2008 Public Internet M&A: Year In Review

Bill Burnham, an ex-Wall Street analyst and current hedge fund manager posted reviews on Public Internet M&A, Software IPO, and Internet IPO activity for 2008. As expected, all showed a dearth (understatement) of activity.

Looking at the M&A statistics, it seems to me that the lack of actviity is related to two factors; one short term and the other industry structural. Addressing the short term issue is that it's hard to place a value on a company when it's stock (and yours) is melting down an average 41% in a six month time frame. We have seen spastic run-ups and run-downs and they just about always freeze buying and selling.

The larger issue is the lack of IPO's. This multi-year freeze seems to be turning the software/internet market structure from a classic triangle (with the largest number of companies at the top and the greatest on the bottom), to more of an hourglass where the middle-market public companies, which historically account for an outsized % of transactions, are disappearing. The disappearance of these firms, not replaced by new ones, is limiting M&A volume. Three related factors ought to be in alignment to bring back the software/internet middle market; company performance, ready equity buyers, and Wall Street firms willing to bet their balance sheets.

We are in the midst of some tidal changes that will undoubtedly give us great opportunities, but just not the same one's we saw for the past 10 years. For many investors, as Warren Buffet once said, 'the shifting tides will expose those of us who were skinny dipping'.

Online sales numbers

Underscoring the maturing of the overall online commerce segment of the Internet, The Wall Street Journal is reporting that online sales were off by 2% from Nov 1 through Christmas Eve. Relatively, this was not so bad as overall, retail was down 6-8%. The sheer numbers of US shoppers who visit each of the major sites highlights a maturing US channel (per Quantcast):

Ebay 64mm
Amazon 54mm
Walmart 37mm
Bestbuy.com 20mm


It seems to me that the 'advantage' to the consumer of shopping online vs physically is narrowing. Hand held smart devices going mainstream now gives instant access to verify pricing 'fairness' and the well known pro's and con's of physical vs online shopping seem to be heading towards a market share balance.

Overall, I sense a feeling, excepting Amazon, that innovation in online selling seems to have stalled. Looking at leading sites that included AAPL, Best Buy and eBay, I was struck by how little improved was the shopping experience. Moreover, the price advantage inherent in a business model where efficiencies in labor and real estate ought to translate into better pricing seems to have disappeared.

In my view, absent new innovation in the online experience/value, the halcyon growth days of explosive commerce growth are behind us.

Morgan Stanley's 08 Internet and Economy report (click here)

Mary Meeker, et al, recently published their year-end report for the state of the Internet...and the economy. Over the years, I have looked forward to reviewing the report as the data and perspective have been invaluable. Often, they showed a perspective that was unpopular, and right on. It's a long document and, surprisingly, I have not been able to find any real nuggets of gold that would add to or modify my venture investment thoughts...yet.

For those that want a guide, suggest you jump to:

p24 for a macro guide to US Advertising spending by Medium. Q2 Internet growth slowed to 10%, but was nicely ahead of all other major arenas which dipped into negative territory.

p26 highlights a regression analysis showing the 3x correlation of Ad spending growith to real GDP growth (not a good sign in a recession).

p38-43 is a major theme of the report. Relative to time on site, video and social are way undermonetized. Many slides highlight the value for users, no mention of the value for advertisers (who are the real customers).

p69 shows the growth of advertising inventory, and the slowing CPM's as inventory is greater than supply. They call this a short term issue...until the pace of new inventory slows dramatically, or engagement with viewers rapidly improves, I doubt they are right.

p78 details Mobile Internet growth (smart phones). With 5B page views, it's a dynamic 325+% growth rate! Expecting 3G critical mass in '10 (p81)

p93 presents the global trends for internet usage; 10 largest emerging markets surpass 10 largest developed markets in terms of number of users....not revenue.

p 105 their closing thoughts "Companies with cogent business models that provide
consumer value should survive / thrive – consumers need
value more than they have needed it in a long time"...as do the shareholders for many of these consumer facing companies.

The Rosenberg case (Click here)

Thanks to my smart friend Larry, who forwarded a report by David A. Rosenberg, an economist with Merrill Lynch. He shares a historical perspective of today's recession, followed by my thoughts on how this affects an investment perspective in the software/internet arena. His case:

1. Unlike each of the past 32 US recessions since the Civil War, this one is a 'balance sheet' variety, where households are rapidly reducing debt($29b in Q3)

2. Past recessions were influenced by the Fed tightening credit, inflation, and excess inventories. Leading up to this recession, each of these metrics were behaving in an anti-recessionary way

3. We are seeing a fundamental demographic shift with the average baby boomer nearing 50 years and in the natural life mode to delever liabilities. Therefore, it is not realistic to expect the consumer spending to cushion any downfall

4. The repeal of Glass-Steagall in the mid-80's fueled great competition by financial institutions to gain market share in the consumer sector. With the household debt/income ratio at 140%, and with the demographics noted above, we should expect deflationary times as consumers focus on debt reduction and not spending. Deflation is his major theme driven by (demographics, excess inventory, excess labor (unemployment), and reduced credit affecting CAPEX).

5. Expect the Federal government to jump in and try to fill the gap, to avoid deflation, with at least $600b of incremental spending. Especially in light of the Q3 numbers where household net worth contracted by an astounding $2.8 TRILLION! This far exceeds the $1.9 trillion loss seen during the break of the Internet bubble in Q3 '01.

What does this mean for Internet/software venture investing?

If the case he makes about deflation and reduced consumer spending is true, then the sector of investments that are advertising supported will suffer for the duration as the customers for these services will be balanced sheet constrained.

It seems to me that a more promising arena would be one where vendors offer product/services that EXACERBATE a deflationary outlook by enabling net short-term spending reductions, or a longer-term strategic cost saving shift gained by a shift in basic infrastructure that addresses labor or operating costs.

In the Enterprise and SMB environment, the combination of tight credit, and deflation should accelerate the move to SaaS and open source based solutions. For the consumer, where more $ is spent fixing PC's than purchasing them, look for outsourced support (iYogi or Reimage (I am on the board)), as well as a a shift away from premium priced brands....the premium for cool is moving away from the average Joe. Speaking of Joe, Frappacino's ain't so cool no more.

Lux et veritas- Light and truth

Yale University announced yesterday that the value of its liquid securities within its endowment dropped 13% during Q3 + October. More meaningful, the overall endowment, that includes 'Alternatives' such as Venture Capital investments, LBO's and Real Estate dropped by 25%. As the market continued to punish investors, and the Alternative category tends to report write-downs later than public valuations are reported, the news for the full year, will surely be worse.

It's clear that the primary source of funding for venture firms; endowments, family offices (hello Mr. Madoff), and pension plans are under tremendous pressure to meet current obligations. The TRUTH is that the private equity community, (including the fund of funds) will see a rapid trickle down effect from these mark-downs that will include sales to secondary funds who will continue funding LP obligations (best case), defaults of current obligations (worst case), and a shut-down of funding new groups (certainty).

Companies are only as healthy as their customers. The customers for venture funds are their LP's that entrust their precious capital to firms in an effort to mitigate risk and seek healthy returns. If the customers (LP's) are not healthy, there is less funding, and a contraction of fund sizes, coupled with the gross number of firms who receive capital.

Unlike real estate and the LBO world, in the venture business, this may ultimately be good news as the thirst for capital, from a per company perspective, from early to mid-stage companies, appears to be diminishing as the recipients of their capital harness capital efficiency garnered from just in time infrastructure (Amazon's EC2), just in time sales, and just in time development.

Similar to the secular alignment during '01-'03, when many funds reduced their size and raised smaller successor funds, we may be at the verge of a similar, but horizontal shift throughout the industry. The TRUTH is that this painful ecosystem environment may align the business models of mainstream venture with the trend for capital demand by its constituency. If so, all this pain will give us a healthier ecosystem.

A return to 'little game' venture, coupled with the entrepreneurial spirit of self-exploitation by building equity through working insane hours at below market rates, is what brought us MSFT, AMAZON, Ebay, LINUX, ORACLE, DELL, etc. The foundation of the venture industry has been paradigm shifts started by small disparate groups of entrepreneurs, and initially supported by no or little capital, often disparaged by large organizations and too small for large venture to properly deploy capital 'efficiently' for their business model (notable exception is Kleiner Perkins).

I believe the Grateful Dead said it well; 'Once in a while you get shown the light in the strangest of places; if you look at it right'

Where for thou exits? (click here)

Updata Advisors and Morrison & Foerster have just published a survey, conducted during Q3, of senior executives in the software, internet and related services industry about their M&A interests. The survey covered executives in the US, Asia and Europe.

This is a topic that keenly interests me as, over the past few years our industry (internet and software), has experienced an uneven exit environment; with windows opening and closing at an ephemeral pace. I have found that keeping current on the M$A environment is a critical element towards appreciating the window of opportunity to reap rewards for many years of hard work.

Key findings:

1. Buyers expect to remain active (45% expect M&A to increase or remain the same), as the economy gives many players the ability to grow global market share at more reasonable prices.

2. Large-cap buyers are expected to lead the way. Unfortunately, if true, this will probably continue the trend of reducing the number of public companies in the industry and, unless refreshed, result in a smaller universe of buyers.

3. In the Internet sector; security, e-commerce infrastructure and content providers are the most interesting to buyers. Interestingly, social and shopping sites were laggards. If the intentions of the survey bear out, it seems there's a mis-match between many of the internet investments over the past 3 years, and buyers intentions.

4. Nearly 70% of transactions are sourced from internal sources...not introduced by bankers. Again highlighting that effective Business Development/partnerships is the most reliable way to a positive exit.

B of A's latest Internet report (click here)

I think that one of the most useful metrics when looking at public valuations is the P/E to growth ratio. It just makes so much sense that faster growing companies would have higher P/E's and the contrary, as we see in recessionary times, is just as true.
Over the years, I have seen this ratio, on a normalized basis, approximate 1.2. As an illustration, if a company is projecting 20% growth, you would think the market would reward the firm with a P/E of around 24x.

The latest B of A Internet report has a some nice data (p 12-13) that looks at their coverage universe, segmented by large and mid-cap and advertising and commerce that shows which of the covered firms would be above the valuation line (more than fully valued), or below the line (less than fully valued). From the charts, it seems as if advertising is about fairly valued today, and with a limited universe, e-commerce is not significant enough to note.

From a macro industry view, unless we see a continued deterioration of expectations, it seems as if we have achieved a reasonable balance between valuation and growth.

Feeling social?

With all the talk about declining CPM's (and related metrics)... and a son who is taking High School economics, where he's been exposed to the dreaded supply/demand curve, I decided to look at the deal flow we have seen over the past 18 months (nearly 600 companies) and look at the % that were intending to build/grow companies that had banner/social advertising (supply of pages) at the core of their business models. With the sector's torrid growth, I suppose it was no surprise that nearly 60% of these reviewed companies had advertising based models that were reliant on CPM's or similar variants for revenues.

The industry has seen a massive expansion of inventory (pages) available for advertising, with some estimates touting that, in a scant 3 years, social pages now account for nearly 50% of all ad based inventory. With signs that, in a general sense, social inventory reached equilibrium with advertising spending sometime in late '07-early '08, it's not surprising that the unabated growth in pages, coupled with a stagnation (decline) in spending has shifted the CPM pricing curve for many of these firms in a negative way.

This is a natural supply/demand ebb and flow. But what I am watching is the impact the funding environment has on the success of these entrepreneurial ventures. Building social networks is a bit like building a proprietary information database where it often takes 2x the planned time and money to critical mass, but when you do, it's like owning gold mining rights into perpetuity. Today, building companies, such as Twitter, is akin to flying a plane and adding components in mid-air. You must have great faith, leading-edge innovation, or a serious safety net (capital) to achieve a critical mass substantially larger than originally planned to reach self-sufficiency or to build meaningful shareholder value. I think at least two of the above conditions are necessary for survival...three to prosper.

The natural outcome of this rationalization will be a reduction of inventory, via shuttering companies, to a level where we have market forces again in alignment with demand. From what I have seen, it will be a tall order for many companies to cross today's economic chasm. I am afraid the outcome for these businesses will be akin to the cold freeze when the 'dot bomb' imbroglio was mostly confined to the Internet. True the burn rates are lower, and management is more focused on sober business metrics, but it's a tall order to fight the broad economic tape.

M&A activity will not alone solve the economic equation shareholders find themselves in today, where they have the option to fund companies with declining asset values, hoping for a greater payback tomorrow. Chris DeWolfe, of MySpace, was quoted here that they are being approached by companies willing to sell themselves at a fraction of the value of a scant few months ago as capital to fund loss making operations is now scarce.

If past is prologue, many entrepreneurs are already making a 'left turn' and are busy building companies that leverage areas (like where end-user prices are inflated to support brick 'n mortar sales/marketing) where a great price reduction will encourage demand to outstrip available supply.

Minding your P's, Q's and insights into T's

One of the beauties of the Internet are the wonderful niche markets that rapidly develop into viable nationwide and global businesses due to the low cost of distribution and harnessing the creative talents from many corners. Often, many in the venture community only stumble upon these situations when they have reached a nice critical size that raises their visibility to the general public.

Recently, Wired Magazine had a nice article by Clive Thompson on: How T-Shirts Keep Online Content Free where he noted that a myriad of folk have set up companies to hawk T-Shirts with monikers from bands, politico's, TV characters, or other sundry sources.

CafePress , drives a reported $100mm of '07 revenues, with $20mm in profits and 60% growth by creating a community of nearly 7mm people who create, buy, and sell custom T's. Social, commerce and content all meet at CafePress. Below are numbers for CafePress, as well as one of the competitors, Zazzle, courtesy of Compete.com



Now that we have the T's covered, I am sure entrepreneurs will find great equity building opportunities in the P's and Q's.

The VC landscape

Mark Peter Davis, of DFJ Gotham posted in the Silicon Valley Insider excerpts from his speech about 'why VC's aren't investing anymore'. He was clearly exaggerating for effect, as we are in the midst of a slowdown, not meltdown in the VC space.

The capital allocation issue, where institutions seek to diversify their investments into various buckets, is a big problem. Ironically, the decrease in the value of public stocks, means they are under allocated to this area, and many are seeking to lessen their investments in 'alternatives (including venture) to re balance. This macro situation only partly masks the micro effect....returns in the venture market have disappointed many institutional investors. Over the past 5 years, the Venture market has been a bit constipated as many dollars were invested, but too small a % were returned. Positive net portfolio returns are a different, and more difficult, story. The economic situation, 'the denominator' problem highlighted in the piece, clearly exacerbates an already difficult environment.

The only long-term solution is around innovation that opens new markets, or fundamentally destabilizes an existing one. Only by pushing the envelope (yes, taking risks) will investors and entrepreneurs garner the type of sweet returns that justifies investment in the asset class vs alternatives, such as 'vulture' investing (downtrodden public companies), 'secondary' investing (buying LP interests from individuals/institutions interested in reallocating), or 'value' investing (low p/e stocks). An arch focus on profitability, at the expense of innovation, is a path that surely leads over a steep cliff.

Despite a terrible economic environment, in the midst of the early 80's we saw the IPO's of Oracle and Microsoft. Two companies that were riding fundamental paradigm shifts that brought institutions running to the venture asset class as tangible returns were available in the dawn of a new paradigm. Capital efficiency in the internet area is clearly important, but alone, is not sufficient to drive stellar returns necessary to support investments at the pace of the last decade.

Web based services...ready for hyper growth?

I was listening to the quarterly report from Liveperson (LPSN), a micro-cap stock that has not been a strong performer in the public market (I am not a shareholder). The article in Sunday's NYT that highlighted the positive trend in the Spirituality market piqued my interest.

The Company provides an on-line service that facilitates real-time assistance and expert advice. Essentially, they are in two businesses; a platform that assists their customers provide on-line support (chat and CRM) for consumers. More recently, they acquired Kasamba, an Israel based firm that offered a marketplace for consumers to directly connect to thousands of experts online.

One of the gurus of the online market business is Jeff Leventhal. Jeff, is the founder of Onforce, a stunningly successful marketplace for contract service professionals (primarily IT). Jeff is someone who is best known for solving the age old 'which came first, the chicken or the egg' question. In marketplaces, the question is referred to as 'do you build the sellers or attract the buyers first? As we tout the capital efficiency of building internet and software companies, it seems to take twice the time (and more than that in capital) as expected to build a viable, self-supporting community.

Services now represent more than 50% of the GNP, but only a fraction of on-line commerce. Think of the metaphor of building an 'Ebay for services'. Essentially, you sell/buy time and expertise, not physical goods. It's a tricky issue as trust is paramount to success.

My experience is that the buyer trust issue has held back success. If you have happy buyers, sellers will flock. It seems to me that the rise of trusted payments, video cams, and instant reputation measures, that buyers will get far more comfortable using these services. Probably with pure consumer activities first, then with a move to the mainstream. Fortunately, hundreds of vertical markets exist for such services, ranging from the 'pure' consumer (porn, health and spirituality), to more business oriented services (e.g. programming, IT support). Each of these markets represents potential revenues in billions of dollars.

Recessions force folk to do things more efficiently; whether buying physical goods, or, perhaps, expertise.

As my friend and fellow investor, Howard Morgan says, he named his blog WaytoEarly, because he works with companies, and markets, that are mostly early in their life cycles. In such instances, backing people who you trust can get the job done is paramount. This is one reason I have always been intrigued with my investment in Bitwine.

Survival is not a strategy (click here)

Wonderful post by Anand Rajaraman of Cambrian Ventures on the importance of growth, for young venture backed companies; especially in difficult times.

Free, commoditization and Microsoft

Yesterday, Microsoft announced plans to offer free internet downloads for a fully configured (e.g. not a freemium service dependent upon a scaled down free version upsold to a full-featured service) anti-malware service; Morrow.

Great news that will, hopefully, spur Symantec, Trend, Mcafee to embark on an innovative path to offer great(er) protection, tuning, and remediation. Entrepreneurs, and their venture capital backers should be encouraged that a slow growth AV market will face greater commoditization than AVG or Avast could hope to accomplish and the established players will turn to M&A to ameliorate this meteor strike.

One Company, Reimage (where I am an investor), is clearly heartened by the news as they anticipate their rapid revenue growth will be buoyed by:

1. The cost of embedding AV in their offering has now dropped to close to zero
2. The opportunity to continue to build their affiliate network has now dramatically increased, while the cost should decrease.

The view from on high- New York Angels meeting

Yesterday, I attended the monthly meeting of the New York Angels, a group of 75+ Metro New York investors that fill the gap between friends/family and venture capital financing. Members include Esther Dyson, Gideon Gartner, Josh Kopelman, Scott Kurnit and Chris Anderson. (I have been a board member for 3 years). As background, over the past 4 years the group has invested more than $20mm in 50+ young companies. The companies mirror the Metro NY landscape with many investments in the internet arena, a smattering of retail, and a respectable share of medical oriented firms.

David S. Rose, the Chair is well plugged into the Angel investing activity around the country, through his investment in Angelsoft and he began the session with a perspective of the way Angel investors seem to be reacting to the market downturn. He sees Angels taking a 'new approach to investing' whereas, despite continued innovation, follow-on rounds for seed investors will be mostly problematic as the venture community is hoarding capital to support their existing portfolio companies; leaving diminished resources for new investments.

From a deal overview, he sees valuations plunging in the 40% range to a pre-money in the $1mm range for seed investments. Moreover, the business objectives for stakeholders will place a premium on getting to self-sustainability, at the expense of growth. This shift is directly tied to his perspective that scant resources will be available from professional investors, so it's better to own a grape than to throw out a rotten watermelon (my words, not his).

One of the beauties of Angel organizations is the diversity of backgrounds, thought, and opinion; sort of like going to the in-laws for Thanksgiving. As such, let me share why I disagree with some of the sentiment expressed by David:

1. I don't think professional investors are interested in small companies that have reached break-even and 'with fresh capital' have the potential, but not the record of seeking break-out growth. The environment is littered with firms that have great potential, but limited growth that a VC simply does not have the time to filter all the coal dust to find the diamond. The math for early stage venture investing success dictates that each portfolio of an early stage investor should have at least one 10x that returns most of the fund. Each investment ought to have that potential.

2. I don't see a plunge in seed stage valuations. Depending on which side of the field you are sitting on, it's a shame (or a virtue) that investors can't own more than 100% of a Company. Realistically, the market dictates a healthy balance between greed and avarice whereas early investors, post-investment, ought to leave a healthy amount of equity in the entrepreneur's pocket. After all, these are the folk whose passion will drive them to 24/7 company commitment, who will face multiple rounds of later dilution and are the glue that will make your investment more valuable. Owning too much, too early is a Faustian bargain.

Instead of a plummeting prices (ok, there will be some moderation), I see a 'right shift', whereas seed investors who put money behind ideas, will now look for a finished product. Those seeking a finished product, will look for some measure of market acceptance. And each will invest at their historic valuation levels for an investment that has now been measurably de-risked.

Entrepreneurs seeking seed capital will revert to cold garages. Prudent investors will have wonderful opportunities to participate in a changed risk/reward environment. One, whose later returns, will depend upon participating in investments that are showing signs of attaining, or have reached market leadership.

Decision Speed

In a recent board meeting, a healthy discussion ensued around the trade-off between growth and prudence (e.g. spending reduction) in turbulent times. In the aviation world, it's known as decision speed, whereas an aircraft (plane or helicopter) needs to reach a certain velocity to get airborne. Moreover, for safety sake, critical abort alternatives present at various levels of velocity.

Unlike aviation, such decisions in Company building involve the construction of such a multivariate equation that decisions are not always clear and evident. In the software/internet spaces, we live in a fluid environment where the execution of strategic objectives is seldom a straight line and Decision Speed often feels like a way of life. For sure exacerbated by broad market conditions.

To provide a framework for thinking re-investment considerations, I look at the following guide (not covering all alternatives):

1. Company in a growing market, growing market share, and path to self-sustainability. Starting with an easy one; action.....continue to invest, and go for it.

2. Company in a static market, growing market share and path to self-sustainability; action... examine if ecosystem partners are interested in a combination. Market will probably shake out; action;...it's the time to be a lead player, or exit to one who will lead.

3. Company in a nascent market, unproven business and market share irrelevant; action; share the pain (mgm't and investors) if knowledge gained support initial investment hypothesis.

Our industry has fresh memories about dealing with such turbulence, as well as operating in high velocity environments.

Many other scenarios exist, only limited by your imagination. I have found that devising the best plan lays with a candid assessment of your position, then taking action. Sometimes this action is not governed by the academic perspectives of what is best for all stakeholders, but the unique situation individuals or organizations find themselves in.

I have heard it said that now may not be a time for heroes; but it's also not a time to defer pursuing a definitive course of action; based on the facts, not what's popular. This may indeed be heroic.

Freemium business model

In a number of internet market segments (gaming, content distribution, security, performance enhancement), participants seek to lower the cost of customer acquisition through giving away a starter version of the product and offering a paid enhanced version. Often the board room debate centers around the cost to provide the service (bandwidth, storage, support), marketing, and the conversion rate to an enhanced version that is a gateway to the paid model.

It's important to differentiate between companies that focus their energies around the conversion from free to paid, vs. vendors who concentrate on 'free' to use, but are advertised supported. The later really support themselves via an attention tax that users pay each time they use the product. The beauty of this tax is that, for vendors such as Google, the tax, when properly implemented is not too obtrusive, and adds to the overall user experience.

Chris Anderson posted an insightful article in Wired that discusses his views, with a link to MMMPOW that cites statistics in the gaming market. Per MMPOW, here are conversion rates from free to paid for select successful vendors in the casual gaming arena:

* Club Penguin: 25% monthly uniques pay, $5/mo per paying user
* Habbo: 10% monthly players pay, $10.30/mo per paying user
* Runescape: 16.6% monthly uniques pay, $5/mo per paying user
* Puzzle Pirates: 22% monthly players pay, $7.95/mo per paying user

These are way higher than my experience in horizontal business segments, which mostly do not have the benefit of strong community (anyone know LinkedIn conversion to paid?), where a 2% conversion rate is considered successful.

For awhile, the software and internet industry went through a phase where vendors placed an 'annoyance' tax on users of the free product by bombarding them with pop-ups and other annoyances as a way to improve the conversion percentage. Thankfully, competitive realities have minimized this practice as building negative brand equity is ultimately a poor practice (I wonder if today GM feels their planned obsolescence was a good thing?).

Overall, many mail vendors have done an outstanding job of striking a balance between value offered for their free products and garnering revenue for themselves. In their business, it takes a tremendous amount of capital to subsidize horizontal and global applications, before the business can generate positive gross margins through advertising and upgrades. So much capital that the innovation bar is now so high that entrepreneurs must really be doing something special to succeed here.

I am intrigued by the free/paid line in the security and performance enhancement market where Anti-virus, firewall, registry cleaners, disk maintenance vendors, amongst others, have mostly embraced a free to paid model. Sort of like going to the dentist for a free cleaning, with expectations that they will garner the later root canal work.

Is the Venture model broken?

A flurry of thoughtful debate has rightfully begun around a speech and presentation given by Adeo Ressi of TheFunded at Harvard. His presentation argues that the venture model is broken, as evidenced by his belief that the wrong companies are being funded, too much entrepreneurial time is spent raising capital and missteps have brought on the poor returns generated by the industry over the past 5 years. He offers a number of suggestions, with varying degrees of merit, that I won't go into here. But will proffer that, unlike the auto industry, as well put by Thomas Friedman's great op-ed, How to Fix a Flat, the industry is not fundamentally broken, but in the midst of a transformation.

The National Venture Capital Association is celebrating its 35th year and. per the Association, its members have backed companies accounting for 10.4 million jobs and $2.3 trillion in revenue in the US in 2006. As you would expect for an industry that's been around for awhile, is geographically dispersed, and consists of thousands of firms, there is no monolithic venture capital industry. Instead, it's populated by a rich mosaic of niche specialty firms. Some like First Round Capital Capital focusing on the earliest stages of innovation, others like Carmel Ventures successfully concentrate on a fertile geography. True, concentrations exist, but like Judiasm, no centralized authority dictates how to prosecute the business. As was vividly brought home by the performance in the financial and political arena's, diversity is good.

But all is not well in VC land. The exit environment can charitably be called anemic. The lack of IPO's (one last quarter, representing the lowest volume since 1977) has caused a consolidating stable of ready willing and able acquirers who, in a less competitive M&A environment, coupled with diminished multiples will slash their valuation models.

The underpining of our capitalistic economy is that dollars flow to opportunity; where investors can earn favorable risk adjusted returns. Entrepreneurs strive to create companies that build equity value through creating meaningful market share, or through creating an engine that throws of growing cash flows. Venture capitalists seek to invest in these companies and reap a portion of these rewards. It's been that way for more than 40 years...so what's the problem now?

Netscape enjoyed its explosive IPO on the same day that Jerry Garcia passed away, August 8th 1995. The opening of a global market opportunity, mostly unencumbured by geographic borders, presented an historic opportunity for wealth creation (returns to stakeholders) that now strives to maintain double digit growth, mostly through exploitation of niche arenas. A few faux markets have been offered as 'the next internet' but nothing has arrived that replaces the heady decade of 20+% growth. I don't believe 'mobile' is the answer. Not because the growth of subscribers, or the need, is lacking. But, investing in an industry where a small number of gatekeepers controls the distribution channel exposes entrepreneurs, and investors, to a level of risk that is simply too great to bear. Love the milk, but please keep the cow.

Positive trends are nonetheless afoot. Brought to us, not by the monolithic gatekeepers, or the venture industry, but where you would most expect, and hope for it. The entrepreneurs are speaking.

"I need less capital" In software/internet Big Venture Capital is gone. Small markets are best served by small investments.

"I need less people" We will stand on the shoulders of the open source community, use 3rd party distribution (affiliates) and SEO our way to brand building.

"I will innovate" The IT industry has 3 legs that move independently. Software, communications and hardware provide the foundation for value creation. Parodying the parable of the 3 Little Bears, one is reaping the benefit of years of investment (communications), one feels about right (hardware) and the last is ripe for a fundamental shift (software). None of the past shifts were the derivative of big capital (corporate or venture). No reason to expect it will be the next time.

Reminder to self, keep an open mind to the geeky looking/sounding person you meet. They just may be the game changer.

Budget slashing

It seems as if the first, and perhaps, last wave of systemic budget cutting brought on by the collapse of the financial services industry and pronouncements by stalwart venture firms, led by Sequoia are now behind us. Balancing the rush to preserve equity, often at the expense of equity creation, was a more balanced view expressed by Alan Patricoff.

In the venture business, there is always merit to surviving for another day. However, it's my experience that this is not the way to earn consistent returns for LP's, but a way to minimize capital exposure to under performing investments. Prudent companies, especially in our industry, led by folk who experienced the nuclear events of '01- '03, for the most part are not living way beyond their means today. One can always cut expenses, but our industry has consistently shown that creating equity value is most closely aligned with market share leadership. Moreover, the foundation for creating sustainable value, certainly in times of questionable exits, is by earning a volume of revenues, greater than your expenses.

Try as you may, but no young company, founded with a growth oriented DNA, that I remember, has ever slashed their expenses to victory. Many companies appropriately encouraged to slash budgets find themselves with now unproven markets, or a value proposition which has not yet resonated. Nevertheless, if a company has momentum, this environment presents an incredibly capital efficient time to garner market share as distribution, R&D and customer acquisition expenses are in a deep downward spiral.

The balance between growth objectives (often cash consuming) and balance sheet maintenance is what just shifted as the cost of capital soared by at least 30% in the past month. It takes a brave soul, full of passion and confidence to unabashedly continue with the leap into the unknown.

No doubt that some stakeholders will be massively rewarded for this confidence, it will take a few years to know just who...

Acorns to Oaks

More often than we realize, singular people, or small passionate groups do things that change the world in positive ways for the rest of us. Many times we don't realize the magnitude of the change till the wave rises up like a tsunami, ignored till it hits the beach.

In technology, we are accustomed to seeing these waves and now expect them every decade or so:

Joe Ossanna, Ken Thompson, Dennis Ritchie and Doug McIlroy brought us Unix

Richard Stallman and Linus Torvalds stood on their shoulders and brought us Linux

Dave Winer, Ramanathan Guha and Dan Libby birthed RSS

Bill Gates and Paul Allen created MSFT

Don Chamberlin and Raymond Boyce created SQL, which brought us Larry Ellison and Oracle

Tim Berners-Lee, Vint Cerf paved the way for Jim Clark/Marc Andreessen and the commercial Internet.

In politics, we have President-elect Obama, and in Jerusalem, my former Partner Nir Barkat looks to be the Mayor-elect. Both bringing fresh ideas to troubled areas with breathtaking potential.

It starts with an acorn....

Endowments cutting back on PE?

According to PrivateEquityOnLine, Harvard University is in the process of looking to sell $1.5B of PE investments in the secondary market. With nearly $40B under management and 11% invested in PE, this represents around 1/3 of their PE stakes.

I am not sure this action has the hallmark of a hasty panic as indicated in Silicon Alley Insider. Following are comments to Henry's post earlier today http://www.alleyinsider.com/2008/11/the-cash-panic-sweeping-the-vc-industry :


1. While the PE market always has some defaulting LP's, and no doubt the % of defaults will rise in '09, it should not reach the epidemic proportions witnessed in '02-03. Many vintage '00-'01 funds had abnormally high % of investors as individuals/small family offices that were unable to meet capital calls or were margined too high due to lack of diversity of their portfolios. Professional institutions are indeed suffering today from being suddenly overweighted in PE (due to the 'denominator problem' that occurs when PE is tracked as a % of total portfolio value). If the portfolio value decreases, while the PE value remains constant, targets are overshot. By charter, this often triggers events to re-balance within proscribed formulas; which include sale of PE stakes and lower commitments to new managers. Institutional thinking often leads to a belief that the current pain of selling a portfolio at a 'discount' is less than the pain associated with being out of charter.

2. As for Harvard, I don't have any insider knowledge, but they have a reputation for being a market leader due to their early support of VC, and bold actions in the VC market. The later includes a proactive approach to limit exposure to VC funds that, in their view, grew too large for a market opportunity where their target companies (entrepreneurs) preach capital efficiency. I would not be surprised if they forecast the rates of return in buy-outs and real estate, which have traditionally been the largest component of the Alternative investment basket declining substantially. The prospect of these asset categories experiencing fundamentally declining returns, due to the prohibitive state of the debt markets, and deleveraging causing prices to drop, signal a prudent change in portfolio approach, not a panic.

3. Fund of funds, long a source of capital to the VC market are also experiencing long closing cycles. This will hurt PE and VC fund raising.

4. Today's exit environment is truly hostile. Other than hindering fund raising (a big thing), I am not sure it augers poorly for VC firms where we can 'buy low' and hope to reap returns through participating in equity value building by entrepreneurs building companies that will save their customers time, proffer revenues, or offer good old plain fashioned fun. The exit events for these investments are years off; who knows , we may have a President Bush in the White House when this happens....