Burnham's Beat

Venture Capital and Age/Experience Discrimination

At the risk of being provocative, let me state a general and rather counter intuitive rule of Venture Capital: The more experienced and older and entrepreneur is, the harder it is to raise money for anything that isn’t directly related to their previous work history.

It’s true.  Just ask VCs to describe an entrepreneur and they will invariably start out by saying something like they are “an enterprise guy” or a “consumer guy”  or “networking nerd” or whatever.  Many entrepreneurs find out that once they are typecast in this way it’s almost impossible to raise money for anything other something in the same industry space as their last deal.  Sure a few entrepreneurs manage to break the mold, but it’s not easy to do and those that do generally have the scars on their backs to prove it.

This wouldn’t be so bad except for the fact that that the inverse also seems to apply as well.  That is, the younger and more inexperienced you are, the more willing VCs are to give you the benefit of the doubt.  25 years old, never worked in a big corporation but what to start a company focused on “enterprise sales collaboration”, why knock yourself out; here’s $5M and no questions.  45 years old with a successful internet advertising startup under your belt and trying to start the same business?  Be prepared for a lot of intense questions about how you are going to address your “lack of domain knowledge” and suggestions that you hire an “enterprise marketing star” before looking for funding.

The type-casting is not just industry based, it’s also role based.  If you have a technical background, be prepared for VCs to consider it impossible for you to ever have any general management skills or marketing/sales skills and insist on your hiring some useless marketing/bd person. 

I have witnessed this first hand numerous times where VCs give experienced guys the nth degree about their supposed industry blinds spots and skill deficits, while they give young guys on their first startup a relative free pass.  Heck,  I myself made this mistake with several technical founders who turned out to be far better managers than the professional ones I helped hoist onto them

Now, the obvious retort here is that it is in fact really tough to teach an old dog new tricks, but arguably many of the key skills of making a start-up successful (good management, entrepreneurial drive and instincts, etc.) aren’t domain or role specific.

The lesson of this rant, I suppose, is that if you are trying to raise money and actually have a lot of experience you are much better off trying to raise money for an idea that directly leverages your most recent industry experience and is consistent with how you are most likely to be type-cast by VCs because trying to something outside of that box is guaranteed to make the fundraising process even more painful.

The Consumerization of Enterprise VC

(My day job is investing in the public markets, but I have a small personal portfolio of private investments, mostly angel investments in Internet and software related startups. In the past six months I have spent some time helping a few of these companies raise venture capital and this is the second of three posts I am writing on some of the key trends I have observed during this process.)

In my last post I wrote about how VCs were essentially abandoning the early stage Internet market and instead waiting to see which firms gain traction before placing any bets.  As I said before, I don’t have a problem with this trend in theory because it makes rational sense given how the consumer Internet market is evolving. 

However, a more personally disturbing trend that is emerging in the VC marketplace is one in which VCs are taking the behaviors they have learned in the consumer Internet space and trying to apply them to the enterprise IT space, especially to any SaaS based software/service (which is basically a huge chuck of enterprise IT start-ups these days).  Indeed it is not uncommon for enterprise SaaS startups to get the same line from VCs that consumer Internet companies are getting, namely “come back and see me after you have a site up and a bunch of customers”. 

A Whole Different Ball game
At first blush, such demands don’t seem that unreasonable, after all, many of the same trends impacting the consumer Internet space, such as the decline of up front capital costs, are impacting the enterprise IT space.   However, the enterprise IT space remains a very different animal from the consumer Internet space.  Three key differences between the two are:

1. Enterprise customers don’t do betas. Consumer Internet companies can recruit beta customers easily because they are literally giving something away that while useful, is still relatively trivial in the grand scheme of most people’s lives.  In contrast, what enterprise manager is going to risk their career entrusting sensitive data or business processes to a site that officially declares itself as not ready for prime time?  Sure they might help test the site with dummy data and provide feedback on it, but in general “beta” is not a good word when it comes to recruiting enterprise customers.  This means that for any enterprise site to get real traction it has to formally launch the site and be willing to represent it as reliable, scalable, and secure from Day 1.
2. Enterprise SaaS infrastructures are inherently more expensive than consumer infrastructures.  While building a reliable, scalable and secure enterprise web service is a lot cheaper than it was 5 years ago, it’s still relatively expensive.  Enterprise customers tend to ask pesky questions about things like data security, disaster recovery, peak capacity, application integration, financial viability and even (gasp!) customer support. At most consumer Internet sites these questions are never asked, but enterprise sites have to put these kinds of things in place before many companies will even consider trying them.  Yes, you can build an enterprise site for $250K, but no enterprises will actually use it until you support that site with a lot of expensive infrastructure and services which makes enterprise sites inherently more expensive to build and operate.
3. Enterprise services must still be sold.  Most consumer sites have a very simple business model:  give away your service for free and hope enough people like it that you can start to make some money from advertising, referrals, and perhaps subscription frees.  In contrast, most enterprise sites have no realistic hope of ever getting significant advertising or referral revenues and thus they must charge each and every customer.  Sure, they can come up with innovative ways to lower up-front adoption costs, such as “freemium”, “try before you buy” or what have you, but at the end of the day they still have to convince companies to pay them money and that takes sales and marketing in the form of lead generation, inside sales, and pre/post sales support, at a minimum.  Yes,  that’s less expensive than the old model of hiring $250k/year direct sales reps to go elephant hunting, but it still costs money.

Net, net, despite the fact that enterprise IT sites look somewhat similar to consumer Internet sites, the fact remains that enterprise IT sites are still significantly more expensive to build and operate.

Shrewd or Lazy?
Given all this, the position that VCs are increasingly taking in the space, that of  “come back when you a have a product and customers” is highly frustrating for enterprise entrepreneurs.   Should an enterprise site be fortunate enough to build out its entire infrastructure and then recruit a bunch of customers to its platform, the question really becomes: What in the world do I need a damn VC for when the hard part of the startup is over?!?   Granted, expansion capital will still have a role, but by asking enterprise entrepreneurs to go build and operate fully functioning businesses before they will even consider making an investment, VC’s are establishing an awfully high Ask, one that has some of the same implications as it does in the consumer space, namely it makes angel investors the king makers and creates a selection bias in the expansion stages towards “small ball” investments. 

Personally, my problem with VCs doing this is that I don’t think it has the same rational basis as it does in the consumer space.   VCs all know that you can’t just wing it with an enterprise business.  They know that enterprise customers care about financial viability, customer service, and infrastructure and that all those things take money.   The only thing I can come up with is that the consumer space is training VCs to be lazy investors.   Why go out and do a lot of work to understand a company’s target market, gauge potential customer interest and assess the competitive landscape, when you can just declare success a crap shoot, go golfing and tell someone “call me when you have traction”.  I understand the attraction of such a stance, but whereas it has some basis in consumer Internet because it’s arguably anyone’s guess what big trend is going to hit the tween set next, within enterprise IT, there is usually a very objective set of demonstrated market needs and you know that companies will pay for products that cost effectively meet those needs.  I guess what I am saying is that applying the same set of investment criteria to enterprise IT startups as you apply to consumer Internet startups strikes me as intellectually lazy and the anti-thesis of true venture capital. 

All that said, I don’t believe that this is the predominate mentality within enterprise IT investing just yet.  It’s just that over the course of the past year or so I have seen the trend gain more and more prominence.  For the sake of innovation and a healthy enterprise IT market, here’s one trend I hope gets nipped in the bud.

The Great Abdication: Consumer Internet, Venture Capital, and Angels

(My day job is investing in the public markets, but I have a small personal portfolio of private investments, mostly angel investments in internet and software related startups. In the past six months I have spent some time helping a few of these companies raise venture capital and thought I would share some of the insights I have learned through that process over the course a of a few posts.)

Anyone who has recently spent anytime fundraising for a consumer internet start-up in Silicon Valley quickly comes to an inescapable conclusion: there is effectively no Venture Capital available to Consumer Internet startups.

“How could that be?” you say. After all didn’t Twitter just raise 100 large @ $1BN post? Didn’t Facebook raise $200M @ $10BN pre? Yes indeed they did, but rather than confirming the health of Consumer Internet Venture Capital, these deals merely provide prime examples of how screwed up the space is.

Too Many Deals Needing Too Little Money
To be sure, there is plenty of investment capital available for Consumer Internet companies that have demonstrated significant market traction in terms of traffic or revenues, but there’s almost none available for what, up until recently, would be considered the sweet spot of true VCs: Seed or Series A startups. Alas, the days of a bright entrepreneur thinking up a great idea, putting together a business plan, and then having a Sand Hill VC take a leap of faith to fund the business are effectively over, probably for good.

Why is this happening? Well there are really three main trends driving VCs out the venture capital business in the consumer Internet space:

1. Start-ups costs for consumer internet companies have plummeted. A few years ago my former partner Ryan McEntyre wrote what I consider to be a classic post on the decline of technology of technology costs for startups. Since that time, technology costs have continued to plummet to the point where a start-up can now host their entire consumer internet service in the cloud for a few hundred dollars a month with effectively zero upfront capital costs. The combination of low start-up costs with RAD-like web development environments such as Ruby-on-Rails, has in turn led to an explosion of web sites and services in almost every conceivable niche.
2. VC Fund sizes have increased. The average VC fund size grew almost 250% between 1990 and 2002 and has grown more since. The reason is simple: the more funds under management, the more fees, the more “risk free” money for partners to split up. Unfortunately bigger fund sizes present VCs with a conundrum: if they increase the size of their fund to make more “risk free” money, they necessarily have to increase the average investment size because if they don’t increase the average size of their investments they have to add more partners to do more deals and adding partners effectively cancels out the financials benefit of increasing the fund size. Needless to say, most VCs have resolved this dilemma by increasing the size of their investments.
3. VCs increasingly perceive the market success of Consumer Startups to be almost a Random Walk. A few years ago, if you told VCs that Twitter would do a financing at $1BN pre, almost all of them would have laughed heartily at the thought. Same thing if you had told them that Friendster, a Kleiner & Benchmark deal with an A-list management team would be schooled by an east coast (East Coast!) knock-off run by a 23 year old. Yet here we are. Despite all the bravado about investment themes, deal flow, and thesis driven investing, in moments of candor many VCs will tell you they have been surprised as much as anyone else by which deals have worked and which deals have not.

The Great Abdication
So thanks to these three trends what we currently have in the consumer Internet space is the following situation: We have a ton of start-ups that need a increasingly small amount of capital to actually get off the ground. We have a ton of VC funds that need to invest in deals that take up more capital, not less. And we have a bunch of individual VCs who have determined picking early stage consumer internet winners is at best a crap shoot.

Confronted with a profusion of random walk startups that don’t actually need a sufficiently large amount of investment, VCs have made a very rational decision: they’ve simply abandoned the early stage Consumer Internet business and resigned themselves to only providing what is traditionally known as expansion or even late stage capital. An added bonus of refocusing on expansion or late stage deals is that these investment rounds tend to be a lot larger which means more money can be put to work. Sure that money goes in at much higher valuations and thus returns should theoretically be lower, but for many VCs, thanks to size of the their funds, returns are not as important to them as they used to be.

Implications of the Great Abdication
There is nothing inherently wrong with what the VCs are doing. They are arguably acting very rationally given the market trends they are faced with and more than a few will probably generate good returns with this strategy. However, their behavior does have several long term implications for the Consumer Internet space including:

1. Angel investors are becoming the dominate force in Consumer Internet Venture capital. The vacuum created by the withdrawal of VCs from traditional Seed and Series A opportunities in the Consumer Internet space has been filled by a motley collection of angel investors. It is angel investors, not VCs, that are writing checks based on good ideas, business plans, and “alpha sites”; not VCs. The importance of angel investors is such that it is not unusual these days to see an internet startup publicly announce its round of angel funding, when in the past such events did merit a public mention. Yes, angel investors have always provided seed money, but they today they typically provide 100% of what was once considered Series A money as well.
2. VCs are boxing themselves into a pretty tight investment window. VCs retreating to the expansion stage makes a lot of sense in theory, the only problem is that if all of them retreat at the same time, it can make for some screwy market dynamics. I can count on two hands the number of VCs in the last 3 months who have told me something along the lines of “this market is crazy, anything with traction is getting multiple bids at huge valuations without even putting together a powerpoint presentation, while everything else is just roadkill.” The reason this is happening is that you have a ton of VCs sitting on a ton of capital (which they have to deploy) and they all are holding out hope that they will be the one person to realize that a company has started taking off before anyone else does. The reality is that the traction is obvious to everyone (quantcast anyone?) and they all swoop in at the same time. What’s more, because of the dynamics in the consumer internet market, most “hot” companies entering the expansion stage will end up spending very little time there. It seems as though if you blink, a company can go from interesting alpha site to 50 million uniques and at 50 million uniques the companies are demanding what would traditionally be considered late stage valuations. Thus there is a very short window of opportunity to fund “hot” internet startups and way to many VCs with way too much money chasing just a few “hot” deals within this window.
3. Only “small ball” ideas are getting funded. Because VCs generally won’t back Seed or Series A startups, these startups must rely on angels for financing. Now putting together $100K or even $250K in angel financing is doable for most entrepreneurs, but much more than that can be difficult to accomplish. This is leading to kind of natural selection in that only internet companies that require $250K or less to get off the ground are even being started. If you have a really big idea that requires $5M before it can launch, you might as well not bother because your chances of getting funded are close to zero. Now big ideas aren’t necessarily better, just look at WebVan, but the current state of consumer Internet VC is so biased against big ideas that one has to wonder: are there big ideas that are being left on the table simply because VC’s aren’t willing to stomach the upfront risk?

Truth be told, I am admittedly painting this story with a pretty broad brush. There are still some VCs doing Seed/Series a deals, some of whom I know well, but even they would admit that on the whole on the average, the trends and implications that I describe above have some validity. Still I can’t help thinking that while The Great Abdication may make logical and financial sense for VCs, it is creating an incentive structure and reward system that not only marginalizes traditional venture capital firms in the long term but one that theoretically leaves a lot of potential growth and innovation “on the table” not just from startups that require more than $250K to get started but from the thousands of low cost Internet startups that haven’t yet caught lightening in a bottle and just need a little financial push to get to the next level.

2008 Software IPOs: Year in Review

While the Software sector did not fare as poorly as the Internet sector when it comes to IPOs in 2008, it did not do much better.  In fact it did just 1 better; as in 1 IPO for all of 2008. This is obviously the smallest # of Software IPOs since we began compiling a list of them 5 years ago.

Who was the lucky winner?  It was a security software company called ArcSight (ARST).  ArcSight managed to get public on Valentines Day, 2/14/2008, at a price of $9.00/share.  Things were looking grim for ARST in mid November with the stock trading close to $4/share, but they fortuitously reported a "beat and raise" quarter in early December and the stock rallied furiously.  So much so that Arcsight closed the year at $8.01, off only 11% from its IPO price.

Other than Arcsight, the Software IPO space was a quiet as a country mouse and based on the paucity of recent S1 registrations it will be awhile before there are any more Software IPOs to speak of.

2008 Internet IPOs: Year in Review

This is going to be an easy review.  That's because 2008 will likely go down as the first year in the modern "web" era of the Internet that there wasn't a single Internet related IPO in the major US stock markets.  That's right, not a single one, zippo, nada.  There were a few spin-offs and a couple cross listings but as for brand new spanking public Internet companies there wasn't a single one.  It's enough to make a make a grown VC cry.

As it stands, the last IPO of an Internet focused company was arguably NetSuite, which went public on 12/20/08 at a price of $26/share and closed today at $8.44.  And that 68% price decline, ladies and gentlemen, is all you need to know on why there hasn't been an Internet IPO since then.

That makes it 377 days without an Internet IPO.  I modestly suggest that Sand Hill VCs should tie a ribbon made of $100 bills around a Redwood tree outside their offices until such time that the market stops holding their late stage deals hostage.

Granted there were only 30 IPOs in the entire market in 2008, but you'd think that what is supposedly one of the fastest growing, highest technology sectors in our economy would be able to contribute at least one good IPO.  Oh well, maybe next year.

Who Will Be The Biggest Loser: 1999 VC Funds or 2006 PE Funds?

1999 vintage Venture Capital funds are infamous for being some of the worst performing private investment funds of recent memory with the average 1999 Venture Capital fund returning only about $0.95 on the dollar through 6/30/08.  The poor returns of these 1999 funds are a result of two main factors:

1. These funds were raised at or near the height of the tech bubble.
2. These funds were often fully invested within 12 months of closing.

The result was a ton of money invested very quickly at very high valuations.

During the 3 year market correction that followed the tech bubble, venture capital lost favor with many institutional investors.  Many of these same investors instead plowed their investment dollars into private equity funds.  These funds enjoyed huge returns early in the decade as an extremely loose credit market combined with very low risk premiums and declining loan underwriting standards gave rise to such as wonders as dividend recaps, PIK toggles, and covenant light loans.  By late 2006, private equity firms were raising absolutely gigantic funds with terms and fees that would make many VCs blush.  Part of the private equity pitch at the time was that because they were buying well established firms with ample cash flows and "fundamental value", private equity would never see the same kind of market collapse that cratered 1999 and 2000 vintage VC funds.  LPs generally lapped up the pitch and as a result during 2006 and early 2007 there was a ton of money raised and invested very quickly at relatively high valuations.  Sound familar?

Fast forward to today's market and the "fundamental value" of many private equity funds appears highly suspect thanks to two main developments:

1. The credit markets have completely imploded effectively making it impossible for private equity firms to refinance existing debt.
2. The recession is impacting earnings and cash flow which in turn is increasing the likelihood of loan defaults.

Against this backdrop, the massive leverage that enabled private equity firms to put up such huge numbers in the 2002-2005 time frame now looks like it has the potential to absolutely decimate 2006-2007 returns.

But don't take my word for it, just look at the market.  Unlike VC investments for which no reliable daily market values exist, most private equity deals issue publicly traded debt and that debt provides an immediate window into the health of the deals themselves.  Just how healthy are those deals?  Not very healthy at all.

Even after today's big rally, the kind of senior bank loans often issued against private equity deals are trading at or near all time lows with some of the highest profile private equity deals trading at discounts of 25-30% from par.  What's more, many closed end mutual funds that specialize in such loans are themselves trading at 20-30% discounts to their Net Asset Values which strongly suggests that senior loans have even further to fall.  Clearly the market is anticipating some major defaults in private equity land in the near future.

Defaults are bad news for PE funds because they are generally catastrophic for the equity holders in a deal and the equity holders in these deals are, you guessed it, the 2006-7 private funds.  Thus, if the market is to be believed, a lot of private equity funds are going to see catastrophic losses on their equity investments in the next couple years.

Private equity LPs, like many homeowners these days, are about to learn a lesson in the downside of leverage.  They may end up wishing they put all their money into 1999 VC funds instead.  Imagine that!

4 Things to Do After You Get Your First Term Sheet

I’ve recently been involved in helping a couple companies with their first major round of VC financing.  It’s actually been pretty interesting for me because I have histroically been on the other side of the table.  In addition to generating several stories worthy of “The Funded” and getting a better appreciation of the trials and tribulations that entrepreneurs must go through when trying to raise money, I also gained a better appreciation for just how important it is to properly manage the “end game” of a VC financing.

What is the “end game”?  The End Game generally takes place after you have gotten a term sheet, but before you actually sign it.  How well you manage this process can make a big difference in the actual terms and pricing you ultimately get, so it pays to approach this process as thoughtfully and diligently as you do any other part of fundraising.

With that in mind I present 4 things that you should definitely do after getting your 1^st term sheet:

1. Get a second term sheet:  It may sound flip, but this is the single most important thing you should do upon getting your 1^st term sheet.  Nothing loosens up a VC’s purse strings or makes them more flexible on a particular term than the threat of competition.  Without competition (real or perceived) you have very little leverage against a VC.   Now getting one term sheet, let alone two, is tough enough, but getting two must be your goal and you must not waiver in pursuit of that goal even you after you get the 1^st one.  The biggest problem most entrepreneurs have executing on this strategy is that they have mismanaged the sequencing of their fundraising.  Many entrepreneurs make the mistake of pursuing an “in order” fundraising process whereby they take one meeting, run that process to its logical conclusion and if that doesn’t work out try to get a meeting with another VC.  VC fundraising must be pursued concurrently!  You must put as many irons in the fire in as short a time as possible so that all the firms start the process at roughly the same time. As firms progress through the process, you should do your best to try and “herd” them along by trying to slow down the ones pushing ahead and speed up the ones lagging behind.  The ultimate goal is to ensure that when you receive your first term sheet you have several other firms that are very close (within a week or so) to potentially issuing their own term sheets.  Proper sequencing ensures that you are not forced to take an inferior “bird in hand”.
2. Ignore term sheet “expiration dates”:  Most VCs put “expiration dates” in their term sheets (usually at the end).  In almost all cases these are artifices that are inserted into the term sheet in order to put pressure on the entrepreneur and to try and prevent them from “shopping the sheet”.  The reality is that as long as you are negotiating in good faith with a VC they are not going to pull a term sheet.  That’s not to say that VCs won’t pull a term sheet if they feel like you are being dishonest with them or have no real interest in taking their money, they will, but as long as you deal with them professionally and explain to them why you need more time to consider their offer, they will extend their phantom “deadline”.
3. Do some due diligence of your own:  One of the more unfair aspects of VC fundraising process is that VCs are allowed to take months probing every orifice of your company, but entrepreneurs are expected to make one of the most important decisions of their life in a week or two and often with little or no information.  There’s no good reason for this and all entrepreneurs would be well served by taking some time to do some basic due diligence on any investor who has offered them a term sheet.  I suggest, at a minimum, talking to at least two entrepreneurs that the VC has funded and then talking through with the VC A) all the deals they have done and what happened to them B) the current status of their fund and partnership.  Doing your own due diligence has 4 main benefits 1) it may help you avoid making a bad decision  2) it will create the perception of a competitive process 3)  it will make you appear more savvy and diligent to the VC  4) it can come in handy when you are trying to stall while you get your second term sheet.  Don’t go overboard and act like a VC by asking lots of annoying questions and drilling to the center of the earth on irrelevant/tangential questions; just ask for a few reasonable pieces of information and be very gracious about it.
4. Negotiate:  By the end of the fundraising process most entrepreneurs are so fatigued and shell shocked that when they finally get a term sheet they are loath to do anything that might upset the apple cart.  This situation generally leads to some pretty one sided “negotiating” sessions in which the entrepreneur meekly asks to eliminate the triple participating preferred, the VC says “NO!”, and the entrepreneur quickly retreats.   The reality is that VCs expect some negotiating and their first offer is never their best.  That means you should, within reason, feel free to push back on their initial offer.  Of course, if you have a second or even a third term sheet you can push back even harder, but even if you only have one term sheet you should still push back.  As they say, it never hurts to shake the tree.

If you follow these four pieces of advice you will put yourself in position to get the best possible outcome.  The most important thing to remember is that once you get a term sheet, the whole dynamic of the fundraising process changes and the ball is now in your court.  How you “return serve” can make a big difference in the outcome as I've seen VCs increase their initial offers anywhere from 25–50% when these principals are applied.  Your mileage may very, but its definitely worth a shot.

 

Microsoft/Yahoo: A Bad Deal For Silicon Valley: Take II

Marc Andreessen has posted a very thoughtful rebuttal to my argument (as well as Fred's and few others) that the Microsoft/Yahoo deal is a potentially a bad thing for Silicon Valley.  The funny thing is that I actually hadn't noticed the post yet in my feeds but it was brought to my attention by a number of people who were basically like "Oooo, you've been served!" and were wondering if I was going to challenge Marc to some kind of blog-off or something.

I hate to disappoint folks, but after reading Marc's post I actually agree with most of what he has to say, especially his overarching message to start-ups, which I took to be "Focus on building a great business and the exit will take of itself".  Marc also made a number of other good points around the M&A environment which if I could sum it up were basically "Hey, life will go on, other companies will try to take up the slack, it's not the end of the world."  In particular I think his point that a combined Microsoft/Yahoo may prompt some second tier firms to increase their M&A is a good one.  I also agree that over the long term, creating a big bureaucratic behemoth such as Microsoft/Yahoo is a good thing for start-ups because it means that start-ups will likely be able to dash ahead of the lumbering giant and secure fresh new areas of opportunity well before the folks at Microhoo file even their TPS reports and get out of their staff meetings.

That said, I still think that Microsoft's acquisition of Yahoo is still a net negative from an M&A perspective.  Yes, it's certainly not the end of the world, but on the whole and on the average it's never a positive thing to have an active, well endowed, acquirer removed from the mix.  Yahoo may not have been buying 50 start-ups a year, but they were still one of the most active Internet acquirers not just in terms of deals, but also in terms of bids.  Indeed the most important party in any deal is not the actual buyer but the second place bidder and Yahoo had seemed to make a career out of being the second place bidder lately.   Finally, thanks to its huge market capital, massive traffic and strong (although not relative to Google) monetization platform, Yahoo is one of the few Internet acquirers who have the luxury of being able to easily drop $50-$100M on a "feature" without really thinking about it.  I totally agree with Mark that if you are building a "feature" with the intent of getting acquired by Yahoo or whoever, you were likely doomed to failure a long time ago, but at same time, the cynic in me has seen a lot of "features" get funded in the valley over the past two years often under the assumption that if they get enough eyeballs one of the big three M&A fairies will swoop in and drop $100M just to "keep up with the Joneses".

So I agree that life will go on in the valley and there are some real positive non-M&A aspects of the deal for start-ups, but at the same time, I think net, net it's bad for the M&A environment.  That may change over time as new companies emerge to take up the slack, but over the next 24 months things could be a bit rough because not only will you have Microsoft and Yahoo thoroughly distracted,  but IAC is going to be a complete mess due its dispute with Liberty and AOL appears consumed with consummating its death spiral within Time Warner.  I am sure M&A bankers will do their best keep the deals flowing, but if you have an Internet start-up, given the turmoil within the big acquirers and the rapidly deteriorating economic environment, as Marc suggests, you should definitely just keep you head down on focus on building a real business.

Microsoft/Yahoo: A Bad Deal For Silicon Valley

There's a ton of discussion today about Microsoft's unsolicited bid for Yahoo.  Much of the discussion focuses on whether or not the deal is a good thing for Microsoft, Yahoo or Google's shareholders.  While it's possible it could be a good or bad deal for one, the other, or all three, one thing is for sure:  this a bad deal for Silicon Valley start-ups and their VCs.

How could that be?  Because by swallowing up Yahoo, Microsoft will be removing one of the biggest and most active acquirors of start-ups in Silicon Valley.  The intense competition between Microsoft, Google, and Yahoo has arguably been one of the main factors helping drive up M&A activity and prices for internet related start-ups.   It seems like every rumored acquisition over the past few years has had all three fighting in some way to win the deal.

Even though Yahoo has been wounded of late, it still had a market cap in the 10's of billions of dollars which allowed it to be a legitimate competitor for any deal under $1BN and in fact Yahoo has been a pretty active player in that market whether its del.icio.us, flickr, Rivals, etc.

If it's acquired by Microsoft, that will leave only two Internet media/search acquirors with the ability to easily do sub $1BN deals.  What's more, while Microsoft has recently show a willingness to deal really big deals such as Acquantive and now Yahoo, it has traditionally been less willing to smaller "tuck in" deals, deals that Yahoo has traditionally been much more active in.  Indeed, Microsoft has traditionally been dismissive of these deals because they just don't move the needle for them and their engineering staffs still retain a relatively high degree of NIH attitude.

Losing one of the Valley's most reliable "tuck in" acquirors and second place bidders is a net negative for the Valley.  It will make M&A less competitive in general and will reduce the # of potential exits for "me too" start ups" to 2 instead of three.  That's bad news for Internet content/search start-ups and their VC backers anyway you look at it.

Stratify: A Post-Bubble Success Story

So Iron Mountain, the world’s biggest record management company, announced today that they are going to acquire Stratify, the leader in legal eDiscovery,  for $158M in cash. Stratify just happens to be the first early stage investment I ever made and I thought I would write a bit about the deal because I think it’s an interesting story of a “bubble” company that went through some very tough post-bubble times but ultimately achieved success thanks largely to the perseverance and flexibility of a great team. This is a long post but I think VCs, entrepreneurs and investors will find many of the details interesting.  Before I get into that though I just want to congratulate all the people at Stratify, especially George, Meena , Joy, Sanjeev, Hakan, and Ramana.  You guys hung in there in the face of a lot of adversity and you deserve all your success. 

A Bubblicious Beginning…
I made the original investment in Stratify back in September of 2000, although it wasn’t called Stratify then it was called Purple Yogi and it wasn’t focused on legal eDiscovery back then either , it was focused on a “widget” that automatically categorized news and information in a way that enabled consumers to discover related information easily.   Underneath the widget was an incredible unstructured data management platform built by a team of technology “rock stars”.  While Purple Yogi had undeniably amazing technology (man was it cool!), its business model was a little less impressive in that it really didn’t have one, which kind of explained why it didn’t have any revenues at the time either.  I am embarrassed to say it now, but I invested what was clearly a crazy “bubble” era valuation in their first round of VC funding. That said, 2.5 months after we put that money in, the company raised another round of capital from a new lead investor at an up-round valuation and I was looking at a nice mark up on my first early stage deal in less than 3 months.  I had gone from crazy to genius in 3 months!

Reality Sucks
Reality soon set in though.  As the consumer advertising market collapsed in the wake of the bubble bursting it was clear that Purple Yogi wasn’t going to be making any money selling advertising alongside its widgets, so we decided to focus the business on building an enterprise version of the technology.  This had been part of the plan all along, but it now became the sole focus of the company.  In conjunction with the new focus, we brought in a very accomplished enterprise-focused CEO, made a lot of painful staff reductions, and changed the name to a more corporate sounding “Stratify”.

The newly christened Stratify focused on building a world class unstructured data management platform and thanks to its fantastic tech team it quickly had an awesome product.  For the next two years Stratify tried its hardest to make this business work and it actually had a good deal of success selling to some of the most sophisticated buyers of information management software in the world.  The only problem was that every sale was like fighting trench warfare because Stratify was selling a very “heavy” traditional enterprise software product that not only required customers to write a very large up front software license check, but also required them to make significant investments in ancillary software and support services.   What’s more, because Stratify’s software was so sophisticated and so high-end the addressable universe of potential customers that could A) understand the value it brought and B) had a big enough problem to justify buying it was actually pretty small. The reality was that they had a fantastic product in what was effectively a very small market.  Everyone put their heads together to try and figure out how to build the business faster, but in many ways the company was stuck.  And then something totally unexpected and very fortuitous happened:  I got sued.

Thanks for Suing Me!
In late 2002 I got sued because I was on the board of another company that was embroiled in a legal dispute with its founder who decided to sue the board and company.  As anyone who has had the pleasure of getting sued knows, one of the first things that people do after getting sued is that they collect all the information, typically mostly e-mails, surrounding the issue(s) in question and review them to try and see what the facts of the matter are.  Shortly thereafter you are usually required to give most of these e-mails to the person suing you in a process that lawyers call “discovery”.   As I tried to sift through the morass of e-mails related to this case, I immediately thought of Stratify and asked the CTO if it might be possible to use Stratify’s system to review the e-mails.  The CTO told me that it was in fact possible and that the crack tech team had actually been working on some skunk projects that could be adapted to this purpose.  They quickly cobbled together a makeshift solution and after some initial tests we were all uniformly amazed at how well the system performed and how much easier it was to review e-mails when Stratify’s technology had been used to filter and classify them first.  I was even more amazed when I asked some lawyer friends and they told me that large law firms can easily pay $500K to review e-mails for a single large case.  That sounded like a very promising market.

As it happens, at the same time that we were just starting to think about legal discovery as a potential market for Stratify’s technology, a large software company, who had been flirting with the company for awhile, made a surprise offer to acquire the company as they sensed that due to investor frustration with the slow growth of the enterprise business they might be able to acquire the deal on the cheap.   While I personally thought that there couldn’t be a worse time to sell, practically every other investor wanted to take the deal. They were fatigued and generally freaked out by the market, which at that point in early 2003 was just about reaching rock bottom after almost 3 years of declines.  We settled on a compromise where we took the existing cash in the business and bought out everyone that wanted to sell, which turned out to be almost everyone but us.  After closing that transaction, I set out to try and raise another small round of funding from other VCs and despite a few months of trying I didn’t get a single taker, despite the fact that the legal eDiscovery business had quickly moved from product concept to making a few large sales in less than 6 months.  Nobody was in the mood to take a risk back then.

A Perfect Match
As it turned out though, the legal discovery business not only began to pick up steam, it was quickly becoming clear that the opportunity was even larger and more attractive than we had hoped.   It was like night and day from the enterprise software business.  Instead of 9 to 12 month sales cycles we now had 2 to 4 week sales cycles.  Instead of having to get internal IT to sign off on a laundry list of integration and implementation issues, we sold the product as a fully hosted SaaS solution that was up and running in a matter of days.  Instead of making one big sale per customer, we could make numerous small sales, often to the same partner at a law firm.   Finally, instead of having a very small set of potential large enterprise customers, we now had every law firm in the world and any person or company that had been sued or was suing someone as a potential customer.  Business was so good that Stratify stopped trying to raise the extra capital from VCs and in fact never raised another dollar of equity financing.

I had to resign my board seat at Stratify when I left Mobius, but for the next few years, with the able assistance of Jason and Chris, the team kept building the eDiscovery business to the point that it was clearly a very successful business.  I stayed in touch with the team and tried to offer encouragement and assistance, but they didn’t need any help; they finally had a market and a business model that took full advantage of their fantastic technology.  With growth and success came multiple suitors and it was inevitable that one of them would offer a deal that made too much sense to pass up and that’s exactly what happened today.

Lessons Learned
I learned a lot of investment lessons from Stratify, the most important of which are:

1. Don’t underestimate the value of a great technology team.   Great tech teams can quickly adapt a product to suit changing markets and priorities.  They also create products and technology with lasting value that can be leveraged in multiple ways.
2. If at first you don’t succeed, find a new market and/or a new business model.   It’s often said that very few start-ups achieve success with their original business plan and after my Stratify experience I believe it.  Start-ups should always keep an open mind about potential changes in business model or market focus that might increase the chances for success and should be honest with themselves when it is clear that they are “stuck”.
3. When everyone else is selling, it’s not a bad time to think about buying.  In the public markets they call it capitulation; in the private markets they call it fatigue.   It’s hard to fight the urge to run with the herd, but if you can, you can often make a lot of money.

Venture investments can be real roller coasters.  Stratify went through two business model changes before they found the market, model and product that clicked .  Through it all a core team of people stuck it out and ultimately built a great business that everyone can be proud of. Congrats again to all involved!