Altos Ventures Musings

The First Breaking Point

This is the second in a series of posts discussing rapid growth. The first post talked about the idea of startups as temporary organizations focused on “discovery” rather than “execution.” The successful ones grow to become companies that can deliver consistent results.  

In the venture capital industry, a startup experiencing rapid initial growth looks exciting. Ironically, this is usually when the first breaking point is reached. For example, according to this article about The Maturation of Mark Zuckerberg, even at a company as successful as Facebook, the grumblings started with as little as 25 people, just after a $12 million financing.

The Successful Startup Phase

When a company is tiny, communicating is easy. Everyone knows what’s going on. Everyone knows each other and dialog flows naturally across all levels. Talking to or hanging out with the CEO is not so intimidating. People may not have formal job titles but it doesn't matter because most people wear multiple hats and they do what it takes to get the job done.

There is no need to show off one’s knowledge. People know what you can do. People admit mistakes and acknowledge when they don’t know something. There is no defensiveness because everyone is focused on learning. The entire company is in “discovery” rather than “execution” mode.  However, nothing happens at a startup until someone does something. Execution does matter, even on day one. If someone doesn't pull his or her weight, word spreads fast and something is done about it. It's a matter of survival.

There is tremendous sense of urgency as people race against the clock to make something happen before time or money runs out. Startups get things done with impressive speed. Even with no business (or even a business model), everyone is committed to a common mission - it can be as vague as "put a ding in the universe." There is clarity and commitment around what needs to happen - like building a product or taking care of customers – so everyone is focused on getting things done rather talking about it. Meetings, if held at all, are usually short and informal. There are no politics, no competing agendas or competing business units fighting over resources.

The First Breaking Point

Force of personality and brute force might be enough to get the job done when a company is small but there aren't enough hours in the day or night. Due to growth – in customers, employees and complexity - things can feel out of control for the first time.

Around this time, startups feel an urgent need to switch into “execution mode.” The vast majority of dollars in the venture capital industry is invested after significant “traction” – evidence of rapid market adoption. Post funding, expectations can run high as new investors want to see companies “execute” and deliver results.

As startups shift into execution mode, doubts about management’s capabilities can creep in. This is not just investors’ doubt. It can be about co-workers and even self-doubt. If a company believes it is in execution mode, patience can run thin, especially if the burn rate is high. Every time plans change for the worse, credibility takes another hit. Explanations are seen as excuses. Investors hate surprises and so does everyone else, when in execution mode.

Eventually, there may be a push to hire executives who have “been there and done it before.” In Silicon Valley, ushering in “adult supervision” is almost a rite of passage. Unfortunately, after burning through more time and money, people realize that the business is not (yet) predictable, no matter who is in charge.

In the meantime, there may be subtle changes that lead to a cultural shift. New managers who are hired for their expertise may not have the agility or mindset of early employees. In the quest for predictability, risk taking may get snuffed out.

In contrast, in the early days, projections were seen as guesses. Plans were hypotheses that needed to be tested and validated. Negative surprises were seen as opportunities to learn and grow, rather than opportunities to cast blame in order to hold someone “accountable.”  

Reset Expectations

Getting through the first breaking point is not about rushing into execution mode. It’s a gradual process that will never end. A framework we’ve found useful in assessing progress along a continuum is the Capability Maturity Model (see the five levels of maturity below). It’s a development model whose origins trace back to studying software projects (and failures) in the 1960s when computer science was in its infancy and few “best practices” existed. Within any company, there will always be processes at different levels of maturity. It's important to keep in mind that even successful large companies will have chaotic episodes and continue to live with countless undocumented, ad hoc processes that are developed and refined over time. 

1. Initial - the process is new, ad hoc, chaotic and undocumented. Individual heroics are relied upon to get the job done. The focus is on outputs.
2. Repeatable - the process is somewhat documented. Repeating the same steps may be attempted. It’s not clear if the process will yield desired outputs.
3. Defined - the process is well defined, documented and confirmed as a standard process that can produce results.
4. Managed - the process is quantitatively managed in accordance with agreed-upon metrics.
5. Optimizing - process management includes deliberate process optimization and improvement. 

Conclusion/Lessons

• All growing companies go through the first breaking point so don’t panic and don’t over-react.
• There is no single moment in time in which a company switches into execution mode.
• Reset expectations. There are no short cuts to repeatability and predictability. It will take time, iteration and constant tuning.
• Remember essential qualities from the startup phase that will continue to be important.
  • Continue to balance discovery and execution. Focus on learning rather than blaming.
  • Get clarity and commitment around shared goals. Look out for political behavior and stomp it out.
  • Focus on getting things done. Output is more important than process. 

Replacing CEOs

I regret to say that I've personally served on a dozen boards of venture backed companies that have replaced CEOs. It's usually not a good sign. It doesn't mean those start-ups were doomed; but it does mean drastic change was needed.

The decision to replace a CEO is never taken lightly. Replacing any CEO is difficult enough. Replacing a founder/CEO is even more traumatic and fraught with risk.

Although I have never seen a case in which a CEO, even a founder, is indispensable, over the years, my partners and I have formed a strong preference for founders.

Most founders have never been a CEO. Some may have never even had a corporate job (Mark Zuckerberg, for example). Yet we prefer to work with them as they learn on the job. 

I won't get into why we prefer founders (not the main topic of this post) but I'd recommend checking out these articles discussing the merits of founder CEOs: 

• I first wrote about our preference for founders three years ago: Ousting the Founder 
• Ben Horowitz wrote this more recently: Why we prefer founding CEOs 
• Steve Jobs' Law: Why Founders Make the Best Leaders

When my partners and I first got started more than 15 years ago, we replaced CEOs quite often (though I'd esimate it was about average for the VC industry as a whole. I'll share actual data later in this post). In contrast, my eight most recent boards have yet to replace a CEO.

One data point which reflects the presence of founder CEOs in venture portfolios is CEO ownership. When we tell people that the typical CEO in an Altos backed company owns more than twice the equity of a typical venture backed CEO, they assume it's because we invest less money (resulting in less dilution). While this is true, the bigger factor is that most of our CEOs are founders.

On average, the minute a board replaces a founder/CEO, that company's CEO ownership percentage drops. For example, when Eric Schmidt was hired at Google, the CEO ownership stake dropped to 4%, far lower than Larry Page's stake. 

Another reason we replace CEOs less often is selection bias. We are less likely to invest in the first place if we believe a new CEO will be needed. I'm always surprised when a VC submits a term sheet that calls for the retained search for a new CEO from day one.

We'd rather not make an investment, if we don't know who the CEO will be. As the saying goes, "go with the devil you know versus the devil you don't." We must believe, at least in the beginning, that the person we're backing can develop into a great CEO.

In the case of backing a "professional CEO" we must believe that the person has what Warren Buffett calls "owner mentality" (it might not be as good as founder mentality, but it's better than most). 

Of course, this does not mean that we will never fire a founder or replace a CEO. We make plenty of mistakes. To see if we might learn from them, I decided to look at some data from our current and past funds.

After studying a data set of more than 60 companies, I found that the probability of a CEO change increases dramatically with each new round of financing, unless a company is already profitable. A CEO who can control her own destiny is much less likely to get replaced. 

Given that the companies in this data set have raised more than a billion dollars from over a hundred different venture firms, I suspect that there is a similar pattern for the entire VC industry, even if specifics vary from fund to fund. 

In the chart below, each bar represents a group of companies based on how many rounds of funding were required to get to profitability or exit. The height of each bar represents the percentage of companies that replaced CEOs. 

  In companies needing only one or two rounds to get to profitability or exit, CEOs were replaced less than 14% of the time. At the other extreme, if a company needed four rounds or more, the replacement rate sky-rocketed to 85%. For companies that required three rounds, the rate was 53%, which is about average for the industry (see article below). 

Given this data, I'd advise start-up CEOs to get their companies to profitability sooner. Control your own destiny. Otherwise, deliver an exit before you run out of money and have to raise another round. 

Other Factors:

When a CEO is replaced, the rationale is usually quite subjective. "The team has lost confidence" or "lack of leadership" are typical quotes from board members considering a change. 

For me personally, I've learned that my stress level about any particular company goes up and down with confidence in the CEO, regardless of how the company is doing. Let me try to explain. 

Even if a company is doing really well, if I do not have confidence in the CEO, I tend to worry a lot because things might fall apart; and sooner or later, the shit usually does hit the fan.

In contrast, even if a company is struggling, if my confidence in the CEO is high, I stress less because I know there is a smarter and more capable person staying up at night not only worrying about things but doing something about it. 

That said, other than obvious reasons such as lying, cheating or stealing, I believe the following are other, more objective, factors correlated with change in CEOs:

1. Time - eventually, all CEOs retire, die or get fired.
2. Lack of growth - a flat profitable business might be OK for some but not for VC backed companies that promised high growth to investors.
3. Employee turnover - higher than normal turnover happens for two reasons: great people are hired but are repelled or mediocre people are hired and must be replaced. Successful companies typically have turnover rates that are significantly lower than industry averages. 
4. Burn rate relative to cash balance (key metric we track is months of cash remaining)

More Data:

The following article has some interesting statistics. Out of 50 high-profile VC-backed companies in 2010, 54% had replaced founder CEOs: "Do VCs usually fire founder CEOs?" 

I'd also recommend checking out these questions on Quora for more info and discussion:

1. On average how often do founding CEOs get replaced by a VC controlled BoD?
2. How do VCs eventually come to the conclusion that they need to replace the CEO?
3. What skills does a CEO of a growing company need that a founder CEO might not have?

Final Note

I'd like to emphasize that the data points out a strong correlation, not causation. For example, it's possible that VCs are more likely to replace CEOs in companies that run out of money and have to raise more rounds. It's also possible (and very likely) that start-ups that hire professional CEOs tend to raise more money and go through more rounds of funding.

Founders are much more sensitive to dilution compared to professional management that are granted more options if a company goes through a massively dilutive round. Founders also want to maximize control. The biggest fortunes have been amassed by founders who have been able to retain quite a bit of control over their companies, sometimes decades after the IPO.

The punchline of the article should be "get profitable" rather than "avoid the 4th round."

They Can't Tell You How To Soar

Customers will always tell you they want better products and lower prices. They might even be able to articulate how much better certain products should be. But don’t expect them to be able to tell you how different those products could be. More importantly, don’t expect them to tell you how you should surprise and delight them.

This was an insight from a book called Different, Escaping the Competitive Herd written by Youngme Moon (I won't review the book but I'd recommend it for entrepreneurs and marketers fascinated by inconic brands such as Apple, Harley Davidson, IKEA and InNOut Burger). 

As Clayton Christensen explained in the Innovator's Dilemma, there is a predictable pattern in just about every product category. Innovation leads to products that improve to a point where customers are over-served (the web browser might be the latest category to reach this level).

From a vendor's perspective, the problem is that over-served customers become so skeptical about the differences between products and brands that differentiation is rendered meaningless. Most customers become not only bored but unhappy.

In category after category, over-served, bored and unhappy customers would love to discover something delightful, remarkable and refreshing. And marketers spend billions of dollars trying to rise above the competitive noise.

Ironically, intense competition only quickens the pace toward blandness and a herd mentality in markets. This trap is hard to escape. The herd phenomena is seen in self-organizing systems as disparate as ant colonies, bird flocks and stock markets. 

Paradoxically, the best way to stand out, might be to NOT focus on beating the competition. At the 1997 WWDC, before he rejoined Apple as CEO, Steve Jobs stated the following (32:43 of video):

"...the other thing I feel very, very, very strongly about is, it's incredibly stupid for Apple to get in a position where for Apple to win Microsoft has to lose. That's really dumb... Apple can win without having to have Microsoft lose."

Don't focus on being better. Don't fret over differentiation. Think Different. Be different. Transcend boundaries. Stand alone. Walk down a very lonely path. 

Something that every entrepreneur should keep in mind is what Jerry Garcia once said: 

"You do not merely want to be considered just the best of the best. You want to be considered the only ones who do what you do." 

What will you do? How will you be different? One place to start, is to be yourself. Be genuine.

To really, really soar, don't just be better, faster, cheaper. You can do better than that. And please, please, please, don't aspire to be "the Mint of XXX category" or "the AirBnB or YYY category" or the "Groupon of XYZ category."

Passion

Fred Wilson wrote a post yesterday talking about Mission Based Businesses and how critical passion is to building a successful business.

Which comes first? Passion for a great mission or a successful business?

Conventional wisdom is that passion comes first (or is more important). I have a different point of view.

For every great business, there are countless well meaning, passionate entrepreneurs who don't make it.

Even great entrepreneurs can lose their passion. Tony Hseih, CEO of Zappos, is a great entrepreneur. In his book, Delivering Happiness, he shares how he lost passion for LinkExchange, his first startup, before selling to Microsoft.

There are good businesses and bad ones. One saying we have at Altos is "it's hard to fall in love with a crappy business."

To remain passionate, it's critical that you build a successful business. You will find that it is easier to fall in love with the business and love what you do.

I've observed many companies start with great missions that go nowhere. I've also seen companies grow their aspirations and missions to something far bigger than they had imagined in the beginning.

Rather than spending much time thinking about a mission to inspire employees and customers you don't yet have, focus on delivering a great product or service. Build a successful business. It all starts there.

Entrepreneurs like Bill Hewlett and David Packard did not set out to change the world. They just wanted  to work together. They built a product and started selling. They had no business plan. No grand mission. They took it one step at a time.

One final word about passion and love. The love you feel for a startup is like the passion in a new relationship. Such passion is intense but it can fade away.

What you want is the type of passion that grows in a great marriage. Marriage is tough. You have to work hard at it and you will go through many ups and downs. But in the end, you just might find true love.

Another Bubble

There is lots of talk about a new bubble forming...countless blog posts and discussions over the past year which I won't revisit. 

The latest theory is that the DST investment in Facebook in 2009 was the Netscape moment of the Web 2.0 era, which means this year might be like 1997 (two years after the Netscape IPO and another 3 years before a crash).

The thing about bubbles is that no one knows for sure. That's why we have bubbles...and pops.

Assuming we are headed into another bubble, some people are giving advice. They say that you should act differently during this bubble.

They will say "it's different this time" - an addressable Internet market of a BILLION people, cloud computing, mobile computing, titanic shifts in ad dollars, unprecedented growth in real revenues and profits, etc. 

To be or not to be lean?

The lean start-up movement has been terrific. Following the crash of the Internet bubble, a new generation of lean entrepreneurs, building capital efficient companies, was born.

But now people are confused. They are again debating the benefits of going fat vs. staying lean. Even some leading proponents of lean are advising entrepreneurs to behave differently (see Steve Blank's post on "new rules for the new bubble").

The problem is that changing your behavior with the times could a recipe for disaster. It is not honest either - certainly, not genuine or authentic.

Strive to do something which might stand the test of time. Do something which will last beyond the next bubble (and the inevitable crash).

Don't worry so much about what others are doing. Let them raise lots of money and spend it on PR or advertising. Why worry about things you can't control? Focus on what YOU need to do.

This will be hard to do. The behavior of everyone around you will change. You will feel new pressures from all around, even from very smart people and trusted advisors.

Here is an example - pressure to raise more money than you need. One of our portfolio companies was approached by prominent investors who wanted to "get in." They tried flattery (a very high valuation). Then they tried a threat (they may invest in a direct competitor rumored to be raising more than $100 million).

Try to resist such pressures. Resist temptation; and above all, resist envy. It is the most insidious of sins. Envy feasts on bubbles even more than greed or fear (of missing out). 

Don't fret about timing. People who try to time it get it wrong. They invest when things get hot. They pull back when things look bleak (i.e. buy high and sell low, even though they were trying to do the exact opposite thing).

Trying to take advantage of the greater fool, means, by definition, that you are a fool. That said, I do have some advice.

If you are going to sell your company, this is a pretty good time to do it. Valuations are high, buyers have cash, they are hungry and they are moving quickly.

If you need to raise money, now is a good time to raise it - equity or debt - the terms are favorable. But remember to be careful when taking advantage of this environment. The time to be cautious is when everyone else is bullish. 

The next few years will be very interesting...

Another Perspective on Yahoo!

Paul Graham published an essay about "the problems that hosed Yahoo" which got shared by many people via Twitter and Hacker News. Many people called it "customarily brilliant." 

I really enjoy Paul's writings but this one didn't sit well with me. I disagreed with key points and came away concerned that young entrepreneurs would learn the wrong lessons from history.

In the essay, Paul suggests that Yahoo failed due to two problems - 1) easy money and 2) ambivalence about being a technology company.

Money

Paul takes us back to 1998, when Yahoo was riding high, making money from big brand advertisers as well as over-funded, "fat startups" (a term popularized recently by Ben Horowitz). In Paul's words, Yahoo was "a de facto beneficiary of a pyramid scheme."

I agree that too much easy money, especially over-funding, can harm companies. Too much money can mask problems. That said, I don't think it had much to do with Yahoo's demise.

We can second guess how Yahoo could have re-invested profits but I would not fault them for pursuing it. They built a very successful company which beat every competitor of their era. 

Everyone benefited from the bubble. If Yahoo had not taken the money it may have been diverted to others and weakened its competitive position. You have to be in the game to even have a chance at riding the next wave. 

Maybe what Paul meant to say was that Yahoo management should have recognized that they were lucky or that their business model was not sustainable?

In hindsight, it's clear that Yahoo did not appreciate the potential for search and perhaps over-estimated the quality of their revenues. But, as Paul acknowledged, no one else, including Larry and Sergei, knew how big search was going to be, in 1998.

It's hard to predict the future and deceptively easy to come up with simplistic explanations in hindsight. Yahoo beat its competitors hands down and built a very profitable, growing business. I would not diss them for it.

Paul's second point was about culture and leadership.

Hackers 

Paul suggests that Yahoo was a technology company but either didn't know it or were ambivalent about it. He also seems to imply that if hackers had run the place Yahoo would have been fine (or at least would not have been hosed).

I disagree with both points.

Yahoo was never a technology company. They were a media company (albeit a "new media" company) from the day that Dave and Jerry started serving up pages from their trailer at Stanford.

When Mike Moritz invested in Yahoo, it was the emerging brand and traffic that impressed, not the technology. Unlike Google, there was no core technology from day one. Later on, Yahoo did develop many technologies - they had to in order to scale (Hadoop is one example).

Bill Gates would have also said that Yahoo was never a technology company. When Gates saw Google, he saw a company that reminded him of Microsoft. It was probably the only company that ever scared him. He never had that reaction to Yahoo.

The important thing is not to be like a Google or Facebook (or the early Microsoft). The important thing is to be yourself. Be authentic. Be genuine.

So maybe Paul's point is that Yahoo didn't know who they were. Perhaps, but I disagree that Yahoo had to be like a Google or Facebook because that is not who they were.

Pixar is a great media company. The fact that they were founded by technologists doesn't confuse them. They even sell rendering software to other companies, including competitors. It doesn't diminish their identity as a media company. 

Disney is another example. Walt Disney Imagineering has been inventing cool new technologies for decades. They were the "new media" company of their generation. You don't have to fit someone else's mold. Be yourself. Be unique.

Another key point Paul seems to make is that "adult supervision" is bad. Implication seems to be that if hackers had run the place Yahoo may not have lost. Again, I disagree. 

There is good adult supervision and bad adult supervision.

Amazon is an interesting case study that, on the surface, defies hacker conventional wisdom. Even as they delve deeper into technology, Amazon's management is stacked with MBAs.

Even their most technical businesses, Amazon Web Services and Digital Media (including Kindle), are led by a Harvard MBA and a Stanford MBA, respectively. Even so, Amazon continues to attract and retain plenty of good hackers. In fact, momentum seems to be increasing in the hacker community. 

There is nothing inherently wrong with adult supervision or non-technical management per se.

That said, I do think people can get seduced by the belief that there is a mythical "world class" management team that can fix your company. On this front, I think Paul and I probably agree. Don't count on someone coming in from the outside to fix your company (or, in the case of Yahoo, your stock price). 

When the bubble crashed, Yahoo looked for a savior. In contrast, Amazon stuck with Jeff Bezos even though their stock took a similarly huge beating. Bezos likes to remind everyone how the pundits called them "Amazon dot toast."

Terry Semel knew little about Yahoo or the Internet when he took over in April, 2001. It quickly led to the mass exodus of the future leaders of Yahoo. The fallout we are witnessing now may still be the after shocks. 

To conclude, I'd like to share a great story about how Nike is still shaking up the shoe industry. When Phil Knight retired after almost 40 years as CEO, he decided to bring in fresh blood and passed over the leading internal candidate for CEO. 

Luckily, Nike had such a strong culture that it quickly rejected the outsider. The new CEO, from S.C. Johnson (the makers of Pledge, Windex and other cleaning products) lasted only 18 months. The new CEO is a home grown prodigy - a former shoe designer who was the internal CEO candidate in 2003. 

With 33,000 employees, there is plenty of "adult supervision." It just happens to be the right kind. 

What Did Bill Gates Worry About? Lean or Fat?

I found this from the transcript of a Charlie Rose interview with Ken Auletta, right after "Googled" was published. It is interesting to hear about what Bill Gates worried about back in 1998, near the all time peak of his power (and the peak of the fat startup era). 

CHARLIE ROSE: And are they on the cutting edge of exciting stuff or are there two more kids in a dormitory room at Stanford that are about ready to come up with something that’s going to blaze new trails? 

KEN AULETTA: Well, we don’t know that. That’s the great thing. I mean, I think I may have told the story when I was on your show, I tell in my book that Bill Gates in ‘98, when I asked him what he worried about, he didn’t say the obvious, which is "My competitors, Netscape, or Oracle or Apple." He said "I worry about someone in a garage inventing something that I haven’t thought of." 

(LAUGHTER)

That year there were two guys in a garage. 

CHARLIE ROSE: Sergey and Larry in a dorm, yes.

KEN AULETTA: Google has the same reason to worry. What is that new technology? One thing they are conscious of is social networking and that could pose a problem for search. 

 

Now, I should also point out that Mark Zuckerberg started Facebook in a dorm room while Kleiner Perkins and Benchmark funded Friendster and Sequoia funded Plaxo during the very early days of social networking.

I feel like a broken record but this is something I wrote in 2006 in Venture Lotto:

The most sought after deals are led by proven managers. Especially popular are entrepreneurs who have made money before - they get investors lining up like sheep.

Ironically, the people who end up creating the blockbusters are usually unproven managers. They emerge from the fringes, and start small, in niche or overlooked markets. They take time to learn and iterate and burn very little capital before turning profitable. They follow a slower, but lower-risk path. In our own portfolio, the companies which raised less funding not only performed far, far better but had much lower failure rates.

Entrepreneurs can't count on a portfolio. The best ones we know are much more risk-averse than conventional wisdom might suggest. They don't take foolish chances. They spend money as if it were their own. They observe, listen and adapt; but fundamentally, they strive to control their own destinies, which is best done by generating profits. They do need a little capital, but they want help and advice even more. 

Ben Horowitz Makes Compelling Case for Lean

Like many of you, I've been following a fascinating and important debate between Ben Horowitz and Fred Wilson over the past couple of days. To recap, it all started with this post: The Case for the Fat Startup.

Fred then responded with Being Fat is Not Healthy which has received a lot of comments worth reading, including some comments from Ben. 

Then earlier today, Ben responded with the best post of all The Revenge of the Fat Guy.

After reading through the posts, I've come to the conclusion that Ben and Fred actually agree on the fundamental points. In fact, the most important point was already made by Steve Blank last year in Lean Startups Aren't Cheap Startups.

Steve, a key figure in the lean startup movement, felt the need make the case that you cannot confuse lean with cheap. He concludes with the point that if you confuse the concepts "when you do find a repeatable and scalable sales model, you will starve your company for resources needed to scale."

The reason I love Ben's latest post is that he helps debunk some myths about Product-Market Fit, which, according Marc Andreessen, is "the only thing that matters" Along the way, he also makes a compelling case (though perhaps unintentionally) for staying lean. 

Ben's post should be a warning for entrepreneurs and VCs who put too much faith behind the magical product market fit concept. Here are some things to watch out for:

1. Product market fit is NOT a discrete, big bang event. If you are fortunate to find product market fit, you will most likely get there through lots of hard work "through partial fits, a few false alarms, and a big dollop of perseverance...there’s no formulaic answer."
2. It's NOT obvious when you have product-market fit. "It’s usually not black and white."
3. Once you achieve product-market fit, you can lose it.
4. Once you have product-market fit, you still have to "sweat the competition."

All of these points should serve as a warning for people with too much money to spend (or invest) and eager to step on the gas once product market fit is found. Given all of the uncertainties, it would be prudent to maintain some humility even if you believe that you've found product-market fit (you can also reach the opposite conclusion - even when in doubt, step on the gas - it's just not the path I'd recommend). 

Ben's last point is important to consider because, on the surface, it makes a case for the fat startup. Since "the best markets are usually the ones in which competition is fierce" you should invest aggressively to make sure you win the market."

I would ask, how much should you raise/invest? How about a billion dollars as Webvan did?

In any huge new market, there is no question competition will heat up. But even a billion dollars is nothing when you are talking about competing against the big guys. 

Rather than focusing on how much money to raise, how about focusing on producing profits and creating a sustainable business model?

When I look at competitors, the ones that scare me are the ones that have found ways to make money and scale at the same time. The "fat startups" that are burning through millions or tens of millions of dollars a month don't scare me.

Ben says that you can't win the market by saving your way there. I totally agree. But conversely, you can't win by spending your way there either. Even if you raise hundreds of millions. For every Loudcloud/Opsware, there are dozens of craters. As David Packard liked to say, "more companies die from indigestion than starvation."

There is no question that Ben is a great entrepreneur who knows first hand how difficult it is to build companies. He knows that it often takes more money and longer than you'd like. So it would make sense to raise more money than you think you need. If someone offers to invest boatloads of money in your company at a great price, you should consider taking it. I agree. But even Ben has said that it should not be your plan A.

If you are one of the very fortunate entrepreneurs who is able to get boatloads of funding at a great price, you should be careful to resist pressures to spend that capital from excited investors. You need to also do your best to resist your own temptations to pursue every great idea that you and your great team comes up with to win the market. A company growing on profits just tends to be much more disciplined than one growing based on boatloads funding.

Just as Ben agues that Twitter is the exception, not the rule, I'd say that Loudcloud/Opsware is the exception, not the rule.

Even Loudcloud/Opsware is not a very compelling case for the fat startup. They raised $346mm in 15 months and went public in March 2001. By September 2002, market cap had fallen to $28mm, which was less than cash on hand and about 8% of capital raised to date. That sounds like value destruction to me. If you were an investor or employee, you'd be pretty bummed right about then.

Then an amazing thing happened. From 2002 to 2007, the company raised no more capital and created tremendous value - great job Ben! They exit for $1.6B in September 2007! I would guess that there was a lot of great technology created in the prior 2 years that helped. But I would also guess that the thought of running out of cash was pretty scary when you are at a $28mm million market cap. If I were in their shoes, I would have been more determined than ever to get to profitability so that I would never have to raise more funding. 

To recap, during the first era (Loudcloud), hundreds of millions are raised and return almost nothing. During the second era (Opsware), if you bought stock, which was publicly available, so any of you could have participated - you did NOT have to be a famous entrepreneur or a hotshot VC to get a chance to invest - you would have made a spectacular return.

Ben Horowitz just reinforced my belief that "fat startup" is not only a bad idea but a dangerous one. Just as the lean startup concept can be harmful if people misunderstand the key points, the fat startup concept can also be harmful. In fact, it can be a LOT more harmful to the VC industry. Entrepreneurs will also suffer from excessive dilution, recaps and wasted lives pursuing bubbles and false dreams.

I'll end with a concept Warren Buffet has repeated over and over again - don't count on the kindness of strangers to save you. Make sure you have enough cash on hand. To me, that is not an argument for the fat startup, it's an argument for the lean startup.

Celebrity Investors, Board Members and Advisors

"The quality and quantity of the financial backing that HomeGrocer.com has received for this latest round of financing clearly indicates that we have a model that is both viable and sustainable." 

- Homegocer's CEO in 1999 Press Release announcing $100mm round 

Chris Dixon's blog post from today about how to select your angel investors talks about a common mistake entrepreneurs make - choosing an investor based on their "celebrity value (by "celebrity" I generally mean in the TechCrunch sense, not the People magazine sense)." 

The same is true for choosing VCs, board members and advisors. We've invested with plenty of famous VCs and board members who were extremely well connected to the CEOs and boards of companies such as Microsoft, Oracle, Cisco, Intel and many other Fortune 500 companies. 

In our experience, celebrity investors and board members do little to help entrepreneurs do what they need to get done. They offer little in the way of strategic or practical advice about hiring, firing, product development, closing deals and financing. Even worse, sometimes the advice can be out of touch with what is going on in the industry or company but due to their celebrity status, some off the cuff comments can carry too much weight. 

Perhaps the most value that celebrities bring to the table are connections (even Chris in his blog post applauded "connectors" who can "introduce you to key people when you need it"). In practice, however, most people with great connections guard their rolodexes. 

Even when an intro is made directly to the CEO of a BIG company, it will get passed down the organization (usually down several levels) to the real decision makers. If the company is well run, the CEO will let his/her people make the decisions. 

If you do choose to use high level connections to force a deal through you should be warned that such a deal can backfire. If you don't take the time to build real support with the right people in the organization, they can do many things on a day to day basis which can ultimately sabotage the deal down the road (and distract you from what you should have been doing in the first place). 

My advice to entrepreneurs is to build your own buzz, based on fundamentals (an excellent banker advised one of our companies to "build your own heat" - it was good advice). You have to deliver real value! 

Also, please, please, please focus on generating your own leads. No matter how big your board or how well connected your advisors are they will NEVER produce the quantity or quality of leads your own team (and sales/marketing engine) will produce for you if you are going to be successful building a real business. 

In my experience, the entrepreneurs who see the most value from celebrity investors/board members and "advisors" build nothing of real value themselves. On the flip side, the best entrepreneurs see little value from celebrities (in fact, they probably find them distracting, if not somewhat annoying). 

Ironically, celebrities begin to embrace entrepreneurs once they think they are going to be successful anyway - with or without them. As it turns out, most celebrities need you more than you need them.

As far as I'm concerned, the real stars are entrepreneurs who create something from nothing.

Disclosure: As Chris D. admitted, as a non-celebrity but hard working small investor, this post is almost entirely self serving.

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?

The Death of Tech and Entrepreneurship?

I had an interesting chat the other day with a former venture capitalist who is now doing private equity (i.e. managing larger funds than ever before). He has given up on venture capital. Too difficult to make money, he said.

He observed that the technology industry has matured. Just look at a company like Oracle. Are they innovating or have they turned into another Computer Associates? Hard to believe that not long ago Larry Ellison used to make fun of CA for not innovating but growing by acquiring maintenance revenue streams. We also talked about the semiconductor and EDA industries. Very grim. Cadence is now trading at far below 1x revenues, yet the technical problems they have to solve are getting even harder as geometries continue to shrink.

One of the characteristics of mature industries is that it takes a lot of capital to start new businesses. For example, you cannot bootstrap a new auto company. It could take hundreds of millions, if not billions of dollars. In our own back yard, Tesla Motors is learning that lesson now (Tesla recently asked for $400 million from the government).

So, since the technology industry is maturing, his new investment thesis is that the only way to make the big bucks in high tech is to write big checks. That certainly fits well with his larger fund size that allows him to invest a lot in each company. It helps justify bigger management fees too.

That whole discussion reminded me of a quote from 1899 attributed to Charles Duell, the former commissioner of the U.S. patent office, who said "everything that can be invented has been invented" (actually, the quote is part of an urban myth. The story has been told so many times that even Ronald Reagan once used it in a speech).

I know that we are living through some difficult times, yet I remain optimistic about our future - the technology industry, entrepreneurship and venture capital. Before talking about the future, let's step back for a moment into the past.

Once upon a time, the railroad industry was thought to be "high tech." In the 1830's, rail road entrepreneurs in the U.K. were followed around by the media much as Larry and Sergey are followed around now (or Marc, Meg and Jeff during the Internet bubble).

Many decades later, the auto industry was thought to be "high tech"...and then there was the aerospace industry...the "electronics" industry...these thing called UNIVACs and Mainframes, etc.

Who would have thought that a college drop-out with no funding would hobble (if not topple) IBM, once the most admired company in America? IBM was so powerful that the U.S. government tried for years to break it up, just as it tried to do with Microsoft. It may try it with Google at some point too.

Sometimes, it doesn't even take a high tech wave to create enormous new companies. UPS and Wal-Mart are examples of companies that would require massive amounts of capital to compete against today (they are the two largest employers in America, not counting the government). They were both bootstrapped companies. Neither company raised any outside capital to get going and to reach profitability. They had modest beginnings...but kept growing for decades and rode various technology waves along the way.

The common theme is that entrepreneurs, over hundreds of years, have defined and re-defined what is - and what is not - the latest and greatest. "High tech" or not, entrepreneurs change the rules of the game. They help create waves (or just ride them) to help topple once dominant corporations.

It seems that great companies of every era get toppled by the next generation. Typically, the next gen seem to rise out of nowhere because they start very small, often without much fanfare. They are too small to notice - until it's too late for the incumbents. It takes less time for the average Fortune 500 company to drop off the list than it takes to grow big enough to make the list.

Destruction is all around us these days. Even companies well established for decades are dying right before our eyes, sometimes evaporating in a matter of days. We are also seeing once great, fast growing industries and once innovative, entrepreneurial companies stagnating, perhaps dying slowly. However, this doesn't mean that we're at the end.

Entrepreneurs, even those with venture funding, can't possibly match the resources of large corporations. Yet, entrepreneurs always seem to figure out ways to do the what conventional wisdom thought was impossible. I'm more optimistic about the future than ever because, as venture capitalists, we see exciting developments all around us. Let me provide a few examples.

I'm on the board of a company which saw an announcement that had strategic implications late last week. On a Friday night, the team got together and hashed out a strategy. They came up with new specs for a product. About 48 hours later, the CTO came up with a new product release (apparently, he doesn't sleep). Unbelievable. Such a thing would not be possible without the Internet infrastructure and the innovations that have come before us. A few years ago, even a team of engineers spending months may not have been able to do what a single engineer can do now in a matter of days.

Another example is a company which is using Amazon's cloud services. As they closed major deals, they were concerned about scalability. They had great software engineers who knew little about configuring routers or managing large farms of servers. Now, a software engineer can put out a new release without leaving his bedroom. The company has increased its ability to scale by 1,000x with less work than ever before. An added bonus was that this required no more up-front capital - which really helps in today's environment.

I have so many more examples. It is easier than ever to bootstrap companies. Salaries are coming down. It is easier to find people. Real-estate is getting cheaper by the week (we've seen office rental rates drop 30-50% in the past 2 months alone). In a meeting with Kanwal Rekhi this morning, he told me that the "fear of God is back. This will lead to better companies. More cost conscious. More disciplined."

I continue to be utterly amazed at what a few good engineers can produce these days. But there's more. It's not just about technology. We are seeing unexpected innovations in business models. New revenue and cost models are being created that were not possible even a few years ago (this should be a topic for a future blog post).

The bottom line is this. The pace of innovation is quickening, not slowing down. It's getting cheaper, not more expensive. Yes, if you want to start a new oil company, it will be expensive. A new auto company? Forget about it. A new ERP company? Workday is finding out that it's pretty expensive. Such ventures are not for us because we bet on entrepreneurs who bootstrap. By necessity, they don't go after opportunities that huge competitors with deep pockets go after.  

As long as I'm a venture capitalist, I will continue to bet on entrepreneurs who can do a lot with very little. They surprise us every day. They are our heroes.

The entrepreneurs we see all around us are very hungry. They will struggle - but they will not stop dreaming. They will not stop innovating. They believe. They will endure.

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!

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.

Fear of The Living Dead in Venture Capital

It was not until I got into the VC business that I found out about the terrible, dreadful "living dead" - a term used to describe companies that merely survive, without future prospects. Normally fearless VCs fear the living dead. So do our LPs (the people who invest in VCs) who worry that we might waste our time (and their money) on a bunch of little companies that go nowhere.

Venture Capital is a "shoot for the moon" - go for the homeruns - business (for more on this topic see Swinging For the Fences). Most deals won't work out but great VCs bounce back quickly and easily. They focus on the winners and waste as little time as possible on the losers. When you think about it, the living dead might be far worse than the total losers because they continue to go on and on...potentially sucking up valuable time, energy and resources...indefinitely. Yikes! No wonder VCs fear the living dead!

The bigger you are (whether in size of wallet or ego) the more you will think that wasting time and money on little ideas and small deals is not worthwhile. For example, Larry Ellison believes that there will be only a handful of survivors in the software business - Oracle, Microsoft, SAP and IBM. To Larry, all others in the software business are as good as dead (or the living dead).

BUT, if you're really dead, then you have no chance.

In the VC business, all of our companies, even the very best, follow a rather bumpy and windy road. In the beginning, every company looks like a struggling little company with uncertain prospects.

The best approach to take in venture capital is to relish in uncertainty and to have a little humility.

There is no way to control outcomes in the start-up game. What you can control is whether or not you do your best and make sound decisions (like spending your time and money wisely) and just deal with problems (and take advantage of opportunities) as they come. If you stay hungry and learn along the way - and just manage to somehow survive - you give yourself a chance to make course corrections, take advantage of changes (often unexpected) in market conditions, or just get plain lucky once in a while.

So let's get back to basics...if you really want to have a chance at a homerun, you have to, first and foremost, make sure that your company survives.

Surprisingly, this is not obvious to some people.

One prominent LP once told me that he would rather have us return NOTHING than to play it safe. He was serious - dead serious. He wanted "volatility" because that's what is expected from the so called VC "asset class."

When I first heard this advice I was a bit shocked!

At Altos, rather than worrying about the dead, the living dead or the homeruns, we focus our early stage companies on getting to 1st base - typically around $10mm in revenues - without burning through a lot of capital.

If we can get to 1st base, then we might start to believe that there could be an interesting business forming. In our experience, most companies don't even make it that far, especially if people get obsessed with creating the next BIG whatever.

After reaching 1st base, some companies might go out of business (the equivalent of getting tagged out at 1st), or get bought out, or start slowing down. Only a minority of the companies that make it to $10mm, make it to 2nd base, or $40mm in revenues. At that level, we start to be fairly certain that we will have a winner...but we still don't know whether or not we have a homerun.

At this stage, some more companies might get acquired and others will start flattening out in growth (start-ups rarely go out of business at this stage but, as in baseball, you CAN get tagged out from 2nd base). Again, only a minority of companies break through to the next level...this time to 3rd base, or $100mm in revenues.

Once 3rd base is reached, VCs will typically get a 10x return on investment (sometimes 100x-1,000x, depending on market froth/timing). By that time, we also know that management is competent, scrappy and adaptable, through multiple iterations of products, strategies, business models.

By the time a company gets to 3rd base, at least 5 years (sometimes 10+ years) have passed. In the technology industry, that's an awfully long time! Whether or not a $100mm company can become a much larger company depends on countless factors that are largely unknowable at the time of investment.

We will submit that there is no way to know - a priori - which company will turn out to be a homerun at the time a company starts out (or when VCs invest).

Here is a thought experiment.

If you were really great at predicting the homeruns (and the losers), what would happen if you abandoned the VC business and started a hedge fund? If you can predict the winners and losers when companies have insignificant revenue streams, then you should be even better at predicting when companies reach $100mm (around the time of an IPO). Hedge fund managers can invest tens or even hundreds of millions of dollars at a time - buying or shorting public companies.

If you had invested in companies such as Oracle, Microsoft, SAP, Dell, Cisco and dozens of other companies shortly after their stocks were publicly available, you could have made 100x or more on each deal. So why waste time investing single digit millions in puny little companies?

As VCs, we love investing in tiny little companies started by passionate founders in interesting, dynamic markets. They always start as small, obscure, insignificant little companies that struggle along the way. The path is NEVER smooth!

It is a fact that most VC backed companies won't even make it to 1st base let alone home plate. But if we build solid businesses, based on sound fundamentals, we've seen that some do break through...to 1st, then 2nd, then 3rd, before reaching for home. We just don't know which ones will break through, often for many years after we invest.

We have ten year funds because it takes time as well as a great deal of hard work and suffering, enduring the ups and downs that come along for each and every company as they grow.

But hey, I'm not complaining about all that suffering (didn't Buddha say that "life is suffering"?). We actually love the bumps and bruises we get along the way. Some might say it builds character. But that's not the real truth. To actually LOVE IT, I'd say that great entrepreneurs, as well as VCs, are a bit quirky (some might even say that they are mentally imbalanced).

Rational or not, it has taken me a while to get over my fears...I fear not, the living dead.

Swinging for the Fences

I recently sat on a panel with Howard Hartenbaum, the founding investor of Skype, which yielded a 1,400x return in 36 months. Howard humbly noted that he was fortunate to have had such a deal so early in his VC career. In his words, "Skype was not the deal of a lifetime, it was the deal of three lifetimes!"

Venture capital is a hits driven business. Over time, it's likely that only 20% of the deals will generate 80% of the profits. (The 80/20 rule originated from Vilfredo Pareto's observation that 80% of his peas were produced by 20% of the pods. He also noted that 20% of the people owned 80% of the land in Italy).

Apply the 80/20 rule to the top 20% and the Pareto principle says that 4% of the deals will produce 64% of the returns. Apply it again and less than 1% of the deals will produce more than half the returns. You get the picture? It’s all about the homeruns.

Given the concentration of returns, LPs are lining up to invest in the "top funds" who have hit the biggest homeruns. Top venture funds are over-subscribed because it is believed that those who produced great returns in the past will continue to do so in the future.

As time passes, the gap between the winners and losers often gets wider. For example, about half of all returns in the VC industry have been generated in public markets due to post IPO (or acquisition) run-ups prior to distributions. If lock-ups and holding periods were longer, the gap would get even wider.

However, in the frenzy to "get in" to top funds, people seem to have doffed their thinking caps at the door. Even as the most sophisticated LPs are cutting back from many so called "top firms," new LPs to the asset class are not only taking their place but piling on.

Impact of consolidation

Over time, consolidation happens in just about every industry and venture capital has been no exception. A small number of firms have been growing to control a large percentage of the capital. Even firms with mediocre track records have been expanding in both scope and scale (because they are still considered to be "brand name" firms).

It's hard to turn down all that money flowing in, especially once people get used to a fancy lifestyle, nice offices, support staffs, and lofty salaries. Assets under management has become the proxy for success and VCs are becoming accustomed to making more money from management fees than carried interest.

With growth, the mentality of VC investment professionals has changed. When people get paid for activity (putting money to work) rather than results (which may take years to sort out) you will get more activity. Compounding the problem, there are pressures mounting to hit even bigger homeruns.

VCs are making bigger bets than ever (which are needed to move the needle on larger funds). Unfortunately, this is leading to value destruction of unprecedented proportions. Between 1990-2001, 63% of invested capital resulted in almost total loss (the median deal lost money). In contrast, between 1969-1985, partial or total losses occurred in only a third of the deals.

Predicting the future

A VC's job is to pick winners that emerge out of a confluence of technologies and markets. Some people seem to think that they can keep doing it even with bigger piles of money. Let's get real.

Obsessed with the future, all types of investors attempt to predict the future (usually by looking in the rear view mirror rather than out the window) - like the direction of interest rates, inflation, deficits, markets, etc. Unfortunately, predicting the future is hard to do.

Alan Greenspan once said "It's very rare that you can be as unqualifiedly bullish as you can now." That statement was published in the New York Times on January 7, 1973, right before the two worst years for economic growth and the stock markets since the Great Depression (yes, even back then he was considered to be one of the nation's top economic forecasters).

Ever the contrarian, as Fed Chairman, Alan Greenspan warned us about "irrational exuberance" before the last bubble crashed. Unfortunately, he said it in 1996. If you had listened to him, you would have missed out on the greatest bull market in history (when most of the venture returns were made).

Creating homeruns?

Alan Kay once said that "the best way to predict the future is to invent it" so perhaps the VC's job is not to pick the winners but to create them. Go visit any VC website and you will see a lot of chest thumping about how great they are at doing this.

Perhaps past successes have gotten into people's heads (see Leggo My Ego). VCs have started to think that they can not only see the next homerun coming, but actually create it (I'd bet that more than 75% of VCs think that they belong in the top quartile).

As a fan of baseball, I've observed that good coaches can help manufacture runs, but they can't do much to create the homeruns. If homeruns in baseball are the outcomes of duels between batters and pitchers, homeruns in the VC industry are the outcomes of battles between entrepreneurs and markets.

In the quest for homeruns, VCs invest tens of millions of dollars, "add value," and put together "world class" management teams to build companies. The funny thing is that it takes less capital to start companies these days. You don't need to pour money behind the homeruns because they don't need it. The best companies generate cash, even as they fuel growth.

Some of the biggest homeruns were not even venture backed - they didn't need the money. Even for those which were venture backed, many were already profitable at the time of funding and, with few exceptions, ALL of them required very little capital to become huge.

Let's get real. VCs don't create the homeruns. The great VCs do help their companies...but there is a fundamental difference in mindset. It's all about the entrepreneurs. The big VC firms may try to inspire confidence (or strike fear), but the best entrepreneurs do their own thing with or without the VCs.

Deductive tinkering

The hands-on, "get big fast" approach is the most common practice among VCs. The opposite approach is a hands-off approach where lots of bets are placed across companies. There's a method to the madness and some unconventional investors have done quite well letting natural selection take its course. People have called this "spray and pray" or the portfolio of options approach.   

Unfortunately, a blind, random process (like evolution) can take a long time to play out. It is also risky particularly as bet sizes get bigger. To our knowledge, not a single significant company has ever been attributed to a spray and pray VC.

There are huge multiplier effects that stem from early decisions and we believe that it is critical to be hands-on. We believe there is a third approach. Venture capital should really be a process of deductive tinkering.

The best entrepreneurs are all classic tinkerers. They experience failures along the way (if you are not failing, you are not really experimenting), but they don't make foolish bets. They give themselves a chance to succeed (or get lucky) by making sure that they survive and stay in the game.

Thomas Edison failed in his first 100 attempts at making the light bulb...but he learned every time about what didn't work. We don't mind the failures. The key is to make the cost of experiments as low as possible. It's like flipping a coin where heads you win and tails you don't lose much. Flip enough times and the odds are that you'll come out ahead.

Some might argue that VCs invest big dollars AFTER the tinkering (to scale or "get big fast"). However, in our experience, the tinkering never stops. While we try to take out the greatest amount of risk with the least amount of dollars, companies take on new experiments at every level.

The idea that there is less risk at later stages is a fallacy. Competition to get into good later stage deals is far more intense (at later stages money is more of a commodity). Not only are valuations higher but a lot more capital is put at risk.

As our companies grow, we create new experiments within companies (it's like creating portfolios within portfolios). For example, several of our companies completed acquisitions or started new divisions over the past year. Our portfolio of experiments would grow even if we did no new deals as long as our companies grow in a capital efficient manner (where we reinvest retained earnings rather than other people's money).

Risk and uncertainty

Conventional wisdom says that in order to shoot for higher returns you have to take on greater levels of risk. We choose to follow a different path.

We look to invest in highly uncertain situations. We call such deals "experiments with unknown upside potential," where the range of possible outcomes is very large (on the upside) but require little capital. This is better than gambling or lotto which have defined, bounded upside. We'd rather take unknown/unbounded upside and known/limited downside.

One of the ways we like to limit downside risk is to invest in bootstrapped companies. In our most recent fund, more than half of our Series A investments have been made in companies that have been in business for several years. Such companies seem to learn more than companies that burn through millions of dollars. People with less money learn to use their brains more.

In other cases, we might even invest in companies that are already profitable but might need a little extra capital (and some assistance) to accelerate growth. Many VCs as well as "growth equity funds" who target bootstrapped, profitable companies have minimum investment sizes of $20 million or more. We look to invest less than a quarter of that.

A third type of investment is starting companies from scratch...but following a deductive tinkering process, rather than a conventional one (see Venture Lotto). The beautiful thing about our business is that we don't need to predict the future. We just keep our eyes open and learn along the way.

Learning requires an active, hands-on approach (so there is a cost) but it leads to value, often realized in totally unexpected ways. Some of our most successful investments are directly linked to a past a disappointment or failure.

We don't feel the need to take on big risks. One of the great advantages of venture capital  is that even multiple failures can't "blow-up" a fund (see articles on LTCM for how billions of dollars can be lost in a matter of days. Hedge fund and other types of blow-ups are discussed at length by Nassim Taleb in "Fooled by Randomness" and the "Black Swan"). There is a huge difference between high risk and high uncertainty. We prefer the latter.

The conventional VC strategy of investing tens of millions of dollars is a risky proposition. There are thousands of venture backed companies that burn through millions of dollars only to get to a point where they seek even more funding to grow. We have some (rather painful) personal experience with this. Some of our companies have gone through Series A, B, C, D...and then after running through most of the alphabet started over with Series 1 or A1.

After making more than our fair share of mistakes, we've realized that such impatient consumption of capital creates fundamentally weak companies. Compared to our bootstrapped companies, they seem to have a much lower chance of becoming a homerun, unless another bubble bails them out (depending on the greater fool is an awfully risky way to try to make money).

VCs cannot manufacture the homeruns by pouring tens or even hundreds of millions of dollars behind companies. It's like pushing on a rope. Such a strategy requires not only a lot of capital but a lot of confidence, ignorance or arrogance. Perhaps VCs should remember the words of the great hall of famer Satchel Paige: "It's not what you don't know that hurts you, it's what you know that just ain't so."

Expecting the unexpected

New technologies can lead to waves of creative destruction. Even in low tech industries, companies come and go. The vast majority of Fortune 500 companies drop off the list much faster than it took to get there - creative destruction is everywhere.

Small innocuous events can set off avalanches of changes which are inherently impossible to predict. Such unexpected changes are extremely dangerous for the giants (who have everything to lose and not a lot to gain). At the same time, they can be hugely advantageous for the hungry new entrants who have everything to gain and little to lose. The beauty of venture capital is that we can bet small but win BIG!

Experimentation and failures go hand in hand - so it's critical to limit the dollars. Lots of money is not required to get value out of experiments - it takes a little patience, an open and prepared mind (willing to observe, learn and adapt), and the right attitude toward risk and return.

Venture capital should not be about putting money to work. Over the years, we've learned that if we focus on the fundamentals and keep doing intelligent things, we can make money even if a company is sold for less than $50mm (the typical value of M&A exits in the VC industry). Rather than trying to predict or create the homeruns, the focus should be on the productivity of capital.

If we build good companies, we've also discovered that some of our companies will just keep growing and growing. We just have no clue which ones will take off (and keep going) and which ones won't at the time of investment. However, we have faith that some of our companies will become the dominant new market leaders (we have several promising ones so far). Creative destruction favors the new entrants. 

The key to great returns

One of the legends of the VC industry recently told me that to be a great VC "you must have the courage to walk away." Maybe it takes courage because mainstream VC investments are becoming so big that they seem too big to fail?

We have a different view. If you invest very small amounts and the experiments fail, it doesn't take much courage to walk away. Our "losers" seem to do a fine job of dying without much help from us - they don't need to be killed.

The key to great venture returns is not the courage to walk away but deep conviction and passion for the big winners (see our Raising Sheep article on the issue of conviction vs. convention).

To paraphrase another great VC...the key is to have a little teflon coating so that you don't get jaded...you have to have the ability to fall in love - with technologies, entrepreneurs and companies - even after you've had your heart broken. Great VCs are just as passionate as the entrepreneurs. It's personal, not just business.

However, perhaps paradoxically, it's also critical to be rational. The homeruns are rare - really rare. If you think that everything can be a homerun, you probably won't even recognize one when it stares at you in the face.

Over the course of decades (if we are lucky enough to be around that long), a very small number of our deals will yield more profits than all of our other deals combined. It's just the way the math works. We can only lose 1x, so if we have a 100x or a 1,400x along with a bunch of 3-5x winners, the overall numbers will be skewed toward the few big homeruns.

So in between the homeruns, the key will be to keep losses to a minimum, learning to a maximum, and generate decent enough returns to stay in the game. Such an approach might not sound terribly sexy or exciting, but we believe that the key to achieving great results is to stick to a rational strategy (rather than gambling money away).

The great investors and businessmen we know are all pragmatic practitioners. They first think about (and protect) the downside, before going for the upside. Following such a strategy takes a lot more faith and courage than you might think. It forces clear headed thinking and hard, disciplined decisions rather than sloppy, wishful thinking and shoot-from-the-hip betting.

Ultimately, it's not about how much we invest but what we own of great companies. We feel - in our bones - that only a few companies will really matter in our lifetimes (and they will NOT require a lot of capital). So, like every other VC we're swinging for the fences too...but we're not going to leave smoking craters in the field if we don't clear the fences.

Raising Sheep

"We're raising sheep in our educational system, not independent thinkers and doers."
      - Paul Orfalea, Founder, Kinkos

Have you ever wondered why so many successful entrepreneurs didn't get the best grades in school?  Even in the technology industry, where education is paramount, many of the best known entrepreneurs were college drop-outs (i.e. Bill Gates, Steve Jobs, Larry Ellison and Michael Dell). Maybe there's some truth to the saying - the A students work for the B students, the C students run the companies, and the D students (or dropouts) dedicate the buildings.

I don't want to diss the best students because we need them. They become our engineers, doctors or lawyers (OK, maybe we don't need any more of that last category). Overall, the conventionally successful will do quite well. Last year, I heard Eric Schmidt talk about "the premium for competence" as he described how Google was able to access top talent they could not attract when they were small. He explained that some people are so competent that they don't have to settle. They can wait to see the data (look for the sure thing) rather join a risky start-up. Good for them.

On the business track, the most popular (and highest paying) jobs graduates of top MBA programs pursue are in management consulting (McKinsey, Bain, and BCG are the most prestigious), investment banking (Goldman Sachs and Morgan Stanley are tops), private equity (just about any firm), and, these days, the most coveted jobs are at giant hedge funds (how depressing).

In school, there are discrete tests with answers that determine the grades. The real world is more complicated. Fundamental tenants such as "be honest" or "work hard" are too simple (and overlooked) to be useful. Good advice can even sound contradictory like "get the facts, do the analysis" versus "trust your gut." The real world is full of apparent paradoxes. There are no black and white answers, just shades of grey, and even being right may not be good enough.

In the business world, the cold reality is that being good - or even great - may not be good enough. The key to winning is differentiation. Great entrepreneurs have an edge  - but it doesn't come from higher IQs or greater imagination. The best entrepreneurs might even be considered simple minded (see the post on Foxes and Hedgehogs.) However, they do possess special qualities. They think and act differently. They don't go along with the crowd. Peer pressure is not their thing. Not only are they willing to be different, they ARE different.

Nature versus nurture?

In some cases, there could be biological differences. For example, dyslexia, a neurological condition which causes difficulty reading and writing, is a learning disability which afflicted entrepreneurs such as Paul Orfalea (Kinkos), Richard Branson (Virgin), Ingvar Kamprad (IKEA), Craig McCaw (McCaw Cellular) and Charles Schwab. Perhaps, as a side-effect of their condition, they were forced to work harder, see things differently, and do things in unorthodox ways.

Whatever the cause, most of the time, there is no scientific proof of biological differences - but let me try to characterize these very special people who turn out to be extraordinary entrepreneurs.

This great country was founded by people who possess characteristics inherent in great entrepreneurs. Such people are rebels at heart. They are willing to fight for what they believe in.  They have the courage to stand up and say that the emperor has no clothes. They never use the excuse "everybody else is doing it." Throw out convention! They can be brash and stubborn. They don't pine to be popular. One might say that they just don't give a damn what others think.

They are skeptics at heart. They won't take your word for it - they always ask probing questions. They are incessantly curious. They look beyond the surface. They dig deeper. They don't fear the truth or the unknown. They don't fear change, they crave it. They strive forward, relentlessly, toward an expansive future, not with uncertainty and doubt but with faith and optimism. In fact, one of their most special qualities is that rare combination of forward looking idealism with a skeptic's realism.

However, contrary to what you might think, they are not driven by the desire to stand out or the courage to be different. They're driven by the courage to be true to themselves - it takes self-awareness and integrity. They are 100% genuine - the real thing - authentic, original, and refreshingly unique.

The willingness to go down an unconventional path requires CONVICTION. As investors, something we have in common with entrepreneurs is this - to win BIG you must have conviction (great fortunes are made through concentrated portfolios, while a diversified portfolio makes it easier to keep). Of course, in the investing world, it takes judgment to decide when a deal makes real sense. (Confused people tend to rely on stock charts or "comps" rather than fundamentals and valuations).

My wife likes to say that I have "an incredibly high tolerance for risk" (she prefers a much bigger safety net). But what I consider to be extremely conservative might appear risky to people who don't see what I see. That's exactly how entrepreneurs feel! They don't feel that they're taking incredible risk. When Bill Gates dropped out of college, he did not see himself as taking tremendous risk (although his "parents were very concerned"). If entrepreneurs don't believe in what they're doing, they shouldn't be doing it in the first place.

It's fascinating to observe people who possess that rare combination of conviction and open-mindedness. Conviction keeps them charging ahead while their questioning nature allows them to constantly learn and adapt. Balancing these paradoxical qualities is one of the keys to entrepreneurial success. 

Qualities such as intelligence or the ability to "think out of the box" are over-rated. You don't need to be smarter or more creative, but you must have your own point of view. This is NOT the same as being contrarian, which can be just as mindless as being conventional (just the mindless opposite).

The crowd is not always wrong. In fact, under the right circumstances, the crowd can be more wise than even the smartest individuals. According to "The Wisdom of Crowds," three conditions must be met for crowds to be smart - 1) diversity of opinions, 2) independent thinkers, and 3) decentralization. Ironically, Surowiecki's book contains many examples of the stupidity of crowds (when such conditions are not met). More examples can be found in "Extraordinary Popular Delusions and Madness of Crowds."

Herd mentality?

Sand Hill Road is full of people who got the best grades from the best schools (VC and private equity shops are full of Harvard and Stanford MBAs). It's a small, tight knit community (the "old boys club" as some might say). They graze the same grounds and talk about the same stuff - big markets, passionate entrepreneurs, connections, relationships, proprietary deal flow, experience, adding value, home-runs, and being part of the "top quartile" (the last point is important because average VC returns have been less than impressive).

The VC industry is full of rules of thumbs and conventional wisdom. The industry moves in herds. Variations of the theme epitomized by the classic (outdated) phrase "you don't get fired for buying IBM" seem to be the mottos most people live by. These days, the most popular deals involve social networking, user generated content, wireless, China and India. Look, I'd never short a tidal wave (like China or the Internet) but the herd mentality (and the lack of originality and depth) is real.

As Yogi Berra says, it feels like deja vu all over again. The conferences and cocktail parties are buzzing from Shanghai to Silicon Valley (see comments from last month's post). Just don't expect to meet the best entrepreneurs at such events. They are too busy to attend. The real entrepreneurs are out there doing their own thing.

At first, what great entrepreneurs do might appear uninteresting, mundane, strange, unimportant or too early (or too late). In the beginning, companies like Southwest Airlines, eBay and Craigslist seemed strange. HP, Wal-Mart and Intuit probably seemed unimportant. RIMM, Qualcomm, and Pixar looked too early. Cisco, Dell and Google were thought to be too late.

In Silicon Valley, the heroes are the technologists ("the suits" are thought of as necessary evils). Unfortunately, in the real world, entrepreneurs must have a nose for business. The great ones always figure out how to make money (even as teenagers, they often have track records - from running newspaper routes, writing code, buying stocks or selling stuff).

Entrepreneurs like Sam Walton, Bill Hewlett, David Packard, and Herb Kelleher didn't care about what investors wanted (or about changing the world or their industries). In the case of Kelleher, a middle-aged lawyer who sketched out his plan on a cocktail napkin, Southwest Airlines operated in the fringes, in small, under-served markets. No one took them seriously for years. They just kept plugging along, posting 34 consecutive years of profitability in a volatile, cyclical industry marred by enormous losses and bankruptcies. (Southwest also outperformed ALL public companies in stock market performance over the 30 year period starting in 1972).

One of the paradoxical qualities of great entrepreneurs is that they are actually conservative at heart. They say "show me the money" - in some ways, they might have more in common with those frugal, skeptical farmers from Missouri than most entrepreneurs and VCs running around Sand Hill Road. Our Venture Lotto article contained this characterization of entrepreneurs:

"The best ones we know are much more risk-averse than conventional wisdom might suggest. They don't take foolish chances. They spend money as if it were their own. They observe, listen and adapt; but fundamentally, they strive to control their own destinies, which is best done by generating profits. They do need a little capital, but they want help and advice even more. Being an entrepreneur is, at times, a very lonely endeavor."

However, this talk about profits should not take away from the most special quality of great entrepreneurs - they inspire others. Don't think of them as shrewd opportunists who read the fine print on every contract, looking to take advantage of every deal. Such people might do well (for themselves), but they won't build wonderful and enduring companies. Great entrepreneurs bring others along. They grow the pie, rather fight for a bigger piece (or the crumbs).

To go back to the example of the founding of this country, problems (like taxation without representation) may stir the pot (like inciting riots or unrest) but revolutions are ultimately inspired by values and ideals (like life, liberty and the pursuit of happiness). In the business world, a problem may lead to an invention or a new company...but exceptional companies are built on a foundation of core values and dreams of entrepreneurs.

If you want to be an entrepreneur, just remember this - follow a different path - your own path. The most successful entrepreneurs win with or without VC funding - they go out and just do it. Forget about the cocktail parties, the hot sectors, hot deals, or what's popular with investors or anyone else - think for yourself. If you do, you just might come up with something that you will pursue with all your heart and soul. Conviction, rather than convention, is the key.

Outsourcing and Offshoring

Last week, I was invited to speak on a panel at Stanford's Conference on Entrepreneurship to discuss "Leveraging Low Cost Locations."

This was not the most popular topic of the conference, but it seemed like a timely one. The day before the event, Cisco announced a big push into India, including relocating upto 20% of executives by 2010. (BTW, the HOT topic was Web 2.0 - of course! People like Mark Zuckerberg and Chad Hurley drew big crowds just as Larry Page did a few years ago).

Not long after the last bubble burst, VCs started pushing the idea of saving money by moving to offshore locations. One VC even claimed that "there isn't a board meeting that goes by that we don't ask, 'Why aren't you being more aggressive (with software development) in India and China?" 

The funny thing is, I don't remember such discussions. What we have observed is that China and India are hot and US-based VCs have been launching overseas funds at a fast and furious rate (I guess it makes for a nice fund-raising pitch).

I have a different point of view - forget about costs. It's not that frugality or having a cost advantage doesn't matter, because it's DOES, but start-ups do NOT gain cost advantage by outsourcing or offshoring!

Why?

Start-ups don't compete on cost savings from outsourcing or offshoring (big companies do it with much more experience and management infrastructure). We compete based on the ingenuity and creativity of our people. If we deliver so little value that we must arbitrage labor rates, we will never make it in the long run. Any start-up's biggest challenge is lack of sales, which you get by solving problems for customers. But even that's not enough to WIN. We beat established competitors (like Cisco) by delivering more value. We can't be 10-20% better, we strive to make at least an order of magnitude leap or do something really special or remarkable. Such breakthroughs hinge on talent, not cost. (The paradox is that great talent and low-cost are tightly linked. Great people HATE waste and inefficiency! The brute force method - spending lots of money - is not how special companies get built. Great companies are capital efficient and profitable).

Last year, when one of our companies looked to hire developers with Peoplesoft experience, we found a great team in Argentina (they worked with the founders of our company years ago, when they worked for Peoplesoft). It's one of many, many examples which have convinced us that it does not matter where people come from - and cost is NOT the critical factor. It's all about getting access to the best people and fitting them together into winning (global) teams.

Some people believe that offshoring is bad for America. Even as a very small VC firm, our companies have over a thousand employees (and/or contractors) overseas. (In fact, 2007 will be the first year that our companies employ more people overseas). Perhaps that's an alarming fact. However, if we do not leverage the best talent, no matter where they are in the world, our companies could not be competitive. Then, sooner or later, we may lose all of our good jobs.

Some people also believe (or wish) that Americans have a lock on ingenuity, creativity, and craftsmanship. Perhaps our companies would always win - IF it weren't for those pesky, copy cat, low-cost competitors overseas - who don't respect IP rights, don't have to deal with XYZ regulations, don't have high healthcare costs, - or some other excuse of the day.

I just don't buy it.

I have an example from the Stanford conference. One of my fellow panelists was the founder/CEO of a company which manufactures goods in the USA and China - identical products produced in two locations. The quality of the products made in China is significantly better at a fraction of the cost.

The fact is, the rate of improvement at the Chinese factory is higher - creating a gap that will WIDEN over time. Perhaps, the Chinese workers are happier to have jobs or maybe they are more hungry - more motivated - to learn and improve. Whatever the reason, the advantages of the Chinese factory over the American one have little to do with cost. The American factory is not competitive - regardless of cost. The advantages of one location over the other have more to do with the creativity, passion and commitment of people.

A counter example is Harman International, a company which has remained competitive even while manufacturing in "high-cost" locations. Harley Davidson is another example of the triumphs of design AND manufacturing in America. In the case of Harman, labor as a percentage of costs has decreased from 20% to 5%. They've accomplished this by leveraging the talents of an inspired workforce who possess a relentless drive to learn and improve (I'd recommend Sidney Harman's book). Eventually, when labor gets down to 1%, what would be the point of squeezing labor costs?

In our portfolio companies, we have not seen material differences in productivity or quality across different countries or cultures. Output is more closely tied to the quality of input - by which we mean good management and leadership. Our managers put together winning companies by finding, nurturing, and developing great people.

You can't treat offshore employees differently than onshore employees. By this, I don't mean being insensitive to different cultures or backgrounds. We have tremendous diversity right here in our own back yard. We've seen Israeli engineers working side by side with Palestinian engineers at start-ups - this kind of stuff only happens here in Silicon Valley. This is a HUGE competitive advantage.

It's unrealistic to think that we can just give the low-cost, non-mission critical work (i.e. the "shit work") to offshore or outsourced workers and expect to be able to attract and retain great talent. In unproven locations, we may start with more boring, less risky projects (for example, a software company might start with Q&A rather than core development). But over time, we MUST give them more interesting work. If great people do not feel like they are learning or tackling meaningful work (some call it the "fun stuff" which keeps them on the leading edge) they will lose interest and look elsewhere.

As managers, if we treat employees as faceless resources useful only because they are cheap, sooner or later, we will get what we deserve - low productivity, zero loyalty, and high turnover. Don't treat workers like mercenaries! The most common reason people quit is not because of compensation, it's because they don't like their supervisors. Ultimately, the outcome hinges on management.

Some of our companies have experienced incredibly low turnover rates even in places like India (which has a terrible reputation for turnover) while other companies seem to have revolving doors. Even when we work with non-employees (i.e. with an outsource vendor), we treat them the way WE would want to be treated. We listen, care, communicate honestly, include people in decisions, share in the upside, etc. In certain cases, we've even given stock options to contractors.

It's a level playing field.

As Americans, we can be very competitive. But to keep jobs here, we have to deserve it! We have to stay hungry and be willing to work just as hard (if not harder) than our competitors abroad. That may be a scary (or depressing) proposition for some people - but it should be seen as a wonderful challenge. Silicon Valley was built on this competitive spirit.

Whether on-shore or offshore, it's comes down to management basics: first and foremost, attract and hire great people wherever you can find them - and then STOP doing dumb things to de-motivate already self-motivated people. Provide opportunities for them to learn and grow. Help them find fulfillment in their jobs. If we want to remain competitive on a global scale, there are no tricks or secrets. It takes great people, hard work, sound judgment and good management.

Bad managers fail on-shore as well as offshore (we've experienced this pain first hand).

Good managers succeed on-shore AND offshore, (in-source AND outsource).

The good news is that America (and especially Silicon Valley) has a tremendous wealth of creativity, experience, and talent. I believe, we will continue to attract some of the best and brightest from around the world (I doubt Chinese or Indian immigration policies will lead to a huge influx of talent from other cultures).

To conclude, Tom Peters has been reciting the following quote for several years:

"A focus on cost-cutting and efficiency has helped many organizations weather the downturn, but the approach will ultimately render them obsolete. Only the constant pursuit of innovation can leverage long-term success."

    - Daniel Muzyka, Dean, Sauder School of Business, British Columbia

In our business - the start-up business - it's not about cost. The key to long term success is innovation, which comes from the hearts and minds of great people - bonded together - to form winning teams.

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)

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.