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06/03/2004

A Microcosm of VC Madness: $250M for Wireless E-Mail

Last week, Good Technology announced that they had raised another $45.8M bringing their total paid-in-capital to a whopping $146M. This announcement came just about a month after one of Good’s main competitors, Visto, announced that they had also closed a new round taking their total funding to a staggering $160M. If you add in competitor Seven Networks’ $55M in funding that means that over a quarter of billion dollars has been invested in just 3 software firms, each pursuing largely the same market.

In the grand scheme of things $250M is not a lot of money, but when it comes to software start-ups $250M invested in one market sub-sector is a lot of coin. The general rule of thumb used to be that it should take about $10-$15M to aggressively “force feed” an enterprise software start-up, i.e. start it and grow it to break even faster than internal cash flow would allow. That rule got tossed out the window in the late 1990’s when a number of software start-ups raised huge amounts of money, but even then you’d be hard pressed to name many software companies that raised more than $100M before going public.

Now if Good et. al. were working on some kind of massive world-changing software platform I suppose I could see investing $250M in the sector, but as far as I can tell Good and the others appear to simply be building middleware that enables corporate employees to access their e-mail (and other applications) via hand-held devices. A worthy pursuit no doubt, but not an earth shattering opportunity for software value creation on par with PC operating systems, App Servers or RDBMSs.

As a case study, this massive over-investment in wireless e-mail provides some telling lessons on what’s really going on Venture Capital these days including:

1. Money is flooding to supposedly “hot” sectors. Popular perception is that VC’s have become more disciplined in the wake of the excesses of the late 90’s and as a result it is generally harder to get VC money and that even when companies get funding, VCs are insisting on reasonable valuations and capital efficient business plans. I would say that on average this perception is true, however in certain technology areas VCs appear to be throwing many of these hard learned rules out the window. With so much dry power out there and so many VC firms, if a sector is anointed as “hot” by the media, by a “star” VC or what have you, then all of a sudden it seems as though every VC and their grandmother are throwing money at the sector faster than you can say “Term Sheet” (See my post on Social Networking as a good example of this.). This behavior tends to not only drive up valuations, but it also results in more competitors and more money raised per competitor as each firm tries to “force feed” itself to faster growth than their fellow start-ups. The end result is too many VCs investing too much money in too many companies. In the case of wireless e-mail, over 50 venture firms have provided the cool $250M+ thrown at just the top 3 competitors. I’ll wager that a good portion of that money has been wasted force feeding the different start-ups in an effort to grow them faster than their competitors.
2. “Hot” companies can still entrance their VCs into supporting crazy burn rates. These days most VCs seem to feel that burning over a $1M/month is a sign of extreme fiscal recklessness. How then is it possible that Good Technology appears to have burned an average of around $2M/month since its founding in early 2000? My guess is that it is because Good is perceived of as a “hot” company and “hot” companies often don’t have to play by the rules of good start-up management. The theory is that the “hot” company can afford to have a high burn rate because there are lots of folks willing to put more money in (at high valuations) and the ultimate pay-off will more than justify the added investment. Unfortunately for this theory as more competitors and more money are being thrown at the same markets, the probability of one firm enjoying an outsized pay-off relative to the others is declining rapidly. The sheer number of these firms combined with the huge amount of paid-in-capital and high burn rates makes them all particularly vulnerable to getting “shopped” by potential acquirers. If there is just one start-up in a sector and 3 potential buyers, then the start-up has a bit of leverage. If there are 10 start-ups and 3 potential buyers, the buyers have all the leverage and they know that the VCs will be desperate just to recover their invested capital, let alone make a profit.
3. VC returns are in an inevitable decline. Too many VCs investing too much money in too many companies results in one sure thing: lower overall venture capital returns. That VC returns should be lower going forward should not surprise any student of financial markets because, as they would know, almost all returns in alternative asset classes have declined as these markets have matured. In the case of the venture market, in addition to overall returns declining over time, I suspect that the distribution of those returns will become more binary over time. When there were relatively few firms and relatively little competition for deals, VC funds could easily build a well diversified portfolio and have their “pick of the litter” in terms of start-up ideas. With so much competition and a much more mature financing market, it will be difficult for an individual fund to build a similar portfolio. This situation should theoretically lead to much more of a “hit” or “miss” environment for individual funds.

$250M invested in wireless e-mail speaks volumes about some of the challenges facing the venture capital industry today. It says that while many VC’s are talking the fiscally responsible talk, in “hot” sectors it appears as though not everyone is walking the talk. It also says that industry returns are inevitably headed downward thanks to increased competition and greater funding levels.

The key to investing such a climate is likely to be figuring out ways to avoid investing at the tail end of “hot” sectors and to prevent companies that suddenly become “hot” from blowing a ton of money in an effort to “keep up with the Joneses”. There is one piece of good news though: for $250M I am pretty sure we will all be able to follow future industry developments by reading about them on our wireless e-mail devices.

June 3, 2004 in Venture Capital, Wireless | Permalink

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The thoughts and opinions on this blog are mine and mine alone and not affiliated in any way with Inductive Capital LP, San Andreas Capital LLC, or any other company I am involved with. Nothing written in this blog should be considered investment, tax, legal,financial or any other kind of advice. These writings, misinformed as they may be, are just my personal opinions.