Altos Ventures Musings

A Modest Proposal for the Venture Industry: Better Customer Service

There has been much talk lately about the demise of the venture capital industry.  Big funds are imploding after a decade of poor industry returns.  The causes are many: wacky capital markets, Sarbanes-Oxley regulation, ballooning fund sizes, misaligned incentives, generational turnover, etc.  Reviving the industry was such a big topic at this year’s National Venture Capital Association meeting that NVCA leaders issued a bold set of proposals to jumpstart the industry.

I haven't spent much time trying to dissect the causes of our industry’s current malaise.  But one thing I know for sure is that we are doing a lousy job of basic customer service.  How bad?  If you google “venture capitalists suck” you will get more results than “United Airlines sucks”.  A totally inaccurate measure to be sure, but to be anywhere near United Airlines on the suckage scale is not something that our profession should be proud of.  I think we can do better. 

So let me make a more modest proposal.     

We venture investors could do a lot for the reputation and health of our profession by getting back to the basics of good customer service. 

Many of us have forgotten that our business, after all, is to serve investors who entrust us with their capital and entrepreneurs who entrust us with their dreams.   Having raised money at three start-ups before starting in venture, I have more than a few opinions on how venture professionals could act more, well, professional.  Let me start with a few simple ones:

1.    Return calls (and emails)
One of the classiest and most successful venture investors I’ve ever met is Brook Byers of Kleiner Perkins.  Early in my career, I asked him at a panel discussion to share the secret to his success.  He explained that one of his basic rules of doing business was to call people back by the following day.  It sounds so simple, yet every week I talk to entrepreneurs who drive themselves insane wondering when the VC they met is going to call them back.  I’m not talking about unsolicited inquiries (only the appropriate ones of which deserve a response); I’m talking about getting back to people with whom we’ve already met.   Email overload is no excuse.  Not when we’re checking our Blackberries every five minutes.

2.    Pay attention
Which brings me to my next suggestion.  I vividly recall pitching my third startup to a famous Sand Hill venture capitalist back in 1999.  We had studied his portfolio, prepared a customized presentation and shown up early for the meeting, only to have him spend the hour distractedly munching a bag of peanuts and tossing the shells on the table in front of us.  Now that a decade has passed and peanuts have given way to Blackberries, it is a rarity that I sit through a meeting where a VC is not checking email, surfing the Web or popping out to make a phone call.  What’s the point of making all the physical effort to get face-to-face only to be mentally absent?  I’m as guilty as any, so let me resolve immediately and publicly to put my Blackberry away when meeting with entrepreneurs, or at least use it as a drink coaster.

3.    Just say NO
Given that we need to turn down 99% of the ideas that come our way, you would think that VCs would be pretty good at saying “no” to entrepreneurs.   The best salespeople and entrepreneurs know that a quick “no” is better than a long “maybe”.  Some of my VC colleagues don’t like to say “no” to keep their options open for a potential investment, but the vast majority just don’t like using the two-letter word because they are nice people.  They hem and haw and say something about having to “talk to the partnership”, then worry for weeks about how to make up a reason for declining the opportunity.  I’ve resolved to either tell entrepreneurs in the meeting or get back to them within a week.  It sure has made my life a lot easier and I hope it’s helped them waste less of their precious time.

4.    Be accountable
All this is easy to say, but aside from some community rating sites like thefunded.com, venture capitalists are simply not accountable to entrepreneurs.  At Altos, we’ve begun measuring the time it takes us to get initial and follow-up responses to entrepreneurs, but we are by no means perfect.  For a profession that generates all of its returns from the hard work of entrepreneurs, we sure do a lousy job of customer service.  So hold me to what I say.  Call me on it.  If I (or my partners) don’t follow my own advice in this blog, just email alee@altosventures.com and you’ll get a response from me.  If I still don’t get back to you, then you should probably give up on us and try United Airlines instead.

Twitter Envy

After what seemed like the biggest PR week ever for a start-up, I did a Google News search this morning on "Twitter" and found 1,612 news articles. It was more than twice the Google News results for Facebook, Google, Microsoft, Amazon, eBay and Yahoo! COMBINED.

Last month, Seth Godin wrote a blog post talking about the difference between PR and publicity. If great PR is the strategic crafting of a compelling story...just what is the Twitter story? Can there be a credible story without customers (not users) and how they make money?

Before you get Twitter envy and start doing dumb things (like Facebook did changing its homepage) be sure you understand what your true mission is as an entrepreneur.

An entrepreneur's mission is not to get publicity or to become famous. It is to build a company. Without revenues and profits, you cannot have a viable company.

There is no doubt that Twitter has innovative product people and great engineers to be able to handle scalability issues. But let's just see if they will still be around when their venture funding runs out and the hype dies down.

In the meantime, don't learn the wrong lessons from Twitter. Don't rush out to hire a new PR agency. I've seen plenty of companies get hyped, raise huge amounts of funding, and land speaking gigs and magazine covers all around the world. It doesn't mean they will make it. In fact, it might decrease their chances (don't confuse cause/effect).

Yes, they might get lucky and flip the company for a princely sum (as Youtube did). But I doubt they will build a successful business or a lasting company.

What is your definition of success? PR or publicity? Build your company or your reputation? Build to last or build to flip?

Burn the Ships!

The past 6 months have been two of the toughest quarters in decades. Almost every company is struggling - but some are surviving and some are not. What separates them?

I want to share an observation. There seems to be one common theme across every Silicon Valley company that I've seen go out of business. For some reason, the management of companies that abruptly shut their doors thought that they would get more funding. It could have been VC funding, debt financing or some other source of outside capital. That was their back-up plan. They were counting on it.

If you are an entrepreneur, you should have the attitude that there will be no-one to save you. There will be no outside capital. You have to generate revenues, cut costs, make the business model work - or find some way to survive until you do.

This doesn't mean that entrepreneurs should not raise any debt or equity financing. It just means they should never, ever count on it.

In Silicon Valley, it almost seems as if entrepreneurs count on VC as a business model. They aspire to become adept at raising VC money and "exiting" in a few years. What ever happened to the idea of building a real business, funded by paying customers? How about building a company that can stand alone, built to last?

In a book called Predictable Irrational, I found a story that every entrepreneur should think about.

In 210 BC, a Chinese commander named Xiang Yu led his troops across the Yangtze River to attack the army of the Qin (Ch'in) dynasty. Pausing on the banks of the river for the night, his troops awakened in the morning to find, to their horror, that their ships were burning. They hurried to their feet to fight off the attackers, but soon discovered that it was Xiang Yu himself who had set their ships on fire... With their ships gone, the soldiers had no route of retreat. Winning was the only option. 

They won 9 battles in a row before defeating the mighty Qin forces.

If you are an entrepreneur and you think that you will need some more funding to survive - or thrive - I have one piece of advice for you. Burn the ships.

Fat and Happy

One of the biggest challenges that start-ups face is inertia. When you hear comments like “things are fine the way they are” or “there is no interest in making a change right now,” entrepreneurs, or any pioneer, will have a very difficult time making headway.

If you're an entrepreneur, I have good news for you. Fat and happy people are in short supply these days.

The world is ready for change. This means that you will be able to accomplish things that were simply not possible before. Isn’t this is one of the reasons that someone like Barack Obama got elected President of the United States?

Entrepreneurs are not only the agents of change, they are the beneficiaries (see creative destruction).

This is not a time to panic. This is the time to act and to take advantage of the great challenges and opportunities that lie ahead.

Over the past few months, I’ve sensed a subtle but real change in attitude. The ones who are not paralyzed seem more determined than ever. People seem more hungry, more creative, more open minded. They are also more realistic. They face problems with new resolve.

Of course, not all start-ups will do well during tumultuous economic times. But I also believe that it is during times like these, when everyone is NOT fat and happy, that the conditions are most ripe for great new companies – and perhaps great new industries - to come out of nowhere and help change the world.

RIP Good Times? A Different Perspective

Rip Good Times A Different Perspective

View SlideShare presentation or Upload your own. (tags: venture capital)

I put this presentation together to encourage a group of entrepreneurs I was to speak to at a conference in Reno, NV last week.

It's funny how times change.

People who have been following our blogs over the past 2 years know that we've had a more pessimistic, contrarian view of the venture business, even as the number of VC investments, fund sizes, deal sizes and valuations had been going up.

Now, of course, the world is totally different. Whether or not you believed that we were in a Web 2.0 technology bubble, Sequoia declared that the good times were over and it's now time to hunker down and fight for survival. In their widely publicized "RIP Good Times" meeting, they extolled the virtues of cash conservation to all of their CEOs and told them that they had to change in order to survive.

Now, we are contrarians again.

Our companies did not need Sequoia to tell them cash is king. They had been operating that way for years. In fact, more than a third of all of our companies are on track to be profitable this quarter. Many have been maintaining profitability while growing for many years.

The reason that we feel like we are contrarians again is that we have not seen such a good environment for building companies in years. Entrepreneurs are more focused on getting to profitability and building companies based on solid fundamentals. Before, we felt like lonely voices in the VC world, which seems to be filled with people working toward billion dollar exits for money losing companies.

Over this entire year, we've noticed a trend. Some of our companies started seeing a steady flow of high quality resumes from competitors. I think it's now about to turn into a flood! It will be much easier to hire great people who are more hungry and realistic about compensation and how long it will take to build shareholder value.  

For entrepreneurs in it for the long haul, this downturn just bought them more time. Impatient VCs won't be hounding them to take more risk, to grow faster, to get more aggressive. Remember, as an entrepreneur, you have one company. You don't have a portfolio of companies. You can't afford to play venture lotto.

Remember what we said back in 2006 about Foxes and Hedgehogs in Silicon Valley?

"Foxes are great at raising capital - they thrive in bubble markets. Hedgehogs would rather bootstrap - they do far better during the inevitable crashes."

For all you hedgehogs out there, this is your time to shine!

Don't Worry, Be Scrappy

“Don’t worry” does not exactly sound like responsible advice at a time like this. After all, we often remind our CEOs of Andy Grove’s famous adage that “only the paranoid survive”.

But it is a serious piece of advice that we are giving to all of our portfolio entrepreneurs. Over the last two weeks, many of our portfolio CEOs (and fund investors) have been asking us for our take on the current financial crisis. So here it is:

The bad news

Let’s first understand that things will be bad – really bad. In fact, this downturn will almost certainly be deeper and longer than the post-Bubble “nuclear winter” of 2001-2004 that so many of us struggled through as entrepreneurs and investors. That crash was precipitated by a financial bubble seeded largely by the venture/technology markets and abetted by all-too-willing public investors. But despite the fall in IT spending and concurrent drop in the NASDAQ index, the general economy kept humming along. In the five dark years following NASDAQ’s peak on March 9 2000, the Dow Jones actually went up. In the same five year period, the national housing price index nearly doubled. Most Americans hardly noticed the Internet Bubble and crash.

Now this is a totally different story. This economic crisis is about all of us. It’s about a fundamental realignment in global asset values. Whatever happens to venture/technology will be collateral damage, but will likely be worse than what we in tech experienced after the Internet Bubble. If that felt like a nuclear winter to tech companies, this one may well be an ice age for all of us. We may be wrong about this, but we’d rather be wrong on the upside than wrong on the downside.

The good news

As an entrepreneur, there are a lot of factors that figure into your success or failure. Some you control and most you don’t. Macroeconomics is one that you certainly don’t. So if, like me, you believe in worrying only about the things you can control, then this is a great time to get focused on building your business and stop fretting about the economy (see Focus on the Controllables).

In fact, a recession is probably the best time to start a company. Great companies like Disney, GE, HP and Microsoft were all started during recessions. As the clever folks at Google like to say, “creativity loves constraints”.

Why?  Bad times can build good DNA.  A down economy does not leave room for entrepreneurial sloppiness. It forces entrepreneurs to be honest about how good their products are. It mandates financial discipline. In other words, it is a perfect time to get focused, get real and get lean.

After the giddy NASDAQ highs of March 2000, it took most people way too long to come to grips with reality. I had personally just joined the venture business and my first company, Evolve Software, went public in August 2000 – a full half year after the peak. Most companies did not start cutting back until late 2001 and by then it was too late. The smart and lucky ones survived the ensuing five years and some became big winners. But most companies just ran out of money and ran out of time.

The rules

Plenty of smart people have already made prudent recommendations to their teams about what to do in this environment, so I won't repeat. See in particular Sequoia’s doom and gloom presentation to their portfolio CEOs earlier this week and Jason Calacanis’ email. But let me summarize with just two simple rules that we've tried to impress upon all of our CEOs:

Rule #1: Don’t run out of cash.

Rule #2: See Rule #1.

Then, go out and build the next great company.

Financial Weapons of Mass Destruction

The events of this past week made me scrap the article I was working on to write about the crisis in financial markets.

Warren Buffet first wrote about "Financial Weapons of Mass Destruction" in Berkshire Hathaway's 2002 annual report. When it was published in March of 2003, there was quite a bit of press coverage, as there is every year after he publishes his annual letter to shareholders.

In an article written by the BBC, Buffet warned of "time bombs." It seems like the first of many bombs went off a couple of years ago, with the decline of the housing market (and housing stocks), leading up to many more bombs in the past few weeks.

If you read his words, Buffet is quite vivid. His warning was not about the housing bubble or sub-prime loans or even the trillion dollars in CMOs (Collateralized Mortgage Obligations), the pass-thru assets which helped create the mess in the banking industry. Buffet was criticizing ALL derivatives.

Warren Buffet thought some derivatives contracts must have been devised by "madmen." Charlie Munger would say it was sheer lunacy. Buffet talked about "mass destruction" and "spirals that can lead to corporate meltdowns" such as the one which took down LTCM in 1998. Buffet warned of "huge scale fraud" and compared the ENTIRE derivatives business to "hell...easy to enter but almost impossible to exit."

Despite the simplicity and clarity of Buffet's words, few people listened. Even now, people don't seem to understand the magnitude of the potential problems that lay ahead in the global financial system. The derivatives market has grown exponentially since 1998, the year LTCM blew up. The global derivatives market is now more than $500 TRILLION, up more than 10x since Buffet's initial warnings.

So my question is this: how is a $700B or even a $1 Trillion bailout by the US Government in the mortgage market going to make a dent in the overall $500 TRILLION dollar market of even more complex, esoteric derivatives contracts???

How depressing. This is why, as a VC, I don't usually think about or comment on macroeconomic issues. Entrepreneurs and VCs build one tiny little business at a time...and once in a while some of those turn out to be winners that impact the lives of millions of people.

Believe it or not, I'm still quite optimistic about our future. We will get through this. This is nothing like disease, famine or war (at least, there is no war on our soil). There are many companies that are still growing and generating profits and cashflow here in Silicon Valley and around the world.

Most start-ups have no exposure to derivativew contracts and little exposure to the overall financial markets. Yes, the IPO market is closed (for now) but if you have a company which generates cash, you will be fine.

For example, one of our companies - one which has been private for more than 10 years - recently issued a cash dividend which paid out more than our entire investment, just as they did last year. They generate multiples of that dividend in free cashflow every year. Every acquisition they've ever made was paid in cash so I'd suspect that they can continue to fuel organic growth as well as future acquisitions. If they continue to generate cash and pay out more than invested capital every year, it would not be so bad, would it?

If you are counting on bubbles or "madmen" to pay crazy prices for your company when you raise capital or when you try to "exit" you will be sorely disappointed in the coming years. You might even wind up in unemployed lines along with those well educated investment bankers. But if you have a real business, one which delivers value to customers who will keep coming back over and over again, I suspect that you will do just fine. Just keep focused on what you are doing and don't get distracted by the macro issues that seem to swing paper valuations wildly day to day.

The macroeconomic problems we face today are issues that even Warren Buffet can't figure out. That hasn't stopped him from going about his business every day. Those hedgehogs just keep moving forward one step at a time. Since that BBC article in 2003, Buffet has increased his net worth by more than 50% to overtake Bill Gates as the wealthiest person in the world.

Ousting the Founder

I was shocked to learn this week that Diane Greene, the co-founder and CEO of VMWare was ousted. I was not alone. Except for senior management (who found out very late, the night before) the employees of VMWare read about it, just like I did on Tuesday morning.

I guess $1.3B in revenues, $14B market cap, 50% growth rate and market dominance was not good enough for the board/EMC. One slight miss in one quarter and BANG! You're out. Perhaps the board believed industry pundits and worried about competition from Microsoft. So they brought in a "heavy hitter"...former Microsoft exec Paul Maritz as CEO.

I'd guess that the more likely reason was that Diane Green was a difficult person to deal with. There is no doubt that she was a controversial CEO. It was her way or the highway and she churned through senior execs (especially in sales and marketing). She never gave much respect to the folks at EMC either (who owned the vast majority of the stock - and controlled the board).

Some other hard-headed, "controversial" founder/CEOs that come to mind are Bill Gates, Larry Ellison, and Steve Jobs. These founders may be difficult to deal with but I'd rather go with them than take my chances with a new hired gun CEO.

Over the years, we've observed that it's difficult, if not impossible, to match the passion and commitment that founders bring to their companies. It's not just a job for them. It's deeply personal. The difference in commitment is akin to the differences you might observe between missionaries and mercenaries (or hedgehogs versus foxes).

Look, I have nothing against Paul. I'm sure he's a very smart, capable and hard working guy. But this whole situation reminded me of the time Steve Jobs was ousted from Apple more than 20 years ago.

As co-founder and CEO, Diane Green built one of the all time great successes in Silicon Valley. Very, very few companies ever reach $1B in revenues. Even fewer in the technology industry. Even fewer in the software industry. And even fewer ever exceed $10B in market cap.

Why the hell would you fire her?? No, don't tell me...I've heard all the reasons. VCs oust founders all the time. I've been in plenty of board level discussions around this topic!

It's almost a rite of passage in Silicon Valley. As a founder, you start a company, get VCs to fund you, recruit a "world class" management team...and eventually, find your replacement (or get ousted).

What people seem to miss, however, is that just about every great company ever created - in technology as well as low-tech, was built by a founder (or a CEO who happened to join the company very early in its growth phase) and a team of dedicated people who grew with their companies.

I don't believe in "world class" management in the generic sense. "World class" in what??

What I believe in is people who learn on the job and become - over time - the best at what they do. Along the way, they make plenty of mistakes. But that's part of the learning (and perhaps the luck of it - because the mistakes happen to be not fatal for the survivors).

Think about it. Some examples of great companies led by founders for decades are GE, UPS, FedEx, Wal-Mart, Southwest Airlines, HP, Intel, SAP, SAS, Apple, Oracle, Microsoft, Adobe, Sun, Dell, Qualcomm, Broadcom, Nvidia, Dolby, Amazon.com, Salesforce.com, etc.

There are some great companies where the original founder(s) did not grow the company but the CEO who grew the business to $1B+ in revenues joined very early on in the life of the company (typically below $10mm in sales): IBM, McDonald's, Starbucks, Veritas, Cisco and Google are examples.

It'll be interesting to see what happens. Even a founder hanging on to the bitter end won't save some companies (i.e. Wang, DEC). But I'd rather take my chances with the founder who built a $1B business from scratch than go with someone new.

The average tenure of the CEOs in our three largest companies is 9 years. They learned on the job. None of them had been CEO before we started working with them. None had much experience in their industry - the market did not exist, and the technology and business models had not yet been invented. But they are guys who took us this far (average sales of nearly $90mm this year) and we will gladly stick with them as long as they still want the job.

I'd rather take my chances with the people who built the business and grew their companies than the "professionals" - the hired guns - the mercenaries - coming in, after the fact, to "fix" things or to "take it to the next level."

We tell all of our companies this - if you want to build the leader in your industry, you have to have the world's leading experts in your field working for you. But do NOT expect to find them outside of your company. Someone senior from the outside won't come in to show you the way. They won't save you.

Think about it. If you can go outside and hire a CEO or other very senior executives to come in to YOUR company and tell you what to do and how to do it - better than you - then you've created nothing special. There is no secret sauce and you have NO CHANCE of building a truly great company.

We like to tell all of our companies this - the world's leading experts in your business will be the people you develop. The young people you hire today will be your future leaders. Five to ten years from now, they will BE the world's leading experts in your business. You will have to figure it out - together - along the way.

Don't count on those mythical "world class" managers to come in to save the day. Not only are there no guarantees, I believe they will end up hurting your chances of building a special, lasting company. If you do try to hire them anyway...good luck. What I will guarantee is this - they will negotiate HARD for a nice severance package.

Monkey See Monkey Do

A few weeks ago, a fascinating New York Times article described observations of morality in the behavior of apes. For example, Chimpanzees, who cannot swim, have drowned in zoo moats trying to save others. Given the chance to get food by pulling a chain that would deliver electric shocks to a companion, rhesus monkeys will starve themselves for days.

Apes are social creatures. So for the good of the species, evolution has wired them to act in unselfish ways which can be interpreted as moral or ethical. Since we are also social creatures, it might be nice to think that perhaps humans have also developed "good" DNA like those apes.

With the invention of language, logic and technologies (such as the printing press, invented almost six hundred years ago), human societies and cultures have been evolving at rates far faster than evolutionary pace. Even though culture is a human creation rather than a biological one, culture now has a powerful influence over us.

For example, economists demonstrated the influence of culture by studying data from New York City on parking tickets issued to U.N. diplomats. From an economic point of view, diplomats should not care how many tickets they get (due to diplomatic immunity). However, according to the data analyzed between 1997 to 2002, certain diplomats committed hundreds of violations while "not a single parking violation by a Swedish diplomat was recorded...Nor were there any by diplomats from Denmark, Japan, Israel, Norway or Canada."

The reason for such wide variations is that we are not merely products of DNA or economics. Human beings are shaped by cultural and moral norms. According to the article, "if you're Swedish and you have a chance to pull up in front of a fire hydrant, you still don't do it. You're Swedish."

I'm no expert on Swedish culture, but I'd guess that there is a sense of honor and values which influence behavior more so than rules and regulations. In fact, Sweden perennially ranks among the least corrupt in Transparency International's Corruption Perceptions Index.

In modern society, I believe there is a third powerful influence - it is the culture of our workplace. The corporate entity is a relatively new invention dating back to the mid 19th century. Before then, liability was not limited to a corporate entity so owners and managers often risked all of their personal reputation and assets. (What would happen to the venture capital industry if we had to risk far more than invested capital?).

An example of a company with a powerful culture is Toyota (now worth more than GM, Ford, and Chrysler combined). According to Michael Cusumano, a professor of management at MIT, “the founders and the managers created and refined Toyota company culture, which is far more powerful than Japanese culture. It does build on many things that are Japanese — precision, quality, loyalty. But the Toyota culture dominates.”

With corporate scandals over the past few years our confidence in corporations has been shaken. Isn't it ironic to think that apes may have a sense of right from wrong, but humans need more and more laws and regulations? It seems a whole new profession is thriving these days - that of corporate ethics and compliance officers.

Unfortunately, I think we are barking up the wrong tree. New ethics and compliance officers won't shape human behavior any more than new regulations, motivational posters or "core values" statements on plaques. Anyone who has worked for different companies knows that companies have very different and distinct cultures. Whether good or bad, corporate cultures influence behavior.

In the "HP Way", David Packard did not talk about ethics and morality (and certainly not about compliance). He did talk about values - integrity was presumed. Packard promoted mavericks - people willing to buck the system and go against the rules (in order to create a great product and rise above bureaucracy). But when it came to ethical issues, everyone knew Packard had a "zero tolerance policy."

Both Hewlett and Packard set the tone for decades. HP was a highly ethical company long before there was a "Chief Ethics and Compliance Officer" (a new position created by Mark Hurd, after the recent board scandal). So where did they go wrong? As a society, where did we all go wrong? Answering such questions probably requires a book rather than this short blog post.

As VCs, we work with entrepreneurs and managers who shape the culture of companies from day one (whether they intend to or not). For example, I recently noticed that one of our companies has a peculiar culture - most employees get to work by 7:30am. That's unheard of in Silicon Valley, especially for engineers. Well, it turns out that the founder is an early riser and often gets to work by 4am. That company had only one employee last year. Now that it has a few more people, we can start to see the culture forming. (It'll be interesting to see how it evolves).

Over the years, we've observed that the behavior of management has a huge influence on the values and cultures of companies (what they DO, not what they say). If we want more honorable behavior by corporations, we don't need more regulations (and we don't need more compliance officers). What we need is better leadership. Character, integrity and leadership should go hand in hand. Being ethical is also more profitable in the long run. (Even merchants and traders from centuries ago figured out that a great reputation was the only way to build a great business).

Entrepreneurs have always had huge influence over the rate of innovation and the growth of world economies. I believe they can have even a more profound impact. Just as DNA can impact entire species starting from a single cell, start-ups can be the beginning of new corporate entities which can change our lives. It is much easier to get it right from the beginning than it is to change a fully grown entity. Entrepreneurs are the future. They can set the tone with the example they set in the companies they build.

The Future of Software

According to Mark Benioff, the founder of Salesforce.com, the future of software is no software. It's a catchy slogan (Salesforce.com's phone number is 1-800-NO-SOFTWARE) but sticking to such a statement might make Benioff a modern day Henry Ford (who once declared that customers can have any color as long as it is black).

Most of us have already experienced the future of software - and it looks like iTunes, not Salesforce.com (who doesn't have an iPod these days?). But before explaining, let's do a quick review of how we got here.

As the technology industry evolved, it has served wider and wider audiences. Decades ago, it was engineers making products for each other - like HP's engineers making products for the guy sitting at the next bench. The next wave was driven by businesses, culminating in Y2K (even Netscape, the company which helped kick-start the whole Internet revolution, made most of its money from businesses). In the latest wave, consumers are driving the tech industry. When Benioff started Salesforce.com, his inspiration was Amazon.com and eBay not Oracle or SAP.

However, over the past few years, we've seen hackers and entrepreneurs pushing exciting new frontiers and the more I think about it, the software industry will be taking its cues from iTunes, not Salesforce.com.

As Yogi Berra says, it's deja vu all over again. At first, we started with big servers connected to dumb terminals, then we had client-server computing, and then web based computing (i.e. back to thin clients). Now it's back to fatter clients (again).

How fat?

Well, it depends on the application. Hackers are just too creative to be tied down with the "no software" model. Clever hackers working on Google Maps blew away Mapquest using AJAX which makes supporting different browsers and operating systems a whole lot more complicated. But the increased trouble is worth it, from a user's perspective.

However, this is just the first step. We have been seeing an incredible array of new plug-ins, widgets, toobars, and applications which require new downloads and installations. The real developers are back - over-paid script editors can step aside. Companies with talented developers will have serious competitive advantages over Web 2.0 companies that are long on hype but short on technology.

With broadband, multi-megabyte pieces of software can be easily downloaded, installed, and updated and, if done right, they will drive faster adoption and more stickiness. For example, in Korea, PandoraTV (one of our portfolio companies) started by providing a YouTube-like video service. They are now also connecting to proprietary client software on PCs as well as cell phones to millions of users. They are quickly moving up the traffic rankings and were named company of the year (the founder was also named entrepreneur of the year by the Korean tech press).

But wait, there's more - much more!

The real inspiration for this article was not "more software" vs. "no software", but new business models being developed by clever entrepreneurs. It's the combination of hacker creativity AND business model innovation which will revolutionize the software industry.

In the past, high prices for software were required to cover sales and distribution costs. It was like the old door-to-door salesmen selling encyclopedias. (High margins for encyclopedias were needed to cover sales costs, not the marginal costs of updating and printing encyclopedias - which, like software, is relatively low).

Salesforce.com's on-demand, recurring revenue model is better than the outdated perpetual, per-CPU licensing models of SAP and Oracle. However, most SaaS (software-as-a-service) companies are still stuck with per-user or per-seat licensing models which are bound to get blown away by new, more innovative (and disruptive) business models.

To explain the second half of the new software revolution (the business model revolution), let's go back to the iTunes example.

iTunes is free.

The concept of free software is nothing new to proponents of open source software - but the new software revolution has little to do with it. We will see hundreds of new "free" software companies that do not participate in the open source community. The way that Apple makes money from iTunes is through the use of its software and the ecosystem built around it. To date, Apple has sold over 2 billion songs. Not bad considering you can still download those songs from P2P networks for free. They've also sold 50mm TV shows and, within the first few months of launch, they sold over a million movies even though only 100 movies were available. iPods are great (the 100 millionth unit will be sold this year) but what gets customers hooked is the software.

Pulling another example out of Asia, there are dozens of game developers that make millions (sometimes hundreds of millions) of dollars giving away free Internet games. What they charge for are "virtual goods" sold to millions of addicted users. Virtual goods include virtual clothing, music or game elements (such as an upgraded car in a racing game) which help improve game play or one's chances of beating competition.

Buy the song, not the album.

The biggest winners will figure out how to make money through smaller and smaller increments of value. Google's model of charging pennies per click is a good example. The bottom line is pricing must be low (i.e. not vulnerable to disruption) and it must be more directly aligned with value. A great example is Vertical Response, a bootstrapped and profitable email marketing software company, which charges based on the number of emails sent. An enterprise can have an unlimited number of users - the price is the same. Their model is more rational - and highly disruptive to companies selling software the old way.

Content is king.

In the old days, maybe software was more product oriented. For example, tools, operating systems, Word or Excel didn't include knowledge or content - users supplied it. Then as applications became more sophisticated they possessed embedded knowledge or "domain expertise" (examples include QuickBooks, SAP, or Salesforce.com). iTunes takes it a step further.

In the future, software's value may be so linked to content (and data), that it won't be clear which is more valuable - the software or the content? Going forward, software companies will look more like content companies and content companies will have to develop more software (or partner with software companies) to monetize their proprietary content more effectively. iTunes and Google are good examples. So is Xignite, one of our portfolio companies, which provides tools and Web services that stream financial data into applications and websites (they were also bootstrapped and profitable without VC funding).

Xignite doesn't just provide tools for developers. They offer content from their own databases as well as serve as a conduit (and new distribution channel) for a growing list of content partners. You can think of them as a next generation Bloomberg. However, unlike Bloomberg, most of their customers are not from the financial services industry (which is yet another sign of disruption - new users who could not or would not pay for Bloomberg terminals are becoming customers).

Another example from our portfolio is DemandTec, an on-demand software company which analyzes POS (point of sale) data from retailers and makes recommendations on pricing and promotions of products. They combine knowledge gleaned from transactions with market research data (from partners like Nielson) to provide unique insights. They also connect networks of retailers (like Safeway) and manufacturers (like P&G) to solve cross-organizational issues like the thorny out-of-stock problem on retail shelves (DemandTec's massive server farms analyze over $250 billion dollars of transactions from thousands of stores per year on behalf of their customers).

Get better faster.

The next generation of software connects developers directly with customers (not just through PCs but through all sorts of devices and gadgets). There will be no such thing as shelf-ware. If the software doesn't deliver value, software and service providers won't get paid (based on new pricing models). If new software does deliver value, it will be used and usage data will prove to be very valuable to developers. They can do market research everyday or every hour. Doing A/B testing is common practice at companies like Amazon.com and Google. Software companies that follow their lead will get better faster than their competition.

Over time, the usage data itself can become killer content. One of our companies, Instill, started by enabling restaurants to buy supplies online. Now they also make millions of dollars selling market research data (about the food services vertical) to manufacturers such as Coca-Cola. Likewise, if Apple stays alert, they should be able to monetize the data collected from the iTunes network.

I do have to give some credit to Mark Benioff in that he is experimenting with new business models (i.e. they have a 10% revenue sharing program on App Exchange). But Salesforce.com's problem is that they are addicted to a core-business model which is vulnerable to disruption. Most software models are subject to disruption because marginal costs are essentially zero. (I have already seen some start-ups switch away from Salesforce.com to cheaper alternatives). That is why examples like iTunes, Google, and the other companies I've mentioned (that demonstrate new ways of monetizing software) are so interesting.

Ironically, Salesforce.com is a victim of its own success. They can't change their core business model because their whopping $4.5 billion dollar market cap depends on it. This is the trap (and treadmill) that Netscape fell into after their hot, hot, hot IPO. They grew spectacularly (faster to $100 million than any software company since Lotus, which grew faster than even Microsoft). But they were hooked to a business model vulnerable to disruption (when Microsoft decided to give away browsers). If Netscape had been a bit more patient and kept their burn rate under control, rather than ramping up a loser model, they might have been able to figure out other ways to monetize - they could have been a Yahoo or Google (a decade ago, Netscape had more traffic than any website on the planet).

For entrepreneurs as well as venture capitalists, this is all great news. We don't have to be addicted to old business models. We can experiment and try new ones and we can afford to not only survive but thrive on much smaller revenue streams (if we keep burn rates low!). The Salesforce.coms of the world will have a very hard time switching models just as the companies before them found it difficult to switch away from their entrenched business models and practices.

In summary, as we evaluate new software investments, our firm looks for the following characteristics:

1. Easy to use (the bar is getting set much higher, must deliver compelling user experience, not fancy unused features. Solve real problems - duh!)
2. Easy to try (if download is required, should be easy to install and update)
3. Easy to buy (transparent pricing, terms and conditions. No hassle purchase - self-service option, no negotiation necessary)
4. Business model innovation (monetization in smaller increments, through actual use and value. No shelf-ware!)
5. The melding of software, content, and service (usage data can also be very valuable)
6. Increasing efficiencies and value through network effects (scale leading to snowballing competitive advantages)

The Joys of Compounding

"Someone who was compounding money at a high rate, I thought, was the better party to be taking care of the philanthropy that was to be done 20 years out, while the people compounding at a lower rate should logically take care of the current philanthropy."
        - Warren Buffet (commenting on why he waited so long to give away money)

On June 25, Warren Buffet made headlines when he announced that he had committed 12 million B shares of Berkshire Hathaway (worth over $42 billion) to five foundations. Most notably, the Bill and Melinda Gates Foundation will receive 10 million shares (to be disbursed 5% per year).

Soon after that, a friend with whom I've attended many Berkshire shareholder meetings sent me copies of letters written by a young Warren Buffet from 1957 to 1970, when he was managing money for limited partners. These letters reveal the modest beginnings of the world's wealthiest investor:

"Buffet Associates, Ltd. (predecessor to Buffet Partnership, Ltd.) was founded on the west banks of Missouri, May 5, 1956 by a hardy little band consisting of four family members, three close friends and $105,100."

Who put up the $100? It was Warren Buffet, "the General Partner putting his money where his mouth was." He was 25 years old at the time. By the time he decided to liquidate the partnership, Buffet had amassed a net worth north of $25 million thanks to his share of profits over the years (Buffet got 25% of all profits above 6%). That small fortune is now worth roughly $50 billion thanks to Berkshire's growth over the ensuing decades.

Reviewing Warren Buffet's track record is a simple way to illustrate the power of compounding. Virtually all of his fortune is due to the compounding of just one number - Berkshire Hathaway's stock price (the A shares, which have never split). His salary and bonus is only $100,000, less than 1% of what average CEOs of multi-billion dollar companies make, he has never received stock options or grants, and until recently (due to the commitments to foundations) he has never sold.

Buffet's letters reveal that he started buying Berkshire in 1962 at $7.60 per share. He kept buying and acquired control in 1965. As we approach the end of 2006, those shares trade at $105,200 per share (plus or minus a thousand or two). This represents an increase of 24.2% per year over 44 years (a gain of 13,847x).

To hit the point home on compounding, Buffet's letters provide three amusing examples. In his 1963 letter, he included a section entitled "The Joys of Compounding":

"I have it from unreliable sources that the cost of the voyage Isabella originally underwrote for Columbus was approximately $30,000. This has been considered at least a moderately successful utilization of venture capital. Without attempting to evaluate the psychic income derived from finding a new hemisphere, it must be pointed out that even had squatter's rights prevailed, the whole deal was not exactly another IBM. Figured very roughly, the $30,000 invested at 4% compounded annually would have amounted to something like $2,000,000,000 (that's $2 trillion for those of you who are not government statisticians) by 1962."

The next year (1964), he wrote the following:

"Since the whole subject of compounding has such a crass ring to it, I will attempt to introduce a little class into this discussion by turning to the art world. Francis I of France paid 4,000 ecus in 1540 for Leonardo da Vinci's Mona Lisa. On the off chance that a few of you have not kept track of the fluctuations of the ecu, 4,000 converted out to about $20,000.

If Francis had kept his feet on the ground and he (and his trustees) had been able to find a 6% after-tax investment, the estate now would be worth something over $1,000,000,000,000,000. That's $1 quadrillion or over 3,000 times the present national debt, all from 6%. I trust this will end all discussion in our household about any purchase of paintings qualifying as an investment."

In 1965, he wrapped up his multi-year treatise on compounding with the following analysis:

"Our last two excursions into the mythology of financial expertise have revealed that purportedly shrewd investments by Isabella (backing the voyage of Columbus) and Francis I (original purchaser of Mona Lisa) bordered on fiscal lunacy. Apologists for these parties have presented an array of sentimental trivia. Through it all, our compounding tables have not been dented by attack.

Nevertheless, one criticism has stung a bit. The charge has been made that this column has acquired a negative tone with only the financial incompetents of history receiving comment. We have been challenged to record on these pages a story of financial perspicacity which will be a benchmark of brilliance down through the ages.

One story stands out. This, of course, is the saga of trading acumen etched into history by the Manhattan Indians when they unloaded their island to that notorious spendthrift, Peter Minuit in 1626. My understanding is that they received $24 net. For this, Minuit received 22.3 square miles which works out to about 621,688,320 square feet. While on the basis of comparable sales, it is difficult to arrive at a precise appraisal, a $20 per square foot estimate seems reasonable giving a current land value for the island of $12,433,766,400 ($12 1/2 billion). To the novice, perhaps this sounds like a decent deal. However, the Indians have only had to achieve a 6 1/2% return (the tribal mutual fund representative would have promised them this) to obtain the last laugh on Minuit. At 6 1/2%, $24 becomes $42,105,772,800 ($42 billion) in 338 years, and if they just managed to squeeze out an extra half point to get to 7%, the present value becomes $205 billion.

So much for that."

Conventional wisdom is that it is impossible to beat the market by large margins for really long periods. So how did Buffet do it for four decades?

Most people consider Buffet as the greatest value investor of all time (certainly the wealthiest). In the world of venture capital and private equity, investors try to differentiate themselves as "value-add investors" and LPs have bought that pitch investing hundreds of billions over the years. But no-one has come close to matching Buffet's track record for so long.

As it turns out, Buffet is also the ultimate value-add investor. As the CEO of Berkshire for 36 consecutive years, the longest tenure of any CEO of a large company, he has built a $100 billion corporation which will most likely continue to grow for decades. When he retires, his job will be split in two - one person in charge of the operating businesses and one in charge of investments.

As CEO, Buffet has led and built one of the most admired corporations in America. In his own words, "Berkshire Hathaway is the company I wanted to create. It's not the company Alfred P. Sloan wanted to create. It fits me. I run it with our investors and managers in mind, but it is designed to fit me." It has also been one of the most consistent value creation machines in the world. According to annual reports, Berkshire's per-share book value has grown at 21.5% per year for 39 years (1965-2005). Such compounding is even more remarkable when considering that it was accomplished after-tax. During that time, the intrinsic value of the company has grown at an even faster rate resulting in the corresponding rise in stock price.

In the venture capital world, entrepreneurs and investors strive to grow companies and the value of their investments at very high rates. However, in our next post, we will discuss how the power of compounding, as simple as it is, still seems to be tough to grok for most people.

Lessons from Korea

The following article written by Brendon Kim, one of my partners at Altos Ventures, was published by the Software Development Forum in August. I thought I'd post it here also.

Korean Petri Dish

Take 16 million households composed of 47.5 million people and give 75% of them broadband Internet access – access that is at times 20X faster and much cheaper than what we find in the United States – and interesting things will happen. South Korea has often been described as a Petri dish for developments in the Internet.

Over the past few years, the partners at Altos Ventures have spent a great deal of time thinking about, visiting and building relationships in Korea. We have observed that, indeed, interesting things are happening. Many of the most successful Internet companies in Korea have pioneered new behaviors and new business models and while not always directly applicable, there are lessons for Silicon Valley.

We have also observed that most of the better Korean startups share some common characteristics – characteristics we like to see in U.S. companies. NHN Corp. is testament to the notion that local knowledge will beat global expertise. NHN runs Naver.com the leading search engine and portal in Korea. Google and Yahoo may dominate in the United States, but they are mere also-rans in Korea. Naver relies on the familiar advertising revenue model, posting $228 million in online ads last year, almost 40% of the market. What are not so familiar are the results of a search on Naver. In addition to the standard list of links to websites, Naver posts links to other types of documents such as blogs, maps, dictionary entries and books. All well and good, but the most distinctive feature and arguably the reason why Naver is more popular than any other search engine is Naver’s pioneering use of user-generated content – truly local knowledge. Naver encourages users to post answers to queries from other users. Responses are rated by other users and catalogued. Responders are also ranked and given stature in the community. Ask a question about anything, say raising a puppy, and often, the most complete and popular answer comes from another user. Other engines have started to offer this feature, but Naver has such a commanding lead in the number of user entries, that it is difficult, if not impossible, for others to catch up.

Years before young Internet users in the United States were creating profiles in Myspace, Koreans in their teens and twenties were posting homepages in Cyworld. By some estimates one out of four Koreans or 90% of all Koreans in their twenties have a Cyworld homepage. When meeting for the first time, it is not uncommon for people to exchange Cyworld addresses rather than email addresses or phone numbers. The community has developed its own culture and customs. For example, ignoring comments from visitors to your home page is considered extremely rude and you can be pilloried for it. This encourages people to be very active participants in the community.

Cyworld’s revenue model is also pioneering. Basic services are free, but the site generated close to $200 million in revenues in 2005. A large portion of revenues comes from the sale of dotori (acorns), Cyworld’s virtual currency. Users spend dotori to buy virtual objects to decorate their homepage “room” and accessorize their avatars, one upping each other. Rooms might be enhanced with a digital TV or couch or flowers. Avatars might be dressed in the latest fashions or jewelry – all for a few dotori, which eventually add up to a lot of real money. Members are known to spend hundreds of dollars a month on these digital items and countless stories have been told of teens that have been punished by their parents for going too far.

The items selling business model generates revenues (and profits) for the Korean online gaming company, Nexon. Nexon posted well over $200 million selling digital avatars and accessories last year. Among other games, Nexon developed Kart Rider, an online hit in which players race each other in cartoon graphics gocarts. The company claims that nearly one out of four Koreans have played the game and that over 200,000 players are racing at any given time. Races have even been broadcast on cable. With the support of real world sponsors, some have made Kart riding their profession. Nexon does not rely on any subscription revenues; Kart Rider is free to play. Instead, the game charges you for items – accessories, such as missiles to take your opponent out of a race, balloons that lift your kart out of a missile’s way, smoke bombs that cloud your opponents’ vision, goggles that help you see through smoke and performance enhancements to make your cart perform better. The game is simple to play and just minutes a race, so it is easy to get hooked. Every time you lose to a better equipped player, the more you want to level the field or gain advantage and the more you want to reach into your wallet.

Pandora.tv is Korea’s leading video destination on the Web. (Pandora is an Altos Ventures portfolio company.) The company was established months before YouTube in the US. Early on, Pandora’s founder, Peter Kim, saw that some of the most popular sites in Korea revolve around self expression. Cyworld was an obvious case in point and to some extent, so was Naver. So, unlike many other video sites, Pandora was designed to be more about self expression and less about video sharing (although you can certainly do that too). Pandora is mainly organized around channels that members make their own with a collection of videos that expresses their characters or interests. The site posted 300 million page views in June, doubling page views in just three months.

Pandora focused on generating revenues from the start and experimented early with several business models. Pandora derives revenues from a number of sources: pre-roll advertising, where an ad is played before a requested video; consumer subscriptions, where users pay for higher bandwidth; content distribution fees; and “brand channel” sales, where businesses buy a channel for commercial use. Brand channel customers include major corporations such as Reuters, small businesses, churches, schools and even politicians. At the time of our investment, Pandora was already at cashflow breakeven with minimal outside funding.

NHN, Cyworld, Nexon and Pandora innovated in varied ways but they shared some similar characteristics when first starting up. Based on our observations, many of the better Korean companies also share these qualities. At Altos we look for these same characteristics in U.S. companies.

• The company is capital efficient. The venture industry in Korea is not as well developed as that in the US and early stage venture capital is scarce. As a result, most entrepreneurs are forced to bootstrap, looking for revenues early and keeping costs low. Capital efficiency is built into the DNA of the company and the team.
• The company continually experiments and tinkers with the business. Koreans are said to have a cultural bias towards action and learning by experience over data collection. Companies innovate over time by experimenting, learning and implementing the learning.
• The entrepreneur is extremely focused and single-minded, much like a hedgehog. For a country of 47.5 million people, the startup community is surprisingly small and reputation is everything. The entrepreneurs we like have a reputation for being thoroughly committed, headsdown, execution-oriented and interested in creating an enduring business with a solid business model.

In the last several years, Korea has emerged as an innovator in semiconductor manufacturing, wireless, consumer electronics and the Internet. The country is not about to stop here. Korea is in the midst of a major five year government sponsored technology program, the 8-3-9 Initiative, designed to keep Korea on the cutting edge of technologies such as IPv6, 3G/4G wireless, wireless broadband, mobile broadcasting, RFID and digital television. Korea is enjoying its recent role as innovator and Petri dish and we would benefit by keeping an eye on the growing developments there.