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.

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 there...now 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.

What do Sales and Sisyphus Have in Common?

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."

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.

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 investing....like 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.

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.

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 value...be 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.

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 Reuters.com 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.

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.

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.

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!

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.

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.

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.

Widgetbox and Forbes.com

Widgetbox, a Humwin portfolio company, announced today a partnership with Forbes.com

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 Forbes.com on a great launch.

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.

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.

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
  

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.

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.

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.

Decision Making and the Venture Capital Process

I recently read a fascinating scientific paper by Anthony Bastardi and Eldar Shafir titled On the Pursuit and Misuse of Useless Information.

The paper's thesis is that decision makers often delay decisions to pursue additional noninstrumental information - information that a priori will not affect the decision at hand - yet then proceed to make use of the information, thus making it instrumental, once it is obtained.

The key issue for executives and venture capitalists is the following: one needs to determine what information may prove critical to the decision at hand, and, therefore is worth waiting for, and what information is unlikely to affect (and thus need not delay) the decision at hand.

The authors note that "people often arrive at a decision problem not with well-established preferences and clearly ranked preferences, but rather with the need to determine their preference as a result of having to decide, and they often look for additional information in hopes that it may facilitate the choice."

The venture capital process is a class example of this phenomena.

Investors often do not have a priori preferences with respect to an investment decision and need to determine their preference to fund a company and do indeed, as all entrepreneurs know well, seek additional information with which to make their decision.

The central issue is clearly identify which information is instrumental, "information that can alter what decision is made," versus which information is noninstrumental, "information which will not impact the decision at hand if it were available."

Given people like to obtain information and base their decisions on compelling reasons for one option versus another, research finds that, given the option, people will wait for noninstrumental information.

Worse yet, once the noninstrumental information is gathered, people alter their choice based on this noninstrumental information. The cost is not only delayed decision making but also poor decision making as noninstrumental information impacts the final choice.

The key take-away is that all of us, when making a decision, need to carefully think through what we absolutely need to know in order to make a good decision, rather than delaying decision making and leaning on the crutch of more time to gather non-essiential data that may contribute to a poorer decision.

Does Geography Matter?

In a world of high-speed data and voice networks, web-enabled applications, and a global talent pool, does geography matter?

Will technology break down traditional industry clusters and distribute innovation, wealth, and opportunity across an increasingly flat world?

As an investor and resident in the Valley, it is an important question.

Should company founders leverage the benefits of operating in a high-tech cluster and pay the cost premium of doing business here, or should they leverage the benefits of enabling technologies and remain in lower cost geographies?

The work of Michael Porter helps think through the issues. In his HBR article, "Clusters and the New Economics of Competition," he lays out a convincing argument for the long-term viability of clusters.

He defines clusters as,

"geographic concentrations of interconnected companies and institutions in a particular field. Clusters encompass an array of linked industries and other entities important to competition. They include, for example, suppliers of specialized inputs such as components, machinery, and services, and providers of specialized infrastructure."

His core thesis is that advantage in the global economy lies increasingly in local things - knowledge, relationships, and motivation.

Traditionally, competition centered on input-cost advantages - natural and human resources. Today, however, competition rests more on the productive use of inputs, which requires continual innovation. He writes, "modern competition depends on productivity, not on access to inputs or the scale of individual enterprises."

He defines the following characteristics of a cluster that accelerate productivity:

• sourcing of information, technology, talent
• coordinating with related companies
• measuring and motivating improvement
• better access to employees and suppliers
• access to institutions and public goods (venture firms, lawyers, universities)
  
• complimentarities
  
• co-optition, cluster promote both competition and cooperation
  

Clusters also directly support new business formation. Porter argues that working in a cluster allows individuals to more easily identify gaps in the current market offerings, enables efficient access to talent, institutions, partners, etc, and a home-grown exit market (ie established members of the cluster are the likely acquirer).

The most important insight for me is that the modern economy competes on innovation and that operating within a cluster shortens the cycle time to identifying, resourcing, and realizing areas of need and opportunity.

The genesis for this post was a conversation I had with two founders, currently based in Atlanta, about the merits of moving to the Bay Area to start their company. Michael Porter's thoughtful analysis helps me better understand why the Bay Area "cost premium" is well worth it. Market cap is a function of innovation and growth, and innovation is a function of access to ideas, talent, and supporting resources that eliminate frictions and catalyze connections and progress.

Ironically, in an increasingly globalized economy the Valley is gaining not waning in prominence. Boston is now the home to one large public tech company, EMC, and the valley takes close to 40% of total US VC, with CA taking well over 50%.

The key to our magic innovation machine is not to let government policy limit the free flow of talent, energy, and ideas into the cluster. It is incumbent on all beneficiaries of the Bay Area cluster to promote truly free labor markets that serve to fuel our unique productivity and innovation.

Mulesource Raises Series B

Mulesource, the leading open source integration framework, announced today the successful close of a $12.5m Series B. Lightspeed led the deal, with return participation from the Series A leads, Hummer Winblad and Morgenthaler.



The raise reflects five important characteristics of the company:

1. large target market - the integration market is roughly $8bn
2. large pricing umbrella - incumbents' products sell for ~$90k/cpu
3. very active developer community - hundreds of contributors
4. mission critical use cases - high conversion rates from free to paid
5. ramping customer acquisition and bookings

As I wrote in a prior post, the closer to a transaction the higher the open source conversion rates. Enterprise risk controls demand that software that touches critical to revenue/transaction systems be supported.

The attached graphic, forgive my graphics design skills, helps me think through the opportunity

• how large is area A, ie the degree of overlap between a project with an active developer community and a enterprise use case that is mission critical?


• how much headroom is there in area B, ie the pricing umbrella created by the incumbents' price points, TCO, and cost of sale and implementation

I would argue that Mulesource offers a very large overlap, represented by area A, with 10x price umbrella support, represented by area B in the above graphic. The financing, but more importantly the amazing developer, customer, and employee acquisition traction validates the premise.

Congratulations to the team.

Concept to Company Event: Widgets to Riches -- Monetization Strategies for Emerging Web Services Platforms

On Tuesday, May 15th, VLAB and Hummer Winblad are co-hosting the following event:

Concept to Company Event: Widgets to Riches -- Monetization Strategies for Emerging Web Services Platforms

The event is scheduled for 6-8:30 pm at Stanford Business School.

This year's Concept-to-Company will focus on Widgetbox, the leading web widget marketplace and syndication platform. Widgetbox's CEO, Ed Anuff, will present an overview of the market and company.

Other speakers include:

Max Mancini, Senior Director of Platform and Innovation, eBay
Adam Sah, Architect, Google Gadgets, Google
Lance Tokuda, CEO and Founder, RockYou!

The above industry leading experts plan to explore how the widgetization of the web will impact the way we maximize the potential of online communication, efficiency, and revenue generation.

Text from the event host follows:

With the recent proliferation of widgets, widget companies entering the marketplace, and the atomization of content and services, what opportunities do entrepreneurs and VCs see as ways to capitalize on this current trend? Is there a profitable business model for the current trend of decoupling content and services from their source?

Bauer's Second Law

In reading From Airline Reservations to Sonic the Hedgehog, A History Of the Software Industry, I came across a wonderful axiom.

Bauer's Second Law states that:

Talent migrates from areas of well defined and stratified responsibility to areas of expanding activity at a rate proporational to the rate of expansion. Or, stated more simply, talent goes where the action is.

Today, the valley is witnessing an amazing migration of talent from Yahoo!, eBay, AOL, MSN, and other leading web properties to start-ups. The start-up economy is benefiting from Bauer's Second Law in action. The best and brightest Directors and VPs are leaving large cap web companies at a rate proportional to the resurgence of the start-up landscape.

A few years ago, with low rates of start-up expansion, start-ups struggled to attract large company talent. Today, those days are a memory and incredible teams are coming together very early in a company's life cycle. Bauer's axiom helps make sense of the trend and the key driver for the migration of talent towards high-growth vehicles.

Leaders as Weather Vanes

In the 70th anniversary edition of Forbes, I found a wonderful 1915 quote from Charles Mitchell, the President of National City Bank of NY (today's Citibank).

Mitchell said,

"The principal duty of the head of an organization in the formative, developing stage is to pump, pump, pump energy into every fiber of it, to train thoroughly every member of it, and to infuse into every employee white-heat enthusiasm."

Wise words.

A vital lesson for developing leaders is that leadership is a public act. The gestures, facial expressions, and postures of leaders project across the whole organization. Like a weather vane, the comportment of the leader is a viewed as a predictor of the future climate. Leaders must be sensitive that employees will seek answers to the state of the company, health of its prospects, etc in the physical countenance and tone of the leader.

As President Mitchell's quote implies, leaders are also conductors of energy and must be careful to inject vitality, passion, and drive into the culture and not apathy, malaise, and surrender.

90 years later, Mitchell's words of leaders "pump, pump, pumping energy into every fiber" of a business ring as true as ever.

Hubpages: SEO and Dynamic Monetization Innovations

User-generated content is a key secular trend driving consumer behavior, Internet usage, and technology. The legs of the content stool are content creation, search engine optimization, monetization, syndication, and tracking/analytics.

For most small publishers, the process today involves bespoke integration of point solutions to allow for content to be easily created, served, monetized, and tracked. A typical blogger may use Typepad, Ad Sense, Feedburner, and Google Analytics. Not only are solutions stitched together via JavaScript, but also today's solutions fail to provide search engine optimization and dynamic monetization.

Given the Google is a vital source of traffic, it is very important that content appear in natural search results. Given domain aging, link analysis, etc., new sites suffer from very poor natural search placement and limited organic traffic.

Today, content creators need to pick an ad network and STATICALLY bind their content to a single monetization source and format. There is no way to ensure that the most effective ad unit, placement, color, ad network provider, etc. is used for any given piece of content.

Monetization, therefore, is clearly sub-optimized, while natural search results are hard to come by. The net result - very limited traffic and ineffective monetization.

Today, Hubpages, a Humwin company, announced a major upgrade to its self-publishing service. Hubpages provides an integrated content creation, SEO, ad yield optimization, and tracking solution that automatically ensures the best possible natural search results and the most optimal monetization programs.

Since launch in August 2006, Hubpages has enjoyed spectacular growth:

• traffic is growing 150%+ month over month, to 2.4m uniques and 6.2m page views
  
• 90% of the traffic is from organic search - ie SEO in action
• 43% increase in ad yields per page due to Hubpage's Behavioral Formatting Yield Optimization technology
• 20,000 hubs created and 14,000 authors on the system
• $1,800/month/top authors in income

In short, Hubpages delivers not only traffic to authors, but also optimizes the ad yield without any required work from the author to pick an Ad network, ad unit, and ad format.

Abstracting SEO and ad optimization represents a vital breakthrough in freeing authors to focus on content creation and not on bespoke integration of a set of tools with a static tie to a single source of revenue.

VC Returns through 12/31/06

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

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

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

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

Returns are driven by two key components, systematic returns and idiosyncratic returns (see CAPM model). Systematic returns are market returns. Idiosyncratic returns, however, are where professional investors earn their stripes - they are returns in excess of the market.

To be a decent investor, one must at least deliver systematic returns. To be a great investor, one must deliver idiosyncratic returns. In the bubble, random investments looked genius. The systematic returns (returns for the asset category at large) were simply amazing, thereby creating great wealth and perhaps reputations for genius that were more due to circumstance and timing than investing prowess.

The questions for us to ponder is what will be the future systemic returns to the venture capital asset class, and has the inflow of money and people into the venture capital industry made it impossible to generate idiosyncratic returns. Are funds' returns systematic (an index of the market) or extraordinary? Will there be a Vanguard-like vc fund that is a low-fee provider of index funds for the private markets!? What is the basis for extraordinary performance over the market index? Is the success of vc investors and funds due to serendipity or to process?

These are key questions for investors (both general and limited partners). Can one deliver quality returns in an industry full of capital and people chasing "good" ideas?

One key difference between the public equity markets and the venture capital markets is the degree to which information is transparent. The public markets are by regulation open and transparent with data available to all.

The private markets are marked by imperfect information, proprietary insights, and information asymmetries. Certain private investors simply enjoy access to information, ideas, and talent that are not generally available to others. For example, certain leading firms leverage the footprint of their portfolio (talent, ideas, reach) to drive insights that lead to investments that others are not in a position to make. An obvious example, is Sequoia Capital's investment in Yahoo! and Google. With a BOD seat at YHOO, Mike Moritz enjoyed access to information relative to GOOG's search technology simply not available to others weighing the decision to invest in GOOG, presuming they even had the chance.

The question for venture capitalists may be as simple as, "what do I know that others don't?" With the corollary, yet vital question begging, "will I be smart enough and sufficiently certain of myself to act on such information?" For as Keynes famously once said, "Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally."

If one knows nothing proprietary, has no unique relationships, access to ideas, and information, then life may be very challenging.

Limiting H-1Bs: Economic Suicide

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

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

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

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

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

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

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

Large Companies - New Equation of Big Company Behavior

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

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

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

The entrepreneur argued that:

an individual's competency x company size = a constant

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

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

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

Why?

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

While there many reasons, I see three core drivers

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

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

VC Interviewing Best Practices

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

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

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

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

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

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

The file can be downloaded from here.

The Value of Scenario Planning

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

Sure signs of a thoughtful management team are:

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

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

The attached example illustrates the value of data tables in analyzing

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

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

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

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

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