Venture Capital

From here to enternity

Chip Hazard5 Comments

Earlier this week at the AlwaysOn Venture Summit East, Harvard Business School Professor Bill Sahlman declared that the "Median rate of return on VC will be 0% for the rest of eternity".  For those of us who have been in the industry for a while, this is not a new statement from Professor Sahlman, although the qualifier "to eternity" certainly is a new time frame for this claim (and for those of you keeping track at home, eternity likely exceeds the length of my investment horizon).  Rather than debate his point of view, when I heard this I sent out a tweet saying simply "I hope he is wrong".  Soon thereafter I got a reply, which I have heard from several entrepreneurs before, that went something like this: "Don't you hope he's right? We want entrepreneurs to get at bats, and the current model makes that possible".  


I was tempted to reply back quickly with the the short answer of No, but thought this topic may deserve more than 140 characters.  So here is the the longer answer.  In the short term, venture capital that is willing to be invested at a 0% expected rate of return is on the margin good for entrepreneurs in that it helps get companies funded and maybe some of these companies will emerge as real businesses and many entrepreneurs will indeed get their at bat.  In the longer term, however, it is unsustainable and bad for entrepreneurs for two reasons.  The first reason is that the abundance of capital leads to too many companies being funded in any given sector, with the net result being that interesting sectors that can support maybe 5 companies now have 20+ companies pursuing the same customers, partners, and employees and each company is weaker as a result of the level of competitive intensity for scarce resources.  The second reason is that venture capital as a "asset class" competes for capital from investors and if the returns are not interesting, capital will go elsewhere where the expected risk adjusted returns are higher.  Further, venture capital is an inherently illiquid investment and, because of the illiquidity, our investors look for a premium return when they can not access their capital for longer periods of time, just as you get (and demand) a higher interest rate from your bank when you commit to a 3 year CD versus the interest rate you get in your always accessible checking account.  The general rule of thumb is that venture capital needs to generate returns that are 500-1000 basis points greater on a per annum basis than a similar equity investment, say the S&P 500 or the Nasdaq 100.  As a result, unless you are expecting the broader public stock markets to decline by 5-10% per year, a 0% rate of return in venture capital is not sustainable and the industry as a whole will contract, resulting in less capital for the industry and entrepreneurial ventures.  So while it may seem appealing on the face of it to have the industry run for the broader good of innovation, in the end we – meaning entrepreneurs and venture capitalists together – need to earn our keep every day to ensure that capital remains available for great people and ideas.

VCs and Recruiting

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There is an old expression in the Venture Capital business, coined initially I believe by John Doerr, that VCs are really just glorified recruiters.  Given a number of portfolio company searches I have been involved with over the past few months, this is definitely feeling like the case.  

So while I think the entrepreneurs in our portfolio companies do the real leg work in recruiting, and being an excellent recruiter and team builder is a key skill of the executives we back, there are a few important contributions a strong venture capitalist can bring to an executive search at a portfolio company:

  1. A broader context.  If a founder of a company is looking, for example, to recruit a VP of Sales, depending on what they have done before this could be their first time doing so.  An experienced venture board member, on the other hand, might have helped recruit dozens of such executives which provides a broader context in which to assess the executive's skills and fit with the given company.
  2. An extended network from which to surface candidates.  This can result in the VC surfacing up a specific candidate, or knowing enough people who themselves can surface up candidates.
  3. An ability to more deeply reference check a given candidate.  As anyone who has recruited executives knows, reference checking the candidate's background is critical to understanding their skills and fit.  But being able to do so "off-list" is even more important as the key to references is not speaking to the people the candidate provides, but rather understanding who, and speaking with, the references they don't provide.  By the nature of having been involved with many companies over the years, a good VC will often be able to get to these off-list references more readily than the executive team.
  4. An ability to help provide a candidate a third party perspective on the business and why it may represent a good fit for the candidate.  Talented folks will always have other choices and the best candidates will want to do significant diligence on the opportunity.  While not completely unbiased, a venture investor can often provide this perspective and share diligence on what led to their investment decision.
  5. An ability to keep executive search firms honest.  Search firms, while often an important part of a successful recruiting process, need to be managed to avoid them slacking off at the end of a long search or promoting candidates to finish the search regardless of whether the particular candidate is a good fit.  A recruiter is less likely to do this with the involvement of a venture firm given that the venture firm often represents a long-standing relationship and a steady stream of referrals.

So if you are an entrepreneur looking to build out your team, put your venture board members to work!

Get Your Organizational Wheel of Fortune Spinning

Chip Hazard4 Comments

Wheel
A couple of months ago, I had a two week period when many of our CEOs were leading their own 360 degree reviews, where feedback is provided to them by both their direct reports and by the Board of Directors.  If you are a CEO/entrepreneur, I would highly encourage you to do this, as it is a chance to get feedback in a structured, formalized way and to surface issues that can be addressed before they fester and become harder to overcome.  It is also helpful as the skills and management style that worked when your company was 10 people may not be the same as the skills required and the approach you take when you are 50 people or 500 people.  

As part of their 360 process, one of our companies ran a structured workshop in advance of the review to identify what the Board, the CEO and the company’s outside advisors felt were important characteristics and skills the CEO required to be successful.  Here at Flybridge, we also have an internal set of questions we ask ourselves as venture investors before we get involved in a company that helps us as a partnership determine if a given entrepreneur is someone we want to be in business with. Putting these together, below are six questions that you may want to ask yourself, about yourself, as you think about starting a company:

  1. Are you a Pied Piper?  To me, this is a unique skill that allows entrepreneurs to articulate a vision for their company, instill confidence in their ability to achieve that goal and demonstrate personal leadership that leads prospective employees, partners, customers and investors to feel like they absolutely have to join the parade.  These are both personality traits such as authenticity and trustworthiness, but it also means having a unique perspective on a market need and how your solution addresses that need.
  2. Are you introspective and coachable?  Because no one executive has all the right skills and the needs of the leader change as the organization develops, understanding your personal strengths and weaknesses is critical.  This does not mean a lack of confidence; in fact some of the most confident CEOs we work with are the best at understanding where their talents lay. If you have an interest in learning more, A good resource on this front is Daniel Goleman’s book, Emotional IQ. Of course, to be successful you then need to build a team (see #3 below) that has complementary talents to your skills.  
  3. Can you identify, recruit and retain talent?  This is fairly self evident, but I have observed over the years that some companies are great recruiters and have a way of attracting the best people while others constantly struggle to do so.  And yes, the old adage of A players attracting more A players while B players attract C players is true and is something we have observed repeatedly over the years. To be a great recruiter requires constant networking, a disciplined and intense interviewing process and great follow through and sales skills.  I love some of the approaches Paul English, the co-founder of Kayak, uses as outlined in this article.
  4. Can you create alignment across your team in terms of the company's strategy and objectives? Often an entrepreneur is so convinced their way is the correct way, they fail to realize that the rest of the organization may not understand, or buy into, the path forward and will be, as a result, inadvertently working at cross purposes.  This si not to say debate and conflict across the team is bad, in fact it is critical, but coming out of the discussion there needs to be by-in and alignment.  As an example, I was at a Board meeting at the start of the year where we joked that the CEO must have had a button under the table that allowed him to direct each of the team members comments as everyone's strategy and goals for the upcoming year was 100% aligned with the direction the CEO had laid out for the company in the session he had with the Board alone.  Not surprisingly, since that Board meeting, the company has met all their goals and objectives.  Further, because everyone understands and believes in the goal, any mid-course corrections and decisions can be made quickly as there is a common understanding of what needs to be achieved.
  5. Can you operate at a fast clock-rate and make rapid, data driven, analytical decisions despite rampant ambiguity?  I believe start-ups win in part because their decision making cycle is faster than their would be competitors, so being able to make rapid decisions is critical, despite the fact that often there is very little information at hand to make such decisions.  Some translate this into swinging from the hip decision making, but I think the real skill is understanding the ambiguity, asking the right questions in terms of what information would help reduce the ambiguity as quickly as possible, overlaying that information with input from trusted team members and advisors, pushing forward with decisive action and then reacting if need be.
  6. Are you resilient enough to look at adversity and focus on what needs to be done to overcome the challenges and adapt as necessary? Like a shark that can't stop swimming, startups continually need to be moving forward and when the inevitable turbulence arises, it is important that a game plan to overcome the obstacles be quickly put into place, even if the execution of the game plan will take some time.  If the path forward is not obvious, a starting point at a minimum is developing a plan to get to the plan.  Further, listening to input and being willing to adapt, even if it means admitting the original vision has flaws is an important skill, although often easier said than done for strong-willed entrepreneurs

Interestingly, these skills together can be reinforcing in a positive manner.  I call this the Organizational Wheel of Fortune as outlined below:

Orgwheel
 

Let me know your thoughts and if I am missing any key questions.

Quick reminder of the challenges (and opportunities) in enterprise IT

Chip Hazard1 Comment

Last week I did several reference calls on a new project we were looking at in the enterprise IT market.  In each case I was speaking with a senior IT executive at a large financial institution.  The calls were not to the company's existing customers, but rather to people I just felt would be thoughtful on the company's market opportunity.

As it turned out, each had actually evaluated the company's product and they started out the conversation by saying how impressed they were with the company's technical approach, how it was really innovative and superior to other solutions, and how much they liked the company's management team. So far, so good.

Then I asked the obvious next question: so did you buy the solution?  In each case, the answer was no. The why behind the no, however, is what is illuminating on some of the recurring  challenges for traditional start up enterprise IT companies.  Although they used different words, the consistent themes were:

  1. We went with our incumbent vendor.  We know their solution is not as good, but it is good enough and it is already integrated into our infrastructure and we know how to work with them.
  2. This project, while important, was not high enough on our priority list to get everyone's attention.  Given tight budgets, the only new initiatives we are doing relate to driving revenue or addressing pressing regulatory changes in our business.
  3. The company wanted to do a paid pilot with us to prove how much superior their solution was, but given a pilot required standing up new iT infrastructure and integrating into some of our core systems, this was a significant undertaking and not something we were willing to do given point two above.  Further, the pilot was required to demonstrate the business case which left us in a Catch-22 situation.

Many of the takeaways from this conversation are the same as I wrote about two years ago in my long enterprise IT post, but I felt they are worth repeating in the light of this conversation.  First, if your product/market focus requires a traditional enterprise IT approach, which for me means high touch direct sales with a product that requires some level of IT support and integration, you better make sure that:

  1. Your "superior solution" is significantly superior.  As in 10 times better, not 50% better.
  2. You are focused on a company's top three strategic initiatives, because nothing else is going to get funded in amounts or in a timeframe that will make you happy.

As you have likely figured out, these two things are hard.  In the fast paced technology world, sustainable 10x product differentiation is uncommon and fitting that with the ever-shifting strategic priorities of large organizations is even harder.

The alternative, of course, is to think creatively about ways to reduce the friction in the adoption process which is why we continue to be attracted to open-source, freemium and SaaS business models.  Instead of the conversation I had above, imagine if the customer was able to download/ sign up for the company's product -  without consuming any IT resources or getting into a lengthy procurement cycle – and then use the product and see its value.  If the product was easy to use and understand, did not require deep integration or if it did, the integration came "pre-built" via some partnerships, the potential customer would have been able to develop its business case and pre-qualify themselves as a relevant customer.  Thus they would consume minimal resources from the vendor until they raised their hand and said, I am ready to buy.  While this is by no means easy, if you have the right focus across your company in terms of product management, development and sales and marketing, it is likely an easier approach than trying to find that magical 10x better product that meets your customers top strategic priorities in an era of constrained budgets and shifting priorities.


Welcoming 10gen to the Flybridge portfolio

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While I try to avoid promoting Flybridge portfolio companies on this blog, from time to time I will write about our new investments in the hope it sheds some light into how we are thinking about opportunities. 

Today it was announced that we recently invested, along with Union Square Ventures, in a New York City based company called 10gen. 10gen was founded by Dwight Merriman, Kevin Ryan and Eliot Horowitz and they are an open source software company that developed the non-relational database, MongoDB. 

We invested in 10gen for a few reasons:

  1. Strong founding team: Dwight was the co-founder and CTO at DoubleClick, Kevin was the President and CEO of DoubleClick and Eliot was a lead software architect at DoubleClick.  As a result, the team knows a few things about both building large scale web infrastructure and growing and scaling businesses.  We were also fortunate, in a prior life, to have been investors in DoubleClick so we also had the benefit of knowing the team well.  
  2. A belief in the "NoSQL" database market: while the name is a bit of a misnomer, we believe that databases are getting more specialized over time as users realize that the one size fits all relational database model does not often fit what they are trying to achieve with their applications.  Specifically, a schema-free, non relational document oriented database such as MongoDB is particularly well suited to web applications where scalability, performance and flexibility will be highly valued. Virtually all the web developers we spoke to in our diligence were using, either in production or in their labs, NoSQL databases with very positive results.  We expect this trend to only increase as more applications are deployed in Cloud environments as these databases are particularly well suited to that architecture.  
  3. MongoDB is a leading solution in this emerging market: while MongoDB was only recently introduced into the market after a few years of development, the product has been downloaded by tens of thousand developers and is in production at companies such as SourceForge, Business Insider and Disqus.

While there are other reasons we, in short, liked the team, the market opportunity and the company's specific solution.  We look forward to working with this great team to take advantage of this exciting opportunity.  If you have an interest in downloading the product, please click here, or joining the team, please click here.

Immigrant Founders

Chip Hazard2 Comments

A few weeks back, I had the pleasure of doing a panel discussion at a TiE DC event focused on strategies for growing and financing entrepreneurial ventures.  TiE now stands for "The Innovative Ecosystem" and is a not-for-profit global network of entrepreneurs and professionals, although when the organization was originally founded TiE stood for The Indus Entrepreneurs and was focused on entrepreneurs primarily from India.  Befitting this heritage, most of the entrepreneurs I spoke with had Indian roots and as many of them reached out to me to discuss their ideas for their new ventures, i was struck – as i often am at TiE events – by the quality of the entrepreneurs, their passion for their new businesses, and the general level of aggressiveness in networking and seeking advice on how best to move their business forward.  All good signs for the local DC entrepreneurial community!

As I was speaking to everyone, I was also reminded of a study that was commissioned by the NVCA on the impact of immigrant entrepreneurs and professionals on the U.S. economy.  In short, what this study found was that over the past 15 years, immigrants have started 25% of US public companies that were venture-backed and that the market capitalization of these firms exceeds $500 Billion.  Further, 40% of US publicly traded venture-backed companies in high-tech manufacturing today were started by immigrants, including companies such as Intel, Solectron, Sun Microsystems, eBay, Yahoo! and Google.  For those of us in the venture industry, this is not new news as we see this in our daily lives as we meet with new companies, but it is interesting to think about why this is the case.

From my perspective, there are three reasons immigrants to the US make up a disproportional amount of the start-up companies backed by venture capitalists.  First, most of the immigrant founders were drawn to the US for either college or graduate studies in technology driven fields, so they are well trained technically and are no strangers to innovation.  Second, as I saw when I lived for a couple of years outside the U.S., being in a culturally different place tends to lead one to be more curious and to take less for granted, resulting in a proclivity to identify something that "just does not make sense" and therefore is in need of a solution.  Finally, immigrants tend to have a lower fear of failure and seem to be much more open minded to take the calculated risks that are required by entrepreneurs.  From my lens, I think this is because the shear act of leaving one's homeland to study and live outside of what is naturally comfortable is, in and of itself, a significant risk and that those who succeed in thrive in having taken that risk realize that with such decisions often come great rewards.

The frustration with this analysis is how hard the US immigration policy makes it for these talented folks to stay in the US, especially as they are leaving university programs.  If you want to stay in the US post university and work at a company, immigrants quickly discover the H1-B visa program is an annual mess and if you want, heaven forbid, to start a company, it is even more complicated.  It makes no sense that as a nation we do a great job attracting the best and the brightest to our world-class universities and then make it incredibly hard for people to stay, something that is exacerbated in today's world when the idea of returning home for an immigrant from India, China or the like is far more attractive for an entrepreneurially minded individual than it would have been 15 or 20 years ago.  I am not alone in seeing this as a lost opportunity for the US – both Brad Feld and Paul Graham blogged on this in a far more eloquent way earlier this year – but I wanted to throw my hat into the ring of pushing our policy makers to think more creatively about driving entrepreneurship and the associated job creation opportunities in this country.  I recognize this is not a politically popular stance for our elected officials, in fact one Congressman in a discussion of the visa issue recently remarked to one of my partners, "try telling that to the gas station attendant", but if they hear from enough people, perhaps the tide can change.

Family Traditions

Chip Hazard4 Comments

One tradition that has developed in our family is that each night before they go to bed, my two oldest kids ask me about the new companies I saw that day and whether they were interesting as investment opportunities.  Apart from occasionally leading to "proud parent" moments when they dissect the business opportunity to a T, I am always struck by how some stories I hear retell easily and how others don't retell well at all.

While it would be easy to chalk this up to the more technology driven stories not making the transition from board room to living room, the common denominator is actually that great entrepreneurs have an ability to deliver a message that is compelling, concise and easy to remember such that it can be retold in a way that others understand it perfectly.  In our evening sessions, this has proved to be true whether the company is focused on consumers, SMBs, enterprises or OEM partners.  

While delivering a compelling, concise and easy to remember pitch such that I can discuss the opportunity with my kids is not terribly important, the gist of the message is.  Every time you make your pitch as an entrepreneur the recipient will retell the story to someone else and if all they get is blank stares, your likelihood of success goes down.  This is true if you are recruiting and your candidate goes home to speak to their spouse or significant other; if you are selling and your prospective customer discusses the opportunity with their boss or colleague; if you are speaking to the press and the writer reviews the story with their editor or tries to summarize in their blog; or if you are raising capital and your prospective investor discusses it with their partners.

What makes a good pitch?  The first key point is a simple vision of what you are trying to do and why this is important.  Far too frequently this gets bogged down in how you are doing something rather than why.  My kids, and anyone else for that matter, don't care that you have the best technical approach in the world.  Instead they want to know what the technology allows you to accomplish.  As an example, our portfolio company Goby launched today what they describe as a "search engine for your free time".  While the company is based on a tremendous amount of technology from very smart people at MIT, note they don't use the term "semantic" or "federated" or "deep web" in their pitch because, again, people care about what you help them to do, not how you can do it.  The second key point to communicate in your message is a sense for target markets and how broadly applicable your solution can be.  It is surprising to me how infrequently entrepreneurs fail to connect their idea with concrete market opportunities.  In the case of Goby, the connection point is that 71 percent of US adults find themselves frustrated with the irrelevant search results returned by traditional search engines and there is nothing more frustrating than spending your free time researching how to spend your free time!  Finally, the third key point in any pitch is how the idea, customer value proposition and market translate into a compelling business opportunity.  This is the point where my kids often surprise me with their insight based on the simple statement, "but Dad, i don't see how that would ever make any money".  At the end of the day, we are building companies and if there is no means to generate significant revenue, there is no company to be built.

Don Dodge recently had a good post on what should be in a short pitch, but the discipline I would encourage is to distill all your messages into a single powerpoint slide or if you are more ambitious, a single twitter message.  Either really forces the communication of what you do, why it is important, who cares about it, and how that will translate into revenue into a few, powerful sentences.  And then, when you are done, try it out on a 13 year old!

Cut day

Chip Hazard2 Comments

Bill Gurley recently had an excellent post on the state of
the venture capital industry, with an emphasis on how Limited Partners think
about the asset class.  I generally
agree with his primary thesis that: 1) the industry will be smaller and raise
less capital and 2) this is net healthy for entrepreneurship given that fewer
companies will be funded in what would otherwise be overcrowded sectors.  That said, I am not sure the metaphor he
used – a picture suggesting all the industry needs to do is go on a diet to
lose some weight – is right. 
Instead, I think the more appropriate metaphor is what went two weeks
ago in the NFL: teams cutting players to have appropriate sized rosters.

Here’s how I see it: If venture capital funds typically have
4-year investment period, over the course of that time period most firms would
need to raise a new fund.  As a
result, if we look at the four years from 2005 to 2008, when the industry as a
whole raised $125 billion across 952 funds, we have a rough approximation of
the size of the industry on a run-rate basis prior to the recent economic
turmoil.  During this time, it is
estimated by the NVCA that there were approximately 7,500 practicing venture
capital professionals, or $16-17 million of capital to invest per
professional.  If going forward,
the industry raises more like $15 billion per year, or $60 Billion over four
years, at the same ratio of capital per investment professional, the industry
can support only 3,600.

As a result, much as NFL teams need to cut back to get to 53
players on their roster, venture capital firms will need to cut back investment
personnel to reflect the reality of the current funding environment.  I don’t think this change will happen
over night, nor do I believe the industry will actually get to this level of
professionals (about where the industry was when I first joined in the early
90s), but directionally I think this change needs to, and will, happen (and
already is happening).

What does this mean for entrepreneurs?  First, be sure to spend some time
thinking through whether the particular partner you are working with is likely
to be on the team going forward. 
If they have not made an investment in the past couple of years, are working
with a only a small number of portfolio companies, or are focused in an area
(industry, geography or stage) that the firm seems to be de-emphasizing, they
are potentially at risk.  Further,
the firms that are likely to see the greatest cutbacks will be at both ends of
the size spectrum.  The larger
firms that have added significant staff over the last 10 years will likely trim
more than those that have stable sized partnerships and conversely, the smallest
of firms in the industry will be at risk as they just wont have the fee income
to support their organization and accompanying overhead.

Second, the reduced size of the venture capital industry
will result in fewer companies getting funded.  Each one of the venture capital professionals in the industry
today is out trying to make investments, so if there are approximately half the
number of participants, it stands to reason there will be approximately half
the number of companies funded (if all the industry did was diet and have less
capital with the same number of participants, as Gurley’s image implies, one might
incorrectly infer that the same number of companies might get funded just with
less capital each).  While this
certainly raises the bar on the quality of the team, idea and market
opportunity for entrepreneurs, it importantly will result in a significantly
healthier market environment for those companies that do receive capital.  We all have been part of companies that
were pursuing a good idea and market opportunity, only to see a dozen companies
created in that space, with the net result being a bar room brawl in which only
one or two players emerge from the saloon bloody, bruised and vulnerable to
another fight.

So just as cut day in the NFL is not fun, this process in
the venture capital industry will not be easy or painless, but will net result
in stronger teams and a more healthy environment for the industry and
entrepreneurship as a whole.

The Rebirth of Enterprise IT

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(This post pre-dates my own blog and first appeared on my partner Jeff's Seeing Both Sides.  While it is now dated – the first post was from September of 2007 – many of the thoughts still ring true so I thought I would include it here).

When Nicholas Carr wrote his now-famous Harvard Business Review article over four years ago, “IT Doesn’t Matter”, the most damning claim to our industry was that IT had become a commodity input – irrelevant as a source for strategic advantage. Many pundits, from Larry Ellison on down, began pontificating on the maturation, consolidation and eventual death of the enterprise software business – at least for companies whose names are not IBM, Microsoft, Oracle, SAP or Symantec.

The general thesis goes something like the following: 1) corporate IT departments are looking to reduce, not increase their number of vendors and are therefore not inclined to work with start-ups; 2) customers no longer are pursuing best of breed strategies, but instead want integrated suites to simplify deployment and operations; 3) the sales and marketing costs of large enterprise software solutions are extremely high and drive a need for significant investments that are beyond the capabilities of many early stage companies; 4) the overall rate of growth of the software industry as a whole has slowed and there are few areas for innovation. Common analogies used by these pundits include the maturation and consolidation of the automobile and railroad industries in the early to mid 1900s. Pretty depressing stuff.

In the last six years, many venture capitalists are submitting their own vote on this debate with their feet, as the percent of funding dollars to software companies has declined from 25% of all venture disbursements in 2001 to 19% in the first half of 2007. Anecdotally, when you walk the halls of VCs around Sand Hill Road and Route 128, you hear a similar refrain: “We’re diversifying away from software… we are experimenting with consumer-driven business models… we like Web 2.0/new media plays”.

So where does that leave a talented entrepreneur (or VC, for that matter) with deep experience in this now passé field? While challenges remain, we submit that there remain numerous glimmers of hope in the enterprise software market – and certainly the recent reopening of the IPO market and the more robust M&A environment has brought some of these to light. If you look at some of these recent successes, themes and strategies emerge that entrepreneurs can adopt to drive the creation of successful companies:

  • Innovate to drive efficiency. For many times over the last decade, enterprise software companies positioned themselves as automating certain functional departments of corporations. First it was manufacturing, then financials, supply chain, sales, marketing etc. If this is your view of the enterprise software environment, then by and large Larry Ellison is right – there is little room for new categories and innovation. That said, if you spend time with the average CIO, you will hear a different story. In today’s “post-bubble” environment, CIOs have seen their staff and capital budgets cut back, but the demands on their organizations from business executives have continued to increase as companies seek to have a more flexible and cost-effective IT organization to support their business plans. CIOs have gotten their much sought-after “seat at the table”, but with that seat comes the pressure of accountability to deliver bottom-line results. Compounding this challenge of doing more with less is the sheer magnitude of the accumulated applications and technologies that have been deployed by enterprises over the last 20 years. The number of lines of code, disparate pieces of software, and points of integration has exploded exponentially. As a result, there remains a robust opportunity for focused vendors to drive innovative technology into enterprises to drive efficiency in IT operations. The bar, however, is quite high. If you can’t drive a 5 to 10 times reduction in key metrics, the status quo will prevail. A recent success story is Bladelogic, which went public in July of 2007 and trades at 13 times trailing twelve moths revenue, primarily due to the company’s success in automating data center operations, a key means to drive efficiency in IT operations. Opsware, which HP just agreed to acquire for $1.65 billion, is another example and also demonstrates there is a relatively healthy M&A market, as these innovative companies fill key product gaps for large acquirers, such as IBM, Microsoft, Oracle, HP and EMC, as well as mid-sized public companies such as BMC, CA and Symantec.
  • Wrap your software in commodity hardware. One of the complaints you will often hear from IT departments about working with a new vendor is the challenge of integrating their solution into their already complex environments. The mundane, manual tasks of requisitioning and provisioning the necessary hardware to run, or even pilot, the shiny new piece of software slows the path to adoption. As a result, a number of innovative software companies don’t appear at first blush to be software companies at all. Instead they sell pre-provisioned, plug and run, hardware appliances. Companies that adopt this model are not only able to leverage Moore’s law to drive performance, but also can ship their customers a unit that can be slotted into a rack and up and running in hours, not days. This allows customers to trial the solution and see the benefits immediately, mitigating the long sales cycles that plague many traditional enterprise solutions. Further, the appliance approach tends to lead to easier adoption by channels that are better suited to selling hardware than complex software. This appliance strategy was seen initially in the security software industry, but has since spread to other areas such as storage back up solutions from companies such as Data Domain, which recently went public and currently commands a $1.4 billion market capitalization on trailing twelve months revenue of $76 million.
  • Dominate a niche. Start-ups are often caught in a quandary. To raise money and hire the best people, they need to convince VCs, employees and other supporters of the company of a big vision and the opportunity to capture a billion dollar market. To do so, however, they run the risk of going too broad, too quickly and losing the laser focused approach that allows young start-ups to win against large, incumbent vendors. A better strategy is to instead think about climbing a staircase. You know you want to reach the next floor, but you don’t do that by trying to jump up 13 stairs all at once. Ask yourself, “What can I uniquely do today for a customer that solves a real problem and also provides a link to doing more things for those customers in the future?” In today’s age of rapid development, componentized software and offshore resources, software code is relatively easy and cheap to write, and is no longer the “barrier to entry” and source of competitive advantage it was ten or twenty years ago. Instead, what matters to customers (and potential acquirers) is the deep, domain-specific knowledge instantiated in that software. For an early stage company to build this knowledge, they need to be incredibly focused in a given domain and make sure they have people on their team who understand a customer’s business better than the customer does themselves. Unica, a recently public $80 million in revenue marketing automation company in Boston is a good example of this. When they first got going, they had the best data mining tools for marketing analysts on the planet. Not a huge market, but one that valued innovation and provided a logical steppingstone to campaign management, lead generation, planning and the other marketing tools that the company sells today.
  • Explore SaaS (software-as-a-service). If the key barrier to success for early stage enterprise software companies is excessive sales and marketing costs, adopting a software-as-a-service model may be the right approach. This is more than just selling your software on a subscription versus perpetual license basis. Instead, SaaS is all about making it easy for customers to understand, try and, ultimately, gain value from your software. In 5 minutes and for no up front cost, I can become a user of Salesforce.com. Within the 30 day trial period, I can self-qualify and decide if it is the right solution for me and worth the on-going subscription cost. Most importantly, I can potentially do this without consuming a single dollar of their sales and marketing spend. None of the airplane trips, four-legged sales calls, custom demos, proofs of concept or lengthy contract negotiations that lead to the 6 to 12 month sales cycle that costs a traditional software firm 75% of their new license revenue in a given quarter.
  • Consider Open Source. Open-Source is not about free software, but rather products that have seen, or have the potential to see, widespread grassroots customer adoption. A passionate end-user community has the benefit of driving a development cycle that quickly surfaces key product requirements and needed bug fixes. Further, the grassroots adoption of the product provides a ready installed base of early adopters who will promote the product across their enterprise, purchase professional services and acquire more feature rich versions of the product. Like SaaS, this is a way to mitigate high sales and marketing costs. When My SQL looks for customers for the enterprise version of their open-source database, they have to look no further than the estimated 11 million active installations of their software or the 750,000 plus people that subscribe to their email newsletter. RedHat’s version of Linux, Jboss’s version of the application server and Sugar CRM are three other well-known open source success stories, but other opportunities abound.

Enterprise software entrepreneurship and investing is certainly not for the faint of heart, but when pursued with some combination of the strategies above, we believe interesting opportunities remain for innovative companies to make their mark in the world and have a positive impact. Contrary to the claims of many, it is still possible to build these companies in a relatively capital efficient manner. Sticking to some of the examples cited above, it is illuminating to note that Bladelogic raised $29 million of venture capital before its IPO, Data Domain $41 million, Unica $11 million, Red Hat $16 million and Jboss (pre-acquisition) $10 million. Only Salesforce.com raised a lot of capital – $64 million – although almost 75% of that came in their last round when one would assume there was evidence the model was beginning to work.

In the end, we believe the analogy to the automotive industry is flawed. The manufacture and distribution of cars is fundamentally different from the software industry. In auto industry, there are tremendous benefits of scale, the underlying platform (tires, chassis, internal combustion engine, frame and skin) has remained the same for decades, and there is little room for small players to access end-users. Software, on the other hand, is a digital good and an information business. Innovation is limited only by the creativity of the author. Small teams can be extraordinarily productive – often times more so than larger teams and organizations. The underlying platform and architecture has changed several times in the last 30 years, and there is no physical product to distribute, thus end-users can be accessed much more directly. Is there a benefit to the incumbency and distribution might of IBM, Oracle or EMC? Absolutely. Does that mean there is no place for creativity, innovation and entrepreneurship in this industry? Absolutely not.

Succumbing to Peer Pressure

Chip Hazard1 Comment

Given that I have three partners – Jeff Bussgang, David Aronoff and Michael Greeley– here at Flybridge who are thoughtful, insightful and prolific bloggers, I have finally been convinced it is time to join in the fun. While I doubt I will measure up to my colleagues, I will attempt in periodic posts to shed some light into the world of venture capital and entrepreneurship intermingled with occasional thoughts on family and fun.  Hopefully there will be some food for thought and thanks for reading!