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.

Board of Directors

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

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

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

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

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

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

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

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

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

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

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

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

Mulecon 2007

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

See my prior post on Mule here.

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

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

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

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

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

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

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

Shift in the on-line video landscape

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

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

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

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

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

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

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

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

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

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

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

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