~1, one can be sure the target will not be hit. Missed targets kill cash as gross and net burn become one in the same. It truly pays to forecast revenue in a disciplined and realistic manner, especially given the high cost of start-up capital.

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

Sunday, June 17, 2007

Forecasting Revenue

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

Please note that the technique below is best for enterprise-oriented companies rather than consumer Internet companies.

Forecasting Revenue
A key mistake start-ups make in raising money relates to how they model future revenues. This post explains a bottoms-up approach to forecasting revenue. My favorite bottoms-up forecasting method is the productive sales rep model.

In this model, future bookings are NOT a function of market share, size, and penetration rates ($500m market x .005 penetration, or $2.5m) but rather of how many mature sales reps are in the company and the expected sales rep quota and productivity.

A top-down approach is simply too hard to handicap and fails to ensure that a company matches an investment in sales resources with projected bookings and revenue.

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

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

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

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

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

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

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

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

Friday, June 08, 2007

Reid Dennis

This week IBF held the 18th Venture Capital Investing Conference.

Reid Dennis, the founder of IVP, received a lifetime achievement award. His acceptance speech proved both educational and inspirational.

A few highlights follow:
  • Reid began investing in Silicon Valley start-ups in 1952, 55 years ago!
  • His first job out of the GSB paid $425 per month
  • In 1952, there were NO public electronic companies in Silicon Valley
    • HP went public in 1957 and sold 10% of the company at the IPO for $4.8m dollars
  • The first 25 electronics companies required total capital of $300k each and private individuals formed the basis of the early syndicates
  • Reid founded IVA in 1974 and IVP in 1980
  • Reid's firms, IVA and IVP, spawned many of today's top firms
    • Redpoint spun out of IVP
    • TVI spun out of IVA
    • August and Benchmark spun out of TVI
  • Reid played a key role in two pivotal moments in private equity history
    • the 1978 reduction in the capital gains tax from 49.5% to 28%
    • the 1978 change in ERISA laws that allowed pension funds to invest retirement funds in alternative assets
    • in 1975, prior to the relaxation of ERISA laws, the entire VC industry raised $10m
  • He spoke of the need to work with Washington to eliminate tax and regulatory disincentives that limit the free flow of capital to innovation and entrepreneurs
  • With the "carry tax" under discussion in Congress, he warned the audience that the golden goose is at risk if today's industry leaders do not forcefully fight to protect the industry
Bill Gates' commencement speech yesterday at Harvard spoke of the challenge in understanding complexity. He quoted George Marshall who told Harvard graduates,

"I think one difficulty is that the problem is one of such enormous complexity that the very mass of facts presented to the public by press and radio make it exceedingly difficult for the man in the street to reach a clear appraisement of the situation. It is virtually impossible at this distance to grasp at all the real significance of the situation."

I would argue that the impact of cuts in capital gains taxes, ERISA safeguards, etc on the health and vitality of the economy are similarly complex. It is hard to appreciate the link between capital gains tax policy, innovation's access to capital, and regulation on an economy's vitality. Yesterday's speeches by our industry leaders, however, warned of the peril of missing the connections and causality between policy and innovation.

Other speakers included Ed Glassmeyer, the founder of Oak Investment Partners. While he spoke eloquently on the history of Oak and the state of the industry, one story really stood out for me. It took him 4.5 years to raise Oak I.

The chance to see Dick Kramlich, Ed Glassmeyer, Gary Morgenthaler, Lip Bu Tan, Dixon Doll, Reid Dennis, etc recount history, discuss the state of the industry, and prognosticate on the future proved really inspiring.