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Archive for October, 2012

The Unsustainability of Hyper Growth VC Startups

Posted by Bob Warfield on October 24, 2012

Charles Ponzi in 1910

I have 216 subscriptions in my RSS reader as I write this.  While I like to read the Google News page at least once a day, I much prefer blogs for any kind of real insights beyond just news.  I’ve cast such a broad net because I have broad interests and because there are a lot of very smart people out there blogging away their best ideas–it’s a gold mine of inspiration and understanding, and well worth the time I spend sifting through the articles.  My favorite insights come from finding the correlations, connections, and harmonies between multiple seemingly disparate posts.  For today, what got my juices flowing well enough to take out the blogging pen were these two articles:

-  Paul Graham’s ode to growth entitled, “Startup = Growth

-  Jason Cohen’s potentially career limiting, “The Rise of the Successful Unsustainable Company

I say career limiting of Jason’s piece because as he mentions in the post, it is going to annoy some people.  This is probably a career limiting post I am writing too, but that’s okay, I don’t want a career with a successful unsustainable company.

Speaking of which, let’s start there.  What is a “Successful Unsustainable Company?”

Whenever people have asked me why I like Enterprise Software startups more than B2C Internet plays, I always use the same response:

B2C Internet plays are all about fashion trends and I’m not an arbiter of fashion.  I can’t tell you whether this is the right time to make millions using sock puppets to sell pet food.  I can tell you how to solve a hard problem that has valuable ROI in the Enterprise.  I prefer the latter as a way to maximize the value of my career investment portfolio.

That’s actually a bit mellower than my true philosophy, which I’ll say more about below, but it’s where I started.

With that said, not every B2C play is a fashion play.  The fashion play is not sustainable because inevitably, fashions will change and it is hard to keep up when that happens.  There are many B2C companies that have sustainably created value for consumers:  Apple, Amazon, and Starbucks, to name a few.

I well remember the first fashion play I came across.  It was a company called “Pointcast”, and many of the hottest VC’s loved it.  I used to see it running on machines in the lobby of their offices.  Pointcast was a screen saver that delivered news gleaned via the Internet to your screen.  It was intended to be monetized via an advertising model.  It made absolutely no sense to me whatsoever:  How can we sell ads that are only “seen” when the computer decides we have walked away from our PC’s?  Yet, they ultimately received, rejected, and regretted rejecting a $400 million acquisition offer from News Corp before they ultimately went bankrupt.

What went wrong?

They were a fashion.  They were solely focused on growth.  They delivered virtually no value.  They were not sustainable.  Most of all, they self-selected users that were not committed.

This is where I start to wonder when I read that startups are about growth, growth, growth, and dare I mention, “Growth!”  Paul Graham is Paul Graham, but geez, isn’t there more to it than Growth?

Fred Wilson is a smart VC, and though I don’t always agree with him, he is careful to point out that while he loves Graham’s article on growth and generally agrees, his firm wants sustainable growth:

One thing that Paul did not touch on is the difference between organic and sustainable growth and temporary stimulated growth. Things like gaming Facebook’s open graph can temporarily stimulate growth that is not sustainable long term. Investors can be faked out by things like that. Gaming Google’s search algorithms is another way that has been done in the past. When we look at growth, we look for authentic, organic, and sustainable growth that is not overly dependent on a single source, particularly a source the startup doesn’t control. That takes some experience to detect. We’ve messed up there as have most investors.

Sustainable and organic growth that can continue for five or ten years unabated will produce extraordinary returns.

This is laudable, but I’m not sure it really captures very well what I think of as Sustainable Growth.  For one thing, he telegraphs one of the key drivers of the rush to Unsustainable Growth–his firm plans to get out in five or ten years so the rest doesn’t matter so much.

Jason Cohen’s article chronicles the career of Bill Nguyen’s awesome track record at building unsustainable growth.  Putting aside his most recent one, Color, which blew up $41M without accomplishing anything, Jason offers the following list:

  • Forefront — IPO’ed in 1995 by CBT — CBT stock fell 85% in 1998 and prompted class-action lawsuits.
  • Freeloader — On $3m invested, sold for $38m in 1996 — shut down in 1997.
  • Support.com — On 2.5m invested, IPO’ed in 2000 for $32/share — stock price now $2.
  • OneBox.com — On $60m invested, sold for $850m 18 months after launch to J2 just before market crash — score!
  • Seven — On $60m invested, still private, cancelled an IPO.
  • Lala — On $35m invested, sold to Apple for $80m — shut down in June.

Much sound and capital ultimately signifying nothing.  They cashed out, got acquired, and achieved liquidity by any means possible and then died suddenly.

What’s with these deals, and why do so many deals recently look destined to follow the same path?

There are at least two problems endemic to the system that are guaranteed to produce a lot more unsustainable hyper growth companies with unhappy ultimate ends.

The Use of Other People’s Money Leads to Bubble Exits

As a generally financially savvy culture, we have a shockingly limited menu of options when it comes to investing in companies.  We either take debt with its associated meager interest returns and a desire to only take debt in stolid safe organizations, or we make an equity investment and expect skyrocketing growth to let us bail out with enough return to justify the risky business we’ve engaged in.  Despite much evidence that momentum investing is fundamentally unsafe, nobody wants to follow Warren Buffet’s strategy of buying and holding forever.  What a pity given he is the most successful investor of all time.

Most of the exits are engineered to be bubbles in this world.  The IPO is designed to either take as much capital off the table now and sink as Facebook did, or to sandbag the heck out of the value of the company so all the early investors feel so good that the stock can’t help but rise, as Workday did.  Both are bubbles, it’s only a question of who profits–company with more capital raised or subsequent investors and underwriters with more headroom to profit from.  Nobody wants to be in the middle and price at a fair multiple that doesn’t immediately take off in one direction or the other after the opening bell.  IPO markets are dynamically unstable systems.  They are undamped oscillators.  Some of our best fighter planes are dynamically unstable too–it gives them an edge in maneuvering against adversaries when they want to snap suddenly in one direction or another.  It also means the pilot ejects and they crash if the fly by wire system fails because humans can’t fly aircraft that are that unstable.

But moreover, what a shame that we haven’t managed to invent some way of sharing the returns so that we don’t have to create a bubble exit and we can enjoy buying and holding forever.  As a proponent of bootstrapped companies that never raise capital, I believe those companies are awesome.  Yet, I have yet to see a viable structure for how to invest and profit from them in a way that will keep their founders happy as well.  We live in an age when many new models (Kickstarter, anyone?) are being invented, so perhaps it will come to pass.

Meanwhile, the use of Other People’s Money leads to Bubble Exits.

This is due to the inefficiencies of the distribution and management of the capital.  VC funds expect to get lousy returns on most of their ventures.  Ironically, it seems the later they wait to invest in the interest of reducing risk, the lower the returns of the industry seem to go.  But this is no matter because the biggest players still catch enough Google and Facebook-sized waves to prosper and new funds keep rolling in.  Perhaps if you really aren’t that confident in predicting who the real winning companies are the best proxy is to pick the fastest growth companies who will be in a position to monetize at the end of the shortest window of risk exposure.  Hence we’ll be less and less interested in those long-term SaaS plays.

So, we are self-selecting bubbles because we think that minimizes the risk profile, because the other money middle men already set up the IPO markets and such to work as bubbles so they make their returns, and because only the bubbles return enough to win for the portfolio.

Hyper Growth Requires Eliminating Friction, But Commitment is Friction in and of itself

This one is a bit awkward to express and bit abstract, but it is the more important of the two points, so bear with me.

If growth is the only yardstick, then we should design the entire Customer Experience to promote growth.  One way to do that is to minimize the friction while maximizing the viral desire to help get the word out.  Twitter is my favorite example of this.  Among all the Social Software, it requires so little commitment; there is almost no friction.  A signup is needed to get credentials, and then just the occasional 140 character Tweet.  Who can’t come up with 140 characters to say about something, even if only what they had for lunch?  Combine that with making it easy to follow, and we’re off to the races.

There are many examples of engineering for friction-free participation.

Pinterest is great fun, I love it, and the friction is even less than for Twitter.  With Pinterest, I don’t even have to be creative enough to come up with my own Tweets, er photos.  I can borrow everyone else’s photos.  I may not have ever uploaded a single photo, yet by simply pointing and clicking I can assemble some phenomenal boards.  It is stamp collecting for the New Millenium.

Or, how about LinkedIn’s recent business of having everyone endorse each other’s skills.  What a wonderful use of the principal of creating obligation.  You get an email telling you that people are endorsing your skills.  You’re gratified, you want to see who is being so kind, suddenly you feel the obligation to endorse a few of their skills, but of course you get handed random people in your network to endorse.  Chances are you wind up endorsing more people than were in the email that came to you and got you started, so the viral factor is going strong.

We’ve learned a lot about how to do this sort of thing, but along the way with all of this single-minded focus on growth, we have minimized commitment.

Just because I have pinned a few photos of Ferraris does not mean I am a Ferrari customer.  Just because I Tweeted 140 characters does not mean those are my most profound let alone my most monetizable thoughts.  What we have is the New Millenium no-ROI marketing.  All those kazillions of dollars spent by the Madison Ave Mad Men are still being spent on the Internet trying to use vehicles like these to move the masses to buy our products.

Seth Godin does the best job of anyone I know teasing apart the value of having customers who are truly committed and not just brand following sheep.  He has endless posts about the subject.  A great recent post is, “Nobody ever bought anything on an elevator.”  I read it as a cautionary tale about gradually building a following and not trying to close the sale too soon.  You can’t close the sale with 140 characters or a picture.  But you can get millions or even a billion people to do something.  Is it something of value?  Is there real scalable ROI?  By scalable ROI, I mean we can keep writing bigger and bigger checks and make more and more profit?

The conundrum is that valuable commitment is a form of friction all by itself.  People are skeptical.  They need convincing before their hearts and minds will fall into line.  They need even more convincing before they go out on a limb and tell their friends.  Look at all that Apple has investment over so many years to build their level of customer commitment.  Sure they see hyper growth in new products now, but it took years to build the foundation of committed customers that enable that kind of growth.  It just might be that when you see a company that is too new to have achieved that level of commitment, that you should decide there isn’t much commitment there.  And if there isn’t much commitment, there can’t be much value being created.

The reason hyper growth is so unsustainable yet so lucrative is it lives in the unique intersection of these two issues.  It revolves around getting more and more people to do something, however trivial, with the promise that later they’ll do something that is not trivial, while being secure in the knowledge that you can exit before that is ever put to the test.

Posted in business, strategy, venture | 8 Comments »

How to Position a VC Startup for Acquisition: You Can’t

Posted by Bob Warfield on October 23, 2012

Whaddya mean you want to sell?

How do you position and maneuver your VC-funded startup for acquisition?

The short answer is, “You can’t.”  

The VC’s didn’t sign up for an acquisition.  They are seeking a billion dollar revenue opportunity because that’s what it takes to move the needle on their portfolio.  If they are willing to talk about an acquisition at all, it is either a totally insane IPO-level valuation, or they have serious deal fatigue and you’d better watch out lest you find yourself walking the “sell-it-before-the-next-round-or-we-shut-the-doors-or-replace-you” plank.  Those sharks below the end of that plank look mighty hungry and the water there is cold.

I’m not going to spend a lot more time trying to convince you of that truth.  I’ve written about it before, and I have lived it more than once.  You may think you’re doing your investors a big favor offering them an early 10x return, but you’re not, so don’t kid yourself.  VC’s are VC’s, they don’t mean anything by it, but they have a job to do and they try hard to be good at it.  Don’t get cross-ways with those gears.

In particular, don’t think you can decide how much money to raise in a way that keeps your options open.  Your options will be determined based on how the VC’s feel about your company’s prospects.  If they’re bullish, they won’t let you sell absent a major hostage terrorist negotiation (been there, done that, do not want any more of those T-shirts).  If they are not bullish, you have much worse problems than deciding to raise a little less money to preserve your options.  Your first problem is you won’t have the luxury of raising less if they aren’t bullish.  At best, they will agree to participate pro-rata if you can find some new sucker to set the price and pony up.  At worst, they don’t go pro-rata and it becomes nearly impossible to raise any money.  I had the joy of trying to operate under those conditions in the wake of the 2008 crash, Sequoia memos, and the rest of the gloom and doom.  One of my VC’s would go pro rata, the other wouldn’t, having already invested in larger competitors.  I walked the plank.

So forget that idea.  It’s a non-starter.  The only way to win is to figure out how to fly faster to the goal, not slower.  And hasn’t that always been true for your startup?

The other reason it is a non-starter is that companies are bought and not sold. Unless you’ve already been in talks that convince you that you have the opportunity to be bought, forget about it until you do have those talks. If you’re thinking you need to preserve the option for talks later, reread the first part of this article where the VC’s are going to decide anyway and then do as follows:

Raise enough to be able to accomplish something in the next 12-18 months that significantly reduces risk and raises the valuation. That aggressive risk-reducing goal you intend to accomplish is central to a good pitch anyway. This is a proposition your Board will understand and can buy into, it is a prudent use of capital, it is a good test of whether everyone is wasting their time (you are if you can’t figure out how to significantly reduce the risk with a defined mission), and it still sets the stage for acquisition talks as the acquirer is acquiring to reduce their own risk, which is almost always the case. If you reduce your risk, it either reduces theirs too or it positions you as closer to the top of the list they could acquire to solve their problem.

Raising less than enough to significantly reduce risk is a sure recipe to show up the next time you need money without having made enough progress. That’s not going to go well at all. See the various excellent posts out there on dilution. Some of those meetings where you need to raise more without having accomplished enough are inevitable, but why set a plan in motion that guarantees it?

Posted in business, strategy, venture | Leave a Comment »

Mobile First for SaaS? Desktop PC’s Dead? Nope.

Posted by Bob Warfield on October 15, 2012

laser keyboardJust reading another great Jason Lemkin post called, “Mobile First? The Desktop Still Has Three Good Years Left in It in SaaS“.  In it, Jason declares that he believes the Consumer Web mantra of “Mobile First”, but that SaaS still has three good years on the desktop.  He gives some very strong reasons why SaaS on the desktop isn’t dead yet:

-  SaaS is three years behind the Consumer Web.

-  SaaS is Enteprise, and therefore involves complexity Consumer Web doesn’t have to deal with.

-  Most SaaS users are still doing data entry.

The last one is the most important to me, and the one I believe will take a lot longer than 3 years to sort out.  We can tame complexity with better User Experience and smarter software.  A lot of Enterprise Complexity is self-inflicted gunshot wounds that could be avoided.  Workday is one company that took a look at first gen and decided they could do a lot better.  There’s still room after Workday for at least another generation that’s better than that at simplifying things.  That, all by itself, will take longer than 3 years.

But that pesky data entry issue is much harder to solve.  We’re seeing some nibbling around the edges at point-of-sale.  Seems like companies in that space, Square and the rest, are taking a good shot at making the data entry associated with making a retail sale very mobile friendly.  We also see it in the field.  Companies like UPS have had mobile devices for years that were essentially doing inventory tracking.  There are RFIDs, scan codes, and the like to automate tracking processes further.  That category has morphed into the Internet of Things in the current iteration of the Hype Cycle and brings active sensing to the game as well as passive identification and tracking.

Despite all that, anyone that spends even a little time in an Office is struck by a certain hardcore reality:  there are a lot of people working on computers at their desks.  Heck, forget visiting an Office, go to the local coffee hangout.  The people you see in these places  are typing as much as they’re using the mouse.  Take a closer look.  Are they relaxed, or are they squinting a little bit every so often and adjusting their glasses?  That’s telling you that even though they have a nice big keyboard and are able to use 10 fingers instead of 2 thumbs (sometimes my 10 are all thumbs, but I still type faster that way) and even though they have a decent sized screen instead of one the size of a deck of cards or less than an 81/2 by 11 sheet of paper, they are still doing work.  They do not have the luxury, for the most part, of being paid to simply lean back and consume information.  Even if their job does primarily involve consuming information, they will still have to add value to that information and communicate that value in some way.

Sales never were all that big on PC’s, but stroll through a marketing department.  Visit a design group working on new web designs.  Check out the SEO people, pouring over their spreadsheets.  See all those folks writing copy.  Can any of them get by very well on Mobile?  Do they even have a compelling need for Mobile, or is it a nice-to-have?  How about Finance and HR?  Can those guys even get a decent spreadsheet application on a mobile device?  Have you been in many interviews or performance reviews where a Mobile Device was doing the note taking?  I bring my iPad to interviews in Silicon Valley and I have yet to run into a counterpart that brought one.  That’s here in the Valley which is years beyond what happens most places on the Hype Cycle.  Software Development or any other kind of Engineering?  Fuhgeddaboutit.  We do start to see a greater preponderance of pads in weighty executive meetings at larger companies.  But let’s face it, these guys aren’t the future.  They’re the ones who not so many years ago declared the PC a non-starter because all the Cool Execs had people to type for them.

As for smaller, more nimble, more forward looking organizations, go visit a startup incubator some time.  I don’t mean a fund raising and entrepreneur-mentoring incubator.  I mean a real live physical space where startups are born.  It would be so much cheaper for a startup to buy each person a nice iPad, eschew the Office since we’re mobile after all, and cut everyone loose to go get things done.  Except, it wouldn’t be cheaper because they wouldn’t get anything done.  There is value in being connected while we’re mobile for the same reason that there is also great value in physical proximity–it enhances communication.  There is value in having essentially a general-purpose computer with us at all times, even in our pockets, for the same reason that there is value in having a particularly powerful machine at our disposal when we have to be as productive as possible–computers enhance our productivity.

Our industry loves to declare things “dead” as soon as the growth rate of another thing is higher than the first. 9 times out of 10, the old thing never really did die or even get particularly sick. It just hit a point of saturation and we were so busy chasing the hype cycle we forgot to check for the nuances.  Good old install-it-on-the-Home-Office-Server is still alive despite the best efforts of SaaS.  It’s not even clear it’s health is really all that ailing, though we could fairly say it is in it’s late 40′s and no longer in that vigorous under-30 year old age whose lucky denizens feel all but indestructable.  You couldn’t start a new on-premises Enterprise company in all likelihood, but the old ones plug right along.

Are we selling more mobile devices than Desktop PC’s?  Heck yeah!  Because they’re cheaper and because the PC industry quit giving us a reason to upgrade.  When the multicore crisis hit and computers quit getting radically faster every 18 months, what reason was left to upgrade?  Fashion.  Hello Apple, goodbye Dell.  If I’m going to have the same computer for four years, it had better be darned cool.  And meanwhile, I can satisfy my gadget fetish with Mobile goodies.  But, just as some VC’s have started to declare that mobile is HOT, HOT, HOTbecause for the first time there are so darned many devices out there ready to buy NOW, there sure are a lot of Desktop PC’s that are connected and waiting for the right must-have applications to be available.

If you want to see SaaS become a Mobile First industry, figure out a way to make Mobile SaaS more productive, not less productive than Desktop SaaS.  Because I’m not sure Fashion is going to work as well for SaaS as it did for Apple.  At least not without having Steve Jobs here to figure out how.

Posted in mobile, saas | 1 Comment »

SaaS Companies that Don’t Grow Pretty Quickly Have Something Bad Going On

Posted by Bob Warfield on October 11, 2012

Just read Jason Lemkin’s post on SaaS company growth.  He talks about two examples:

-  Workday, a $250M SaaS company growing at 90% a year

-  An unnamed smaller $40M SaaS company growing at 33% a year because, “growth is slowing, but we’re still doing great, because it’s all recurring revenue, and growing recurring revenue takes time.”

That bit about growing recurring revenue taking time, as if it is harder to grow recurring than big one-time license sales, is bunk.

Let’s do the math on two examples.  In the first, let’s assume a big one-time license sale company.  For the sake of simplicity, let’s say their average sale is (best Dr Evil impression):  ONE MILLION DOLLARS!

Further, let’s assume their marketing produces enough leads that they close 10 of these deals a year, and therefore have $10M a year in revenue.  Now they have to go on closing 10 deals a year, every year, just to stay flat.  No growth at all is implied in that scenario and that would be a very unhappy software company indeed.

Okay, now let’s consider the SaaS company, and let’s assume they’re in the same market.  So, they charge some fraction of the license company’s one million dollars.  Industry averages are anywhere from 2 1/2 to 4 years until the two breakeven.  Heck, let’s be bullish on things and make it 2 1/2 years.  Therefore they charge an annual subscription fee of $400K.

Now that’s less money, so presumably it’s an easier sale.  It certainly ought not be a harder sale.  And there should be all the normal advantages associated with SaaS.  Namely, it requires way less professional services to install it, the buyer doesn’t have a TCO that includes buying servers and paying more IT people to run them, yada, yada.

Let’s also stipulate our little SaaS company is running pretty near $10M a year in recurring revenue by selling 25 licenses a year.  Now here is where it gets interesting.  If we assume no churn, in other words, 100% renewals, we get the following over 5 years:

100%
Year New Licenses Sold Renewals Installed Base Revenue YOY Growth
1 25 0 25 10000000
2 25 25 50 20000000 100%
3 25 50 75 30000000 50%
4 25 75 100 40000000 33%
5 25 100 125 50000000 25%

Note that from the standpoint of conventional marketing and sales metrics, this company is flat.  If they didn’t have their renewals, they’d be in the same sad shape as our license company.  Instead, they are showing 100% growth after a year, and that declines slowly to 25% by the 5th year.

Folks, that is an amazing tail wind when you think about it.  If you’re going in front of a Board and shareholders to explain your numbers, wouldn’t you want to have a bunch of revenue from renewals automatically baked in every quarter?  I know I would.

So when I say, “SaaS companies that don’t grow pretty quickly have something bad going on,” we can now look at the definition of “bad”.

The first possibility, is that they haven’t seen any real growth in their lead funnel in a long time.  4 years to get to the 33% growth number Jason’s friend was quoting.  If you can’t figure out how to start growing again in 4 years, you’ll be just realizing the time to sell out was about 3 years back.  Bummer.

The next possibility is the lead funnel actual went away.  Here’s the same example where there are half as many new sales each year:

50% 100%
Year New Licenses Sold Renewals Installed Base Revenue YOY Growth
1 25 0 25 10000000
2 12.5 25 37.5 15000000 50%
3 6.25 37.5 43.75 17500000 17%
4 3.125 43.75 46.875 18750000 7%
5 1.5625 46.875 48.4375 19375000 3%

Interestingly, you still have time to react.  It isn’t until about year 3 that things turn really grim.  That’s a long time in the software business.  Did I mention I would rather face my Board and Shareholders as captain of a SaaS company than a perpetual license company?

Last possibility–there is something really wrong with your software, your customer experience, the competitive nature of your market, or even some paradigm shift that eliminates the need for your product that is causing renewal rates to tank.  If we cut that 100% pie-in-the-sky renewal rate to 50%, it turns out we get the same numbers we had when new leads got cut to 50%.  Again, you do have some time to react, but it is not a pretty thing.

Just for grins, let’s see what happens if you can grow your marketing lead funnel the way Old School Enterprise had to in order to get big.  Let’s say you double it every year:

200% 100%
Year New Licenses Sold Renewals Installed Base Revenue YOY Growth
1 25 0 25           10,000,000
2 50 25 75           30,000,000 200%
3 100 75 175           70,000,000 133%
4 200 175 375         150,000,000 114%
5 400 375 775         310,000,000 107%

Gee whiz, doesn’t that paint a nice picture?  And what did Jason start from?  Workday at $250M growing 90%?  Tracks the model pretty well.  I guess those Old School Enterprise guys running Workday know a thing or two about SaaS too, eh?

So keep an eye on your SaaS investments.  They have time to fix it if the growth rate slows–they’ll see it coming from the sales funnel.  And if they don’t manage to get it fixed before it manifests in the revenue, something very bad is probably happening there.

 

 

 

Posted in business, saas | Leave a Comment »

 
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