EarlyStageVC

Enterprise Web 2.0

I don't usually use this medium to comment directly on others' posts, but today I read Dion Hinchcliffe's most recent post and I have to bring it to your attention. If you have been following the pre- and post- Web 2.0 conference chatter, you know that two ideas have been circulating. One idea is Web 2.0 is a set of technologies that enable "social computing" or "participative computing" in a number of forms. The other point of view is that Web 2.0 is nothing more than an incremental refinement and that reading more into it is wishful thinking. (The investment corollaries are Big Trend or Big Bubble).

Myself, I have been of two minds about the concept of Web 2.0. I see substantive changes in technology and methodologies for developing Web applications. But I have always been troubled by the populist "empowerment" sub-theme that is used to define Web 2.0. I don't buy into the wisdom of crowds as axiomatic. I buy into the power of incentives, both tangible and intangible. Sometimes a crowd has the right incentives; sometimes it doesn't.

Computing architectures and social impact are separable concepts. While computing informs social interaction, and vice versa, to define a Web 2.0 app by its reliance upon or enablement of the users seems to politicize technology. The PC gave computing independence to the worker, but "personal empowerment" wasn't an attribute to define what was a PC app and what wasn't. PC apps ran on PCs - by definition.

Dion's post does an excellent job of really placing Web 2.0 technologies into a larger technological context, without the user consequences being part of the definition. He does a much more articulate job of saying what I have been thinking for a while. Web 2.0 is a lighter weight version of SOA. RSS/REST is the new EAI.

Today's Enterprise IT budgets continue to be largely defined by the consolidation happening in the legacy software businesses. Over the next 24 months I think we will see are a lot of IT folks doing heavy lifting with legacy apps by day and playing with lightweight Web 2.0 technologies by night. The innovation at the edge is going to wash into the Enterprise. And when it does, we're going to see IT Departments finally see a platform shift worth making. The potential losers are the legacy vendors with their 'software mainframes.' The winners will be the companies that package componentized functionality with light, maybe even non-procedural, methods of stitching together flexible Web applications quickly.

To paraphrase Marx and Engels, there is a spectre haunting the Enterprise. It is the spectre of Web 2.0. (Maybe I shouldn't have been so quick to throw out the politicization effect of Web 2.0 after all....)

The Birth of Riya.com

Well, Munjal has finally taken the covers off of riya.com. This is very exciting. He has been blogging about the birthing process for some time. And it makes fascinating reading. Now that it’s official (though still in alpha), I thought might be appropriate to discuss another part of the process -- conception, not birth.

I am not going to discuss the who-gets-credit-for-what issue. That’s pretty banal and self-serving if re-hashed. But I do think it is important to share with you how we collaborated in the process, particularly from the VC point of view.

We at Leapfrog met Munjal several years ago. I think the attraction and respect was mutual almost immediately. Consciously, or not, we developed an ongoing dialog about his prior business, issues he was facing and choices he had. This gave us a chance to really understand Munjal’s values, motivations, and business judgment. And he developed the same with us. But the conversations were really just “pings”, nothing formal or really intentional. What’s the point so far? This is a relationship business, and relationships take time.

When he came to us “to kick around some ideas” we began by identifying as many “megatrends” that we could. The first principle of venture investing is catch a wave – catch two, if you can. So digital media explosion, cell phones explosion, gigapixel explosion, bandwidth explosion, grass roots content explosion, etc., were all ingredients in the mix. (We had others as well.) Everything we considered was always tested against the ‘waves’.

Second, we obsessed about barriers to entry or replicability of whatever we were considering. We both know from first hand experience that good ideas are shared memes. Rarely do people have original thoughts that have no predecessors. In the connected world of the Internet, there are lots of smart people who see the same dots and can create the same picture with a little open source and hard work.

Third, there had to be passion – because passion generates vision and vision is the essence of leadership. Munjal has blogged about how he digitized his entire life even before starting Riya.com. Clearly he had the passion about organizing digital media in an automated fashion. Being older (and a photographer who still shoots film by choice), I was sometimes skeptical about the consumer pain that he said was out there. But between the analytical data about digital media explosion and observing behaviors of less computer-savvy and/or more digipix-savvy people, I was able to see my bias was wrong.

Fourth, we had to have a sound business model. There is no “we’ll figure it out later” in our practice at Leapfrog. And Munjal knew first-hand the mortality rate of dot-coms (and more recent social networking and photo sites) that preceded him. We have one and it will be apparent in due course.

Fifth, we had to be able to recruit the key people who would partner with Munjal as co-founders before investing. Both of us wanted to know that it was a great idea and that we had to have a great team to execute it. He found that in Azhar and Burak.

Sixth, we needed to have a business that was capital efficient. Here we are totally aligned with the founders. We are a relatively small fund, by choice. This means that we don’t use capital as a barrier. We rely on intellectual property. It is a much higher ROE (return on equity) way to invest. And since founders have nothing but E, it aligns us with them. One implication is that Munjal could have raised much more money at a higher valuation than he did. But all of us (the founders, Leapfrog and our co-investor John Malloy at Blue Run) felt less capital at non-inflated valuation would serve everyone better in the long run. (If it not clear as to why, perhaps I’ll expand on this in a later blog entry).

So we labored together for several months. We had several cycles of elation and depression as we found ideas we liked, only to convince ourselves they didn’t meet these six criteria. But this one stuck. Now we are on the cusp of bringing it to market. I am not concerned about our premises or our process. They remain sound.

I have to admit I am a little worried that the blogosphere has unrealistic expectations of Riya 1.0. It ain’t perfect. Far from it. The cool factor is there for sure, and it’s really useful. But there is a ‘conservation of karma’ principle in startups. Rising expectations lead to falling realizations. Munjal took a risk in sharing the process of the startup as it was being built. He has tried to share the pain and the joy. Please remember this if you try Riya.com over the next few months. You, too, are likely to feel some of his pain, and hopefully some of the joy.

The Web 2.0 Entrepreneur Bubble

There has been a lot of conversation of late about how much easier it is to start a Web software companies these days. Open source and Moore’s Law are the principal drivers. Great stuff.

It’s springtime in the Internet and there has been a fresh rain. New seedlings are popping up. Great stuff.

Lots of disdain for dumb money because it’s “so easy” to start a new Web company these days on a server and a song…. the case for entrepreneurial minimalism.

But there’s a bubble that the web community isn’t talking about. Let’s call it the Entrepreneur Bubble. The Web 2.0 Entrepreneur Bubble is the flip side of the Web 2.0 Investment Bubble.

We all understand the calculus of the Investment Bubble –

Lots of investors looking to fund Internet Companies
+ cheap access to investable capital
+ relaxed financial criteria (call it business model) in screening
+ shared knowledge of the big tech trends (posing as proprietary investor insight)
+ relative inefficiency in finding potential investments because so many are ‘under the radar’

= many near-identical companies get funded
+ valuations rise in the beginning because everyone thinks they can get 20% of a big market
+ the abundance of similar companies raises the capital requirements so that some can break out by outspending

= shakeout when it becomes apparent that there are too many companies and investor expectations crash

And everyone concludes – Those Dumb VCs – They Should Have Known Better

But consider the case for the Entrepreneur Bubble:

Lots of talented developers wanting to found Internet companies
+ cheap sources of computing resources and personal time
+ relaxed financial criteria (call it business model) in screening
+ shared knowledge of the big tech trends (posing as technical innovation)
+ relative inefficiency seeing what other developers are building because so many are ‘under the radar’
+ the abundance of similar companies raises the need to find a barrier to entry / basis for differentiation

= shakeout when it becomes apparent that there are too many companies and entrepreneurs’ expectations crash

And everyone concludes – Those Poor Entrepreneurs – Too Bad They Didn’t Know Better

But the root causes are the same:

1. It is very easy to make the initial commitment (founding or funding)
2. Underestimation of how many had the same conclusion
3. Underestimation of survival requirements for the ‘too many competitors’ case

I think there is a real Entrepreneur Bubble these days in Internet software. Step A is seductively easy – buy some servers, write some code. Just understand that 10-100 other teams around the world are doing the exact same thing. How will you sustainably differentiate yourself? What will you do when 15 other similar sites appear in the next 12 months?

A thoughtful consideration of Steps B through Z may lead you to conclude (i) you can’t build a sustainable business, (ii) can, but need to invest far more time/money than you originally imagined, or (iii) building a small business is a lifestyle choice. All conclusions are equally valid, but don’t let the hype of the Entrepreneur Bubble confuse the decision.

To me this Entrepreneur Bubble feels like the PC software bubble in the early 80's. As the installed base of personal computers exploded, individual software developers founded companies because it was an order of magnitude cheaper than before. But as the field quickly glutted with dozens of similar companies in each category, the choke point became distribution, leading to the structure of the market we see today. Today's three person startup on LAMP is 1981's Pascal developer. The few that got rich did well. The many that didn't quit their day jobs did OK. And those who quit their day jobs and didn't get rich.... learned something.

Reduced barriers to entry always look attractive to the entrants. But once you enter, you are an incumbent.

Web 2.0 Media Coagulation

Lots of chatter at the Web 2.0 Conference late week about what a renaissance bubble this is. Mary Meeker had a typical presentation full of "it's gonna be huge' Meeker-stats.

One sobering statistic was semi-buried in the presentation. The absence of business models for Web 2.0 highlights its sobering impact. Meeker reported the following
- US yr/yr Internet Ad Revenue +26%
- Google yr/yr +75%
- Yahoo yr/yr +54%
- EVERYONE ELSE FLAT

This reminds me of what Ted Leonsis said eight years ago....

Media does not disaggregate. It coagulates. [The newspaper] industry has proven that. Eighty-eight percent of the circulation in this country is in the hands of 25 top newspapers, within 10 companies. Or, look at the cable industry. There are really only 20 big cable brands, one or two by cate-gory, owned by the distributors. I see that trend happening in this business. The concept of 400,000 or 500,000 free Web sites has miti-gated the value of content. Brands will win. Category killers and scale will win, and some of those brands are starting to emerge.

Granted the big brands of 1997 are mostly not the big brands of 2005. But that's not the point. The point is advertising isn't a viable sole business model for any but a very small number of Web sites.

It's no different now for the small sites than it was in 1997. The only thing that seems different now is that, because the costs of developing web site/app are much lower now, the breakeven traffic level is lower, too. So, Adsense makes sense for small, hobbyist sites. But building a medium- to large-scale advertising-supported business is as hard as it ever was, maybe harder now.

This observation highlights the real elephant that was in the room last week that few really talked about -- business models for Web 2.0. When we see real and new business models around all this social content and the atomized web services, that's when Web 2.0 will cease to be a idea and will really be a platform. Advertising is the 'effort-less revenue' we talk about when we have no idea about the real business model.

Wily+Timestock=Customer Transaction Quality

Last week Wily Technology acquired one of our companies – Timestock. This acquisition should be a textbook example of a great fit.

When we met Timestock, a year and a half ago, we saw enormous potential in what they were doing to 'close the loop' between business objectives and IT execution. Over time, we pushed the Company to re-position themselves around the concept of Customer Transaction Quality, pulling measurement and remediation out of IT Operations and into the line of business where it really matters. The result was a strong enterprise value proposition and higher average selling prices than most other application performance management products.

Wily is a solid, growing, profitable enterprise software company selling a great J2EE management tool. Their customer list is as impressive as their management team.

This is great fit both financially and strategically. Timestock was very capital efficient. In fact, the Company only raised a small Series A investment (Leapfrog was the only investor). But on that investment they managed to build a terrific product and get some major reference customers. In this market, customers like e*Trade, Cingular, GE, Network Appliance, and Xerox don’t generally buy from tiny companies, unless the companies have great products. Timestock did.

Wily now has a really compelling product line story, being able to follow the transaction from the customer all the way down into the deep enterprise infrastructure. The synergies are enormous. Timestock could instrument the customer transactions (e.g. stock purchases for e*Trade) and tell which ones were failing, who is affected, and the cost. Wily’s products can take that defect and isolate the root cause in the infrastructure. The points of integration are obvious and really valuable.

Financially, this made sense, too. Often startups raise too much money early on. Raising too much money actually limits your early exit options by raising the bar that has to be crossed. (The Timestock team actually had another offer to raise more cash at a higher valuation in their series A, but they understood the cost of overfunding – lower ownership, higher bar. So they took our offer.) Timestock was raising a Series B investment when they met Wily. The use of the Series B was to begin to build out the sales channel, management team, and scale the Company.

There is always serious execution risk in building out the enterprise past the first few customers. It’s a risk worth taking if two conditions hold. First, if there enough core skills in the Company to reasonably execute that growth. Second, if you can reasonably expect you are building enterprise value that would be captured in an exit-by-acquisition.

But often the capital spent to build a channel is of limited value to most acquirers. The acquirer usually already has a channel. So if you are building a channel of your own in the enterprise software business, you are committing to an exit by IPO – a very tough proposition these days. (However, you may need to build enough of a channel to get an acquirer’s attention.)

Most small companies raise the A to build the product and a B round to get the first few customers. So they face this build the channel or sell question after considerably more money has been invested – read ‘dilution’. But this one was special. Timestock was efficient and effective in building a great product. The product team was just awesome. They build an unbelieveably scaleable, robust, and easy-to-install product.

Wily should see a very quickly integration of the team and accelerate growth by presenting the product to the installed base. The added plus is that the elegant end-to-end story should help drive a new wave of customers to adopt Wily over IBM, Mercury, and others.

Congratulations to the whole team.