EarlyStageVC

What’s Broken – Venture Capital or Venture Perceptions?

There is an oft-repeated mantra than venture capital is broken.  The evidence cited is the dismal absolute median returns of the venture capital industry.   It is true that the venture asset class has become more competitive in the economic sense, i.e., excess returns are more difficult to achieve.  That is to be expected.   Excess profits attract competitors and returns decline.   But that doesn’t mean all competitors converge to the equilibrium return. It just means that the winners will either have the same strategy as every one else with better execution, or simply better strategies.

Cambridge Associates is a leading consulting firm that benchmarks the venture capital and private equity industry.  Nearly everyone uses their data to assess whether investment performance of a VC firm is “top quartile” or not.  The reason is simple.  Top quartile performers garner the lions’ share of the profits.   Between 1994 and 2006 the returns of the top quartile funds compounded in value at rate nearly 7X that of the median venture capital firm. Cambridge recently compiled some statistics about the venture business which document this. The data are proprietary to Cambridge, but I will share with you a high level view of the results, with their permission.  Of course, the following discussion reflects only my own conclusions.

Once Upon a Time, Everyone Was Top Quartile
The 1994-1996 period was an exceptional time to invest. If you were the first investor in a company in that time period your average internal rate of return (IRR) was over 100%.  Repeat -- your AVERAGE IRR was over 100%!  Not surprisingly, when these excess returns became apparent in 1997-2000, the number of venture firms exploded, as did the amount of capital.  We all know this, and have observed the consequences for the past nine years. The period of 1994-1996 was the Wonder years.  Post-2000 has been more like the Wonder What Happened? years.

The prevailing wisdom from the pre-2000 period was that early stage venture capital is the place to be.  That same wisdom today is be anyplace but venture capital because the old model doesn’t work.  The facts from Cambridge shine a bright light on the alleged wisdom and illuminate a more nuanced, insightful understanding of what drives performance. 

Timing is Everything - Who Knew?
The data in the table below are a paraphrase of Cambridge’s findings.  (If you want the original data, you'll need to become a Cambridge client).  They categorized over 22,000 venture capital initial rounds of investment in a thirteen-year period.  Each investment round was classified from Seed stage to Public, and they calculated the IRR of the initial VC investments made in each year. For example, if Crosslink led a B round investment in NewCo in 1998 as our initial investment, the outcome of our initial and subsequent investments in NewCo would be attributed to the original 1998 investment decision.

I have simplified their presentation to indicate which stages in each year led to IRRs higher or lower than the average IRR of all investments in that year.  Basically, it is scorecard of what kinds of investments you should have been making each year.

The pattern clearly shows that the miracle years of 1996-1999 were all about early stage.  Here’s where the perception that early stage is everything became axiomatic.  Note that as the business cycle shifted in 2000, the best investments were no longer early stage. They were restarts, PIPEs and some late stage deals.  As the economy began to re-heat in the 2005-2008 period, the pendulum again swung back to earlier stage deals.

These data are consistent with our own experiences at Crosslink.  We raised Crosslink Ventures IV in 2000 and Crosslink Ventures V in 2006.  (Elsewhere I have discussed our sector-focused, stage-independent strategy of growth equity investing.)  Our results are consistent with the Cambridge data on venture performance over the same period.    We have found that an ability to move with the market, both by stage and by sector, is a critical factor in achieving top quartile performance or better.

History is Bunk
What are we to conclude from the data?  While market and entrepreneur selection remain fundamental to venture manager success, risk management, time-to-money, and inflection point investing have emerged as perhaps equally determinative of  top quartile performance.  We all know the ‘hits’ nature of the business has been dampened, perhaps forever, but that doesn't mean venture capitalists cannot achieve premium rates of return. The Cambridge data show the business has transformed into a mature asset class where relative performance varies across the business cycle. What’s broken is not the industry, but the outdated perceptions of what strategies drive top quartile performance.

The venture industry has disappointed for a long time, or so it seems.  Certainly that is true when measured against the exceptional period where the average IRR was 100%.  Popularity and profits are incompatible concepts over the long run.  Nevertheless, top quartile venture performance is still exceptional, relative to other asset classes. Below is a comparison of the SP500 performance over the past nine years to the venture funds of vintage year 2000.

Some might counter that the SP500 investment is 100% liquid and venture numbers are merely private equity accounting entries.   However, the $1 invested in the SP500 would be a fully "realized" $0.65 at 2008 year end, while even the median venture fund would have returned $0.48 of cash, plus an illiquid remainder.  The top quartile fund would likely have returned $0.90 or more, trumping the SP500, and still have a substantial upside.  

Are We Blinded By A Remembrance of Things Past?
So is the venture asset class broken?   It doesn't appear to be.  It seems our assumptions of what constitutes "venture performance" are anchored in an obsolete memory of absolute performance, when the world of investing is all relative.  The mythology around venture investing reinforces this belief. Like every business, the successful venture investment strategies require continuous re-invention, not just a repetition of what worked before. Venture capital certainly isn't a license to print money anymore, but it is still the best game in town.  It's just that the rules of the game have changed.

The Coming Venture Capital Boom

No, I am not a Pollyanna.  I see the today’s carnage as much as everyone else.  This year is going to be tough. The destructive firestorm of leveraged, momentum investing has destroyed much of the forest.  But the forest will begin its renewal because Life Goes On, and with it ingenuity, entrepreneurship, and innovation. 

This firestorm is like the Year 2000 cataclysm, with a powerful difference.  Like 2000, there are questions about the ‘death of venture capital’ the ‘death of the consumer’ and the ‘death of the Web.’  It’s all bullshit. It's just a cycle.

Two phenomena emerged from that last great vc-techno contraction. First, the fire incinerated the weakest companies. It left standing, weakened, but inherently great restart and late-stage opportunities.  Yipes.com was a terrific example, founded in July 1999 as a IP data networking services provider. Left for dead twice with two recaps, the third time was the charm. After raising over $300M during the 1999-2005 period. Much of this capital was wiped out. Yipes gave great returns for the investors who saw the opportunity anew in 2005 (disclaimer: we led this round). Acquired for $300M cash in 2007 by Reliance Communications, Yipes was a great company, originally ahead of its time, and made us 5X in 32 months.  We will see dozens of these opportunities in the coming years, but it requires an investment discipline tethered to public market realities about who are likely buyers, why, and at what valuations.

The second phenomenon to emerge from 2000 was the re-invigoration of the Web. As with every wave of innovation, much of the activity became more imitative than innovative as this matured.  YouTube was but the first of hundreds of video aggregators.  MySpace was the first of thousands of social networks.  (If Andy Warhol were alive today, he’d probably be telling us that in the future we will all be our own social network.) The venture money that went into most of these imitations will soon be written off. 

Some substantial services were built from this post-2000 renaissance.  Few achieved both scale and profitability as an independent company.  (LinkedIn is one that may have achieved that goal. Facebook?) Nevertheless, there were many successful exits from the web revival, though paltry few in proportion to the amount of capital, media attention and entrepreneurial energy invested.

So why am I so sanguine about the prospects for venture capital as everyone seems to sound the alarm about Recession, the lack of capital, and the fear gripping the markets? It is simple:

1. Venture capital returns are predicated on scarcity of risk capital.  It has been all too abundant. That will change.
2. Many good businesses will be left on the beach as the rest are washed out to sea – the remaining VCs will invest in them and both the entrepreneurs and VCs will get rewarded as the survivors gain market share and become successes in the economic recover.
3. The economic recovery plan of the new Administration will be massive and favor investments in productivity-enhancing growth sectors like information technology and energy technology.

Investments in material sciences electronics will blossom to provide ever-cheaper sources of domestic clean energy, today’s temporarily cheap oil notwithstanding.  (As the world economy recovers, the new capitalists in China and India will buy more cars and build more factories, rapidly returning oil back where it was and beyond.)

Investments in broadband, wireless, and mobile multi-core devices and cloud computing architectures will continue to reduce the cost of providing high value services in healthcare, personal entertainment, and even traditional enterprises.  Cloud-based computing will allow enterprises to treat IT as a variable cost, increasing their willingness to adopt by maintaining flexibility without big upfront expenditures. 

As the fire continues to rage in financial markets, it is hard to imagine when Opportunity will reappear. But the truth is when everyone sees Opportunity; they are only seeing the reflection.  True Opportunity appears at the market bottom, not at the top.   It’s times like these that test what you believe in, and I believe in the Business Cycle, Human Creativity, and the stimulative effect of massive Government spending. 2009 and 2010 will be great times to invest to reap the benefits in 2012-2014, for those who can judge both business risk and liquidity risk, and have the courage of their convictions.

Initial Experience with Twine

Today Nova Spivack has taken the covers off of Twine and he will demonstrate it today at the Web 2.0 conference.  My prior post on knowledge networks was an attempt to lay the predicate for the concept of Twine as a knowledge network.  So I'll now make this more concrete to explain how I have been using Twine to build my own knowledge network during our initial alpha period.

Knowledge networking is what we VCs do in real life.  I am constantly asking

• "Whom do we know that knows about this" 
• "Didn't we talk to someone a year ago who knew something about this?" 
• "Isn't company X a likely customer of company Y and what do we know about companies X and Y"
• "Didn't [partner z] do a reference check that referred to this new technology some time ago?"

Like everyone, we make heavy use of the web, often sending to each other the  things we have found that might be of long-term interest or relevant to a current project. Within the partnership we communicate largely through email and then we meet every Monday to sync our activities and processes.  Organizational memory is largely in our heads.

My use of Twine is trivially easy.  I use two 'on-ramps'.  One is that I bcc: my Twine account with all my emails.  (I also set up some rules in my inbox to forward copies of certain emails to Twine as well, but my email rules are not as smart and extensive as Twine.)  The other on-ramp is I use the Twine bookmarklet as I browse with Firefox.   These two methods capture pretty everything I  consume in my business life.

As the emails come into Twine, Twine enriches the email to find companies, people, and places in the body. These enriched links connect to other content I have captured as well as Wikipedia and other sources.   So now I have a thread I can follow of what else I know, read, or can find that is relevant to answer the questions above.   This is less critical in the moment than it is  days or weeks after I  receive the new information.

I do the same thing as I browse.  When I find something of interest, I can immediately "bookmark" it into Twine and associate it with the things that I track in Twine.  (I have a personal account and am a member of several Twine  groups, including the Radar Networks Board of Directors group.  Other members of the group see the same information I have place into the group's Twine account. 

This is the real power of Twine.  All the information I have been accumulating has been intelligent interconnected as a personal semantic web of knowledge.  That mimics my own ability to recall what I know.  I don't find this that interesting, yet, because my use of Twine is relatively recent.  Ten years from now, my long term recall of what I knew today will be greatly diminished, unless I use Twine.  More immediately, everyone in my groups (Crosslink Capital, Radar Networks, etc.) benefits from attaching their knowledge networks to mine.  This really allows us to create a group diligence process that represents and leverages everything we, as a firm, know.  It means I know can truly leverage the knowledge and relationships my partners accumulate. The enrichment means we all get more than we put in as we use the product.  This basic process of structure knowledge capture and sharing is nearly universal in business, from major account sales processes to product design collaborations.  We all know that email is fundamentally broken as knowledge capture, retention, and sharing tool.

There is a lot in Twine I don't use, to be honest.  Photos, videos, and threaded discussions are all part of the application.  I don't need this, today, though perhaps in the future.  And there is a lot I'd still like to see in the application, including support for  meeting creation and calendaring synchronization.

The challenge with Twine is discovering all the consumer and business use cases and bubbling them to the top.  But for a terminal early adopter, I have to say it's really going to become an important enhancement to the way I communicate and accumulate what I know (and who I know.)

This is going to be a slower rollout than most web applications.  There is a lot we don't yet know about how to best package it as well as people's usage patterns.  The computing machinery behind the curtain is substantial.  So we still have a lot to do to understand some mundane but essential things like what it costs to support a user.  So please be patient.  The private beta is likely to last quite a long time until we get this right.  We are rapidly learning to live by Thoreau's guidance to simplify, simplify, simplify.

Radar Begins To Raise Its Head

We had a board meeting yesterday at Radar Networks. 

One of the 'truths' of the VC business is the "Oh Shit" board meeting.  Generally, this is the board meeting where you find out the underlying basis for your investment was flawed.  John Jarve at Menlo Ventures holds the record.  As I understand it, he fought resistance from his partners to even get the UUnet investment done early in the Internet boom, AND at the first board meeting after the close the Company was already out of money! (I may have these facts wrong, but it still makes a good set-up.) He had to come back to the well after the Oh Shit Board meeting. UUnet ended up being a monster hit for John and for Menlo.

There is another "Oh Shit" board meeting.  This is the one where the idea begins to show real form and you finally see the materialization of your investment thesis. Software is a visual medium.  Imagine describing Visicalc to the Apple II user in 1979 while it was in development.  "Well you see, it is this non-procedural, general purpose, non-command line thing that solves equations."  Doesn't sound like a Killer App. 

Yesterday the team at Radar took many of the pieces they have been building and assembled their first real, usable demonstration of the platform they have built.  They have spent the better part of a year building a semantic applications platform. Now that the foundation is built, the scaffolding is quickly being raised. Nova's feeling bullish enough about this that he has started to open up a little bit about Radar.  At least he is telling the World what it isn't.  Dan Farber also picked up on this to give it some perspective.

Actually to all you VCs who have asked me about why I am interested in the Semantic Web as a theme and what I have seen that's interesting, I would suggest you read his post.  It does a nice job of laying out a larger framework for semantic applications in the course of beginning to define the sandbox in which Radar will play.  He does a nice job of trying to de-hype the Web 2/3/4 sequencing into more tangible and technical distinctions.

Venture 2.0 - Preamble

This the first in a series of posts on the idea of "Venture Capital 2.0."  I thought it was appropriate to first set the stage of Venture Capital 1.0 as the point of contrast.  This first post is obvious stuff to those of us who have been in the business for a while, but less so for the casual observer.

Venture Capital 1.0 - The Cycle
The venture capital business has always been a ‘hits’ business.  One of my first blog posts (about a year ago) was on the "long tail of venture capital." The average venture investment generates a negative rate of return, but the outliers like Google, Microsoft, Cisco, and Apple have given information technology (IT) venture capital its superior rate of return.  The IT venture capital industry has always been cyclical.  For forty years the cycle has repeated.  Outsized rates of return attract capital, increasing valuations, and depressing returns.  The depressed rates of return created capital scarcity, laying the foundation for lower valuations, better rates of return and a repeat of the cycle.  Public markets have played an important role in the process, providing both the public appetite for new issues, as well as currency for acquisitions of venture-backed companies by public technology companies.

The IT venture capital industry today finds itself in a form of ‘stagflation.’ The absence of interest by the public market has made liquidity difficult to achieve, making the 2000-2005 period a particularly depressing one for those who are incented by capital gains.  At the same time, the interest in U.S. venture fund investment by non-U.S. firms is at an all time high, inflating the size of funds and increasing competition.  Venture capital fees remain at a premium to most other asset classes, but not the returns.

Venture Capital 1.0 - Key Success Factors
Success in IT venture capital investing has been a form of capital and information arbitrage for much of the period up to the late 1990s.  The scarcity of risk capital and the scarcity of insight about evolution of technologies and technology markets made it possible for astute venture capital firms to transform access to capital and superior technological insight into superior returns.  For example, as Moore’s Law was driving the electronics industry to the mantra of smaller, cheaper, faster, Sequoia Capital built a franchise reputation in semiconductor venture investments, based on the experience of its two founders, Don Valentine and Pierre Lamond, both early veterans of National Semiconductor.  A more recent example is ComVentures’ growth and success in the late 1990s.  Seeing the triple effect of telecommunications deregulation, global Internet growth, and ever-changing technologies and standards, the principals at ComVentures capitalized on their market and technological knowledge to raise several early successful funds.

Success begat success in the venture business.  Since venture investments have had payoff characteristics like options, i.e. limited downside and infinite upside, the key to the business has been "deal flow."  Deal flow is about seeing as much of the total distribution of deals, to generate a larger set of 'long tail outcome' candidates.  Success made IT venture capital business a first-order Markov process, where the probability of the getting the next hit was enhanced by having a previous hit, precisely because of the desire of all entrepreneurs to affiliate with "known winners."  The two masters of this phenomenon have been Kleiner, Perkins, Caulfield & Byers and Sequoia Capital.  Both parlayed early successes into institutional franchises. Other firms, many as old or older, have been less effective at sustaining the self-reinforcing dynamic of brand and success.  The sequential evolution of the IT "food chain" from semiconductor (Intel, National) to systems (Apple, Sun, Dell) to software (Microsoft, Oracle) to services (Yahoo, Google) has been the underlying order.

As the U.S. venture capital industry posted record rates of return in the late 1990s, the industry attracted record levels of committed capital that remains in place today.  Despite the abysmal performance of the industry from 2000 to 2005, many firms have been able to attract investors and avoid the re-equilibration and shakeout that has been predicted for the past five years.  It seems that limited partners have become inured to the venture capital cycle, expecting a repeat of the historic boom/bust experiences of old, and to average their rates of return over the next few cycles. 

A belief in forward-averaging the returns assumes that history will repeat.  The thesis of these essays is that the venture cycle has fundamentally changed for Information Technology and that formulae that worked over the past 20-30 years no longer broadly apply. 

• Globalization is both a risk and an opportunity with venture branding.
• Capital is no longer scarce, nor is access to venture capitalists.
• Information technology is no longer rarified and, in many cases, it is inexpensive.
• Global 2000 Enterprises, once the 'go to' customer for any fledgling IT startups, no longer have the risk profile they once had for IT innovation.

As I said, these observations are not new, nor are they particularly insightful.  And some firms are already responding.  The move to Cleantech is a move to exit IT (or diversify) to find alternative industries.  The move to build Indian and Chinese outposts are brand extensions.   

Presumably the Limited Partners who invest in venture funds have more incentive than anyone to develop an investment thesis about Venture Capital 2.0.  The next post will concentrate on the barriers to doing this effectively.

Business Model, Schmizness Model

The term “business model” has bothered me for a long time.  I have always found it to be a glib method of characterizing a company’s relationship with its various constituencies, e.g., customers, suppliers, competitors, etc.  The problem isn’t really the concept.  The problem is that it’s a complex, multidimensional structure that doesn’t really lend itself to a summary sentence, at least not if you really want to understand the business.  Yet it one of those economic terms that has entered the popular lexicon as the rise of business schools in the 1970s and 1980s mainstreamed “businessperson” as a profession (like engineer, doctor, or lawyer).

Wikipedia does a decent job of summarizing the cacophony of ideas that are embodied in the term business model.  I won’t recount them here.  The reason the question “what’s your business model?” bothers me it that the inquirer often judges the answer based on its parsimony, as though simple is prima facie evidence of good.  Occam’s razor applied to business strategy. 

I myself will sometimes ask others the question, but I use it to test for complexity, not simplicity.  I use it as a Rorschach to see how deeply the respondent has thought about the market and which aspects of the business appear most salient to him or her. 

In preparing for this entry, I started to ask myself how do I think about a business model? And how do I test if business models are complete, coherent, and compelling?  When I worked at Bain in the early 1980’s the firm then specialized in ‘strategy’ and ‘business definition,’ equally amorphous concepts. (Amorphous is good when you bill by the hour).   We used to refer to three tests to define whether two companies were in the same business – similarities of cost structures, competitors,  and customers. 

So I sat down and drew this little graphic for myself to try and outline the key concepts that seem to appear in the “business models” of companies that I see in my practice.  I don’t claim this is complete or some form of ‘ground truth.’  It is a snapshot of the concepts that I most readily gravitate toward when I think about “what’s your business model?”   I am sure I have left out huge chunks that will become obvious when I go to my next deal pitch meeting tomorrow. 

 

I am not going to explain every facet.  Most of it is self-evident (I hope).  However, a couple of things are worth noting.  First, at the center are the terms “lever” and “return on equity.”  I think of all these bubbles as knobs or levers in the machine that is a business.  Not all are equally important, but all are impactful choices that Management has made about the business, even if the choice is to ignore this facet.  Second, the objective I want to maximize is return on equity, not growth, not revenue, and not necessarily even market share, though these may be part of what generates ROE. 

I have enumerated some of the common choices more for illustration than prescription.  I should point out the category of “enterprise asset” because I think of this as a separate objective beyond barrier to entry.  The “enterprise asset” is that intangible that is the difference between book value and enterprise value.  It is the reason why an acquirer is drawn to the business beyond the NPV of the earnings stream.  It is the strategic value or what accountants call goodwill.  This box is particularly important in early stage investing, as the exits are so often around acquisition.  The business should have a clear definition of its ‘residual value’ to a potential set of acquirers.

Hopefully some will find this useful as a checklist.   There is nothing Web 2.0 about this framework.  And there shouldn’t be.  Business is applied microeconomics -- Web 2.0 or pest extermination (perhaps a poor juxtaposition – I need an editor.)  Anyway I feel better for having shared my quick and dirty model of a business model.  Thanks for listening.

So, quick, what's your business model, anyway?

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P.S.  I woke up this morning realizing I had overlooked where to place "advertising" in the mix. (Doh!)  This is a big enough oversight that I thought I better modify this before I get blogwhacked.  I think of advertising and cost per action as "transactions."  The reason for this is that advertising is really a form of variable micropayment, i.e., an attention tax.  It scales with an action -- page view -- so it is a form of transaction to me. 

VC Binds that Tie

This past Thursday I had breakfast with an entrepreneur whom I met about six months ago.  He was raising his Series A round.  We met him back then, but decided not to pursue the opportunity.   He is a first class guy and understood our reasons for declining.  Nevertheless, since then he has referred other entrepreneurs to us. He contacted me this past week to talk about a dilemma he was facing and get another perspective on his situation.

After six months he has finally connected with a VC who gave him a term sheet.  He likes this guy a lot.  But he has a problem.  The lead VC is with a firm based out of the Valley and they are trying to build a syndicate.  In the process, he was connected to another VC in Silicon Valley at so-called ‘top tier’ firm with whom the lead VC would like to work.  While he likes VC #1, he doesn’t feel VC #2 really clicks with him, despite the overt feedback he is getting to the contrary.  In particular, VC#2 is trying to suggest business models and go-to-market approaches that seem rather cookbook.

He needs the money but doesn’t feel good about the conversations. What should he do?

The easy advice (and the advice I gave him) was not to jump into this relationship.  It is obvious that he will be tethered with VC#2 for a long time.  So chemistry matters.  More importantly, what is being signaled in the conversation is that VC#2 isn’t committed to the approach. Nor is it likely that VC#2 is committed to the entrepreneur as leader if the default approach doesn’t work.  This is the larger red flag.   So my advice to him was to (1) have a frank conversation with #1 and then #2 about his sense the #2 isn’t really committed to him, but rather the “opportunity,” and (2) work other connections from #1 to find an alternative #2.

The real point here isn’t the lack of chemistry. It is the VC-to-VC dynamic that underlies the issue.  Co-investments are unique points of VC intersection for an entrepreneur, but they are just points on a line for VCs.  We may co-invest in several deals together.  In fact, ‘showing another VC a deal’ is the currency of dating in the VC business.  It is the method by which VCs socially level themselves or raise themselves in the economic-social strata of VC-dom.   So VC#1 has not yet worked with VC#2, but wants to; hence the introduction.   VC#1 is less sensitized to the ‘fit’ issues because this is the beginning of getting into VC#2’s deal flow. 

This quid pro quo is part of the VC ecosystem and a binding tie for which entrepreneurs need to be vigilant.  Everyone wants to be or be in an “A” firm deal.  It signals status and selection survival, like being admitted to an Ivy League school. Brand association is valuable for the VC#1.  Even if this deal doesn’t work, the association will enhance his deal network and will give his a good co-investor logo to show his limited partners.  But the brand inheritance effect is ephemeral for the company.   It is there for the start-up as long as no one knows how the company is doing, usually around round B. But the individual VC is there long after the brand effect has dissipated.  The  question is whether the entrepreneur still is, too.

My Second Job

A few weeks ago I wrote a long post about our recent investment in Abgenial.  One thing I didn't mention is that I am the Interim CEO of Abgenial.  The cash comp is lousy, but the karmic compensation is great. 

Rafael launched the blog today in which he blew my cover. So I felt compelled to add a commentary as a company perspective.  Don't look there for an explanation of Abgenial, yet.  It's more of a statement of what Abgenial is not.  Most of all, Abgenial is not a YAMP - Yet Another Mashup Platform. 

I promise to keep my day job and my second job editorially separate.  I will continue to write here as EarlystageVC, with the same lengthy and infrequent posts on venture capital, entrepreneurship, and the Web as I always have.  The blog at Abgenial will be an advocacy blog -- speaking from an Abgenial POV  to whomever cares to listen.  Hopefully I will accomplish my #1 MBO at Abgenial and replace myself soon with a new, improved CEO.  Then I can stay back in my day job, watching others have all the fun, and swoop in once a month for a few hours and tell everyone how the run the business, i.e. be a VC. ;-)

Investing at the Intersection of Opportunity and Serendipity

We just made a new Series A investment in a company called Abgenial Systems.  Dan Primack and Matt Marshall will pick this up soon enough.  So I thought I should get out in front and discuss this a bit. Pardon me for being a bit oblique in what I am about to describe, but it is hard to strike a balance between transparency and pre-announcement when dealing with early stage investments.  I don’t want to pre-announce or hype what they will do, but I do want to describe how we came to make the investment. It wasn't the usual "show us your Powerpoint and wait for the white smoke" dialog that characterizes most entrepreneur/VC interactions. 

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About a year ago I became interested in the phenomenon called mashups.  VCs try to find Big Ideas that transform existing markets or create new ones. This seemed like a Big Idea, but packaged in a Small Box.  I started thinking about something I eventually came to think of as The Recombinant Web --  a half step between Web 2.0 collaboration and the Holy Grail of a Semantic Web.   After all, the motivation of mashup creators was to recombine otherwise useful silos into new, ever more useful experiences.  Today’s web services are kind of like old, single-tasking PC applications.  They exist largely isolated from each other on a common presentation screen.  Then it was the CRT.  Today it is the browser window. 

The “integration” of Google’s web services or Yahoo’s web services is reminiscent the “integration” that existed in Lotus Symphony, the short-lived successor to 1-2-3.   I especially like this description from 1985  because some things never change. A hit application spawned visions of a platform...

Lotus designed Symphony for access by other programmers. Hooks inside the software help developers write applications for the Symphony environment. Add-in applications directly from Lotus also are expected. Obviously, Lotus wants Symphony to be your only program. Whether this idea is valid depends on several factors, not the least of which is how well the package works with the expanded RAM of such computers as the IBM PC AT. With up to three megabytes possible, Symphony memory problems could become a thing of the past. (Creative Computing, February 1985, p.88)

Sounds vaguely familiar.  "Hooks inside the platform" - the 1985 version of API, and "up to three megabytes possible. Memory problems could be a thing of the past." - the 1985 version of the infinite resource of the Googleplex.

Mashups emerged from the current developer community as a way to exploit the Web as that platform and break  down the stack of proprietary, but "integrated" web applications from GYM.  But “mashups” have lots of limitations as a methodology. Over time I distilled the issues to three fundamental objections. 

• First, the author/user distinction doesn’t scale.  You can’t possibly know what web services I might want to combine nor how.  Only I do.  I want to program the web.  I don’t want you to do it for me any more than I want to go to a site that lists all known queries to search the web.  A corollary to this point is that will be few (no) mashups that are viable standalone businesses, at least not at a scale that has an interesting economic consequences for an investor.


• Second, there is only so much "bookkeeping" that can be done efficiently in the browser. Integrating in the browser is like cooking on a camping stove. It's possible, but it wasn't designed for an elegant and synchronized multi-course dining experience.  Complex and interesting re-combinations are not what browsers and AJAX were designed to support.   

• Third, the idea of users combining arbitrary web services seemed too unbounded and too early. It seemed wrought with lots of nasty issues like service availability/fail-over, financial models,  data formats, and a small issue of programming, programming, and programming.

I started blogging about mashups with the intention of learning-by-publishing.  The more I wrote, the more I learned. The more I learned, the more convinced I became that these issues required a fundamental re-think of how to approach integration. For the concept of re-mixing to become mainstream, It had to be capable of handling sequencing of web services and flows of data, but with a user interaction model as simple as point and click or cut and paste.  A tall order.  The more I stared at concept of "mashups," the more convinced I became that the concept was too parochial.

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Three or four years ago my friend Pete Kolstad introduced me to Rafael Bracho.  Rafael was a co-founder of Active Software and a pioneer in the 1990’s evolution of enterprise application integration (EAI) software.   Active Software went public with Rafael as CTO and eventually merged with WebMethods.  Somewhere along the way, the original EAI vision of simplified application integration became bloated by layers upon layers of standards, registries, modeling languages, protocols, etc. and promise of nimble enterprise services-oriented architectures (SOA) was DOA.

We were looking at an EAI appliance company about 18 months ago and I asked Rafael to help us with the diligence. Luckily we lost that deal to another VC firm  (it since has not gone well).  Afterward, by pure serendipity for both of us, Rafael started telling me about a technology he and a partner had been working on for several years under the name Abgenial Systems.  It was a radical re-think of how to integrate applications.  It was so radical, in fact, that we didn’t understand where to use it, nor did the other VPs of Software Development that we asked to look at it.  By starting with a new conceptual model for what integration and interoperability would mean, Rafael and his partner Jacoby were able to simplify the enterprise integration problem to the point of near triviality.   

I was stumped as to how to make this an interesting business.  WebMethods, Vitria, Tibco were yesterday’s news.  Who cares if you could steal share from these guys? They were locked in a fight to the death on near-free software, bundled with low margin consulting services, and rewarded with market caps running at 1X revenues. 

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My most important observation from immersing myself in the concept of mashups was the recognition that mashups were just another form of application integration, done client side rather than server side.  That launched me in to seeing a potential unification of innovative consumer applications with stultified enterprise applications.

All of a sudden the idea of Abgenial pivoted.  Last Fall, Web 2.0 was white hot on “collaboration and mashing” and Enterprise Software was moribund with “legacy vendor consolidation and broken distribution models.”   Software as a Service was the VC industry’s  Great White Hope, combining Web distribution with Enterprise functionality. (Read this as low cost of distribution and tangible value.) Google, Microsoft, and Yahoo were increasingly veering towards web applications (calendars, maps, photo sharing, etc.) – free form of SaaS.

The Abgenial Pivot was to see the dots were connected.  Consumer web….enterprise web…..Saas….legacy apps…. Mashups….SOA were all variations on a theme and that theme was <hype>Programming the Web</hype>.  It was then that I went to my partners and asked to provide a $250K bridge loan to blow away the haze and find the business in this combination of market intuition and technology.

We did. 

And then we screwed it up.

Thinking that the real innovation here was software, we designed a software business.  Sell a product and make money.  A time-honored tradition.  We approached a bunch of VCs whom I know with (1) a team with a record of success (2) real, protectable technological innovation and (3) a short productization plan.  No bites for a co-investor in Series A. The market said, Wrong! Software Still Sucks.

We went back to the Business Model Drawing Board to re-consider how we could accomplish this grand(iose) vision of programming the web, but with a more palatable adoption model.  In retrospect, I think the first pass of delivering the technology as software was a default option.  It was easiest because this is what the team had done before, not because it was what the market wants today.  So, of course, we moved to hosting -  but hosting what exactly?

We went through several theories of what to deliver, looking at various other companies as role models.  We flirted with being a "better this" or a "better that" but constantly came back to the belief we could be so much more than a Web 2.1 company, precisely because the technology was so radically better and different than anything we had seen. Along the way I managed to get confirmation of this point from folks I knew at Salesforce, Microsoft, Google, and Yahoo, as well as the single most-informed thinker on Web 2.0 software architectures I have met - Dion Hinchcliffe.

I was stretched with my partners.  We were thrashing.  We knew we had something Big, but somehow it was the Business We Dare Not Name. Technology, Platform, Application, Solution -- these are all gobblegook businesspeak that don't define anything concrete. 

Then we had a breakthrough.  Oddly enough it came at meeting at one of the largest software companies back in May.  Rafael and I were both there schmoozing and being schmoozed.  A few conversations into the day, a light went on for both of us.  All of a sudden the fog lifted and it was clear to both of us how to go to market and the natural business model. It was a kind of a Steve-Jobs-in-Xerox-PARC moment.

That stunning moment of clarity was enough to get my greed glands going. I no longer wanted a co-investor.  VCs alternate between fear and greed.  Now that the opportunity, differentiation, value proposition, and path to monetization are clear the next steps are about establishing proof and building a team. I outlined the concept to my partners and we agreed fund this post haste.  We closed Series A two weeks later. The team is hard at work building out the business.  Soon we will begin looking for some senior management, including a world class CEO (hint to reader).

Abgenial isn't really in stealth mode. It is not a state secret, but it is clearly in gestation and explaining it is just a distraction right now.  One thing I have learned after 25 years in software is that innovative software defies description. It has to be seen to be understood. Imagine Bricklin and Frankston describing Visicalc before you saw it.  Imagine Ray Ozzie describing Lotus Notes before you saw it. So please be patient.  Abgenial will emerge from the shadows soon enough, and then you'll see why this Aha! was so hard to find, and so obvious once we did.

Chance favors the prepared mind.  Blogging as a form of thinking out loud definitely helped me prepare mine for this one. 

Web 2.0 – Now What?

There have been several posts chronicling the abundance of Web 2.0 clutter companies.  Rich Ziade had a great post showing the 15 minutes of fame that new Web 2.0 companies have as they circulate in the blogosphere for a week or two.

Baris had great survey of Web 2.0 companies detailing the clutter by category. Ismael has compiled a similar database of Office 2.0 companies.  Last week Brian Benzinger pointed to 50 companies online that basically serve the same function – taking notes.

Evidence of the Entrepreneur Bubble continues to accumulate.  And entrepreneurs are not the only ones chasing the future by looking in the rear view mirror.  The VC community seems to have re-discovered the social network yet again.  MySpace and Facebook have spawned a hundred clones.  I get 1-2 inquiries a week from entrepreneurs in the US, India, or China with social network proposals.  Video sharing is another meme-of-the-moment attracting attention and capital.  Imitation is breaking out everywhere. Last week that frustration caused me to reflect on what it means to have a barrier to entry.

But there is a bigger question at hand and I think it is on the collective minds of everyone who has been immersed in the torrent of Web 2.0 creativity.  Simply put, it is

Now What?

Web 2.0 is on the verge of going from Wired to Tired or so it seems.

VCs and some enterprise folks are starting to talk about Web 2.0 in the enterprise as Web 3.0 – Wikis, RSS, collaboration and knowledge management.  Others call it Enterprise 2.0.

I had breakfast with someone yesterday who is joining a very visible Web 2.0 company to become their General Manager of Enterprise solutions. Hmm…

I subscribe to the thesis of enterprises as a natural user of all this technology and have for a while.  Companies are communities. Supply chains are social networks. A customer base is a community, albeit often not interconnected, except by indirect methods like lawyers and analysts.  Shareholders are a community, often interconnected the same ways. 

Companies have known this for a while.  Recruiting has been an exercise in social networking for a long time, both on the employer side ($500 referrals) and the job seeker side (the origin of the concept of “networking”).

But the difference between collaboration in the consumer and business worlds is one of purpose.   Expression is the primary purpose is many Web 2.0 consumer sites.  It may be expression for entertainment, expression for reputation enhancement, expression for contribution to collective knowledge, or something else. 

Collaboration in a business context has a goal other than the act of collaborating itself.  We used to call these goals business processes.  Collaboration is one important component of a business process, but it is not the whole process.  Another interesting dimension of a business process is a transaction.  A transaction is the organization’s transformation of a set of initial inputs  (customer inquiry, need to hire, etc.) into an accomplished goal.  Collaboration is either loosely or tightly bound to the process.  But so are data and systems.  And that’s the other half of Web 2.0 to me – the lightweight integration methods of Web 2.0.    Together these two parts of Web 2.0 can re-engineer enterprise IT. Interesting. And the Enterprise itself.  Much more interesting.

OK Where?
Mash-ups represent a potentially powerful way to create new ad hoc Web applications out of existing enterprise data and web services.   Business intelligence applications are likely to be the first places we will see these appear for simple reporting and visualization purposes. Ultimately, they will emerge as complete business processes that mash (integrate) enterprise applications with applications in the cloud.  And SOA and Web 2.0 will fully converge.

But the Web 2.0 applications in the enterprise are not going to be the same as the consumer apps in the cloud. And this is more than just “behind the firewall” or not.  Applications are going to be more contextual to have value.  A Web 2.0 method of collaboration for product design and management of the bill of materials isn’t a tag cloud.  Nevertheless, tagging and structuring the ideas are an important part of ensuring the original design intent gets expressed in the delivered product.   A Web 2.0 method of managing a customer base as a strategic asset will encourage customers and vendors to share information and product applications, requirements, limitations, and flaws.  It will also change the conversation in unpredictable ways.  Mining and reporting will be just as important as capturing and ease of use.

Creating the enterprise context will be where most “ported” Web 2.0 applications fail in transferring to enterprise uses.  Because the processes do have a purpose in the enterprise, the applications of collaborative computing will need to reflect that context to be high value.  A wiki could be used in a product development team and a wiki used by a major account sales team.  But the real value will be in structuring the usage, content, reporting, etc., to really impact the goals of the teams. The wiki will be a feature of a larger solution.

This is one interesting Now What? impact of Web 2.0 for me.  Enterprises are the ultimate Walled Gardens.  The distinctions of customer/supplier, employer/employee, management/staff, marketing/sales/engineering, Chicago Office/London Office, IT/line of business all become less meaningful in world where information is more easily, more inexpensively, and more rapidly shared, transformed, and consumed. This will put pressure on organizations (and regulators) in a long wave of upheaval.  Enterprises that harness this fountain of real-time and granular information will have a huge competitive edge - an edge equivalent to the first uses of data warehouses and data mining.  They will find and react to opportunities the way that program traders find and react to market inefficiencies. This  may well be the new Strategic IT.  The strategic IT asset is not the software that automates the process.  The asset is the embedded knowledge of all these enterprise communities and its integration into business processes.

Most VCs today think enterprise software is dead, especially for early stage companies.  I don’t.  I think the days of the $1M sale / 18 months to deploy are long gone.  But new, capital efficient Web 2.0 methods of consumer services morphing into lightweight solutions to empower enterprise users are about to emerge.  Lessons learned in Web 2.0 are going to get monetized in new enterprise IT.  Perhaps that's What's Next.

Addendum: Tech Crunch reports today that Facebook now has corporate clients.