What Changes the Second Time Around?

It’s been a while since I’ve blogged but I’m trying to get myself back on it again. I thought I’d kick off on the backs of our seed investment into appRenaissance announced today.

The CEO of appRenaissance is Bob Moul, whom I had backed in his last company Boomi in 2008. They were a pioneer in the cloud based integration market and Bob led the business to a great exit in 2010 to DELL. Bob left DELL a year later to jump back into the startup world. He eventually caught the mobile bug and joined appRenaissance as CEO earlier this year. When I got the call, it was a no-brainer and we were delighted to partner together again. It got me thinking, what changes the second time around?

1. Price and terms get figured out quickly. Seasoned entrepreneurs know the game; they know the pros and cons of too high/too low; they know the danger of running out too quickly or overcapitalizing; they don’t get sucked in by the hype in the echochamber; you don’t have to unwind all the misconceptions that exist out there. There is a tremendous clarity that allows us to virtually waste no time in coming to a handshake. Whether it was Bob Moul at appRenaissance or Chet Kanojia at Aereo, the conversation took a total of 10 minutes and we were onto building something great.
2. Don’t need proof because the trust is there. For first time entrepreneurs, generally people like to see some evidence of execution. We want to see what you’ve been able to accomplish, before and now. The relationship is so new that it’s hard to take people simply on their word. We want to see it in some numbers somewhere. The second time around, we already know what you can do and have done before. We’re glad to take early risks blindly because the trust is there.
3. Neither side worries about protecting outside case scenarios. You know the ones I mean… Spending a few weeks defining “Cause” and how to get a ladder of severance lengths based on that. Taking great pains to ensure you approve budget because someone might set one at zero and pay themselves insanely. Having to define exit thresholds and multiples because both sides worry about blocking (or not accepting) an exit because someone didn’t think they made enough money. In general, we never get hung up on the above, but they are real and these are the outside cases that strangers might try to protect. The second time around everyone focuses on the core issues, dealing with things that set up good governance and good mutual accountability, and knock them down easily.
4. It’s a lot more fun. If you’ve had a good outcome with someone, it’s likely the second time, an entrepreneur will be thinking bigger, focused more clearly and will want to build longer. Bob’s goal now is no less than to build a big public software company based in Philadelphia. We love BHAGs like that – it clarifies the mission and energizes all around.

Since starting FirstMark in 2008, I am getting my first wave of entrepreneurs coming back for our second time together, and it’s fantastic. We’ve made it a point to build early, deep and longstanding relationships that make us a place to go again and again. They serve as the best references for new entrepreneurs (first time or repeat) we endeavor to work with. And I look forward to doing so in the future with the many incredible first time entrepreneurs I’m so privileged to be involved with now.

Offline to Online: The Internet Inside

I recently tweeted about the acquisition of HauteLook by Nordstrom.  I think this is one example of many we will see in the coming years of large scale, “offline” incumbents buying their way into the future.

I believe every business today is going to be rewritten for the web, or “Internet optimized” as I call it.  This is not about putting up a website or selling online.  This is much more fundamental.  The Internet affects literally every part of a business system and makes it much more cost efficient than their legacy comparable.  Let’s take a few examples:

• Marketing – Paid, organic, display, affiliate and other channels are far more precise and cost effective to pin point your audiences than any blunt mass-market tool of the past.  You are connected to all your customers, it’s just a matter of finding them (and vice versa).
• Product – In an Internet optimized business, the product is instrumented to see real metrics on how people are logging into your application, which functions people are accessing, what breaks and doesn’t, etc.  Each of those tell you in real time what features to focus on or not, develop or discard, etc.  Customers participate in the product development process.
• Development – Multi-tenancy, single instancing, and SaaS makes development easier and faster than the complex install matrix of the past. Cloud services like AWS, Rackspace, Engine Yard and others are fully variable infrastructure available to build upon.  AGILE and other development methodologies create output on regular basis.

Any “new” company is doing things efficiently across virtually all departments from the ground up (and includes areas not mentioned like sales, hiring, finance, and more).  At scale, they will have a fundamentally better cost model than any legacy player possibly could.  The legacy company still has those very expensive relationship based sales reps, or the high touch TV-driven ad model, or the “divine from above”/ “decide by committees” product model.  These are all points of friction that makes them hard to change, slow to adopt new business models, and not innovative.  It also leaves them at a fundamental economic disadvantage.

If you think about it, this concept is true for almost all businesses.  We see retail in the Nordstrom/Hautelook example.  The same is true in traditional advertising versus ad networks; console based gaming versus virtual goods businesses; large media publishers versus blog aggregators/publishing platforms; stock fit retail brands versus custom manufacturers; etc.  The Web is as deflationary across the internals of a business as anything else!  This wholesale rewiring is happening now, creating a unique moment in time and a littany of new companies looking to lead the pack.

The most likely way for offline players to evolve is to buy these Internet optimized businesses, incent those organizations to grow as rapidly as they can, retain the talent for as long as it possibly can, in the hopes they can eventually re-make their overall business by being led by example.  Those that do nothing will not survive, and there will be many;  those that think aggressively have a shot, and I think we’ll see much more of these partnerships with traditional brands and Internet optimized companies going forward.

[Update 4/08 – Random House leads round of financing at Flat World Knowledge]

[Update: 4/25 – The Travel Channel announces $7.5MM investment in Oyster.com]

Buy Me Or I’ll File

The 3Par saga is finally over, and the Company with the larger resources and most similar channel won.  HP is buying 3Par for $33/share or $2.4B in value.  This is over 3x where the Company’s stock was trading before the battle begun.

3Par is a classic example of why many private companies go “on file” (meaning, file their S-1) to drive an M&A process.  If you are a unique company with technology and sufficient scale to go public, that should be a pretty desirable asset.  But many times you need to create a compelling event to get buyers to take a process seriously.  By filing an S-1, you are telling a broad audience that you intend to go public.  Once public, there are a whole new set of fiduciaries the Company becomes obligated to and new set of disclosure obligations.  For example, in 3Par, all bidding happened formally and publicly.  Dell had no ability to lock the deal up and drive it to a close.  Their foresight and brilliance tipped others into action.  We saw the same with EMC, when they swooped in on DataDomain and took them away from NetApp. 

If either of these companies chose to buy 3Par when it went public in November 2007, they would have saved over $1.8B!  There are many companies on file today that don’t really want to be public.  It’ll be interesting to see if these recent public battles spark others into action sooner.

Re-Shaping of the Data Center: The Scoop on the 3Par Bidding War

This morning HP announced they were trumping Dell’s bid for 3PAR, offering a whopping 33% on top of Dell’s 85%+ premium. I’ve read lots of chatter about why, but I think much of the analysis misses the mark.  I thought it would be worthwhile putting the deal in historical context.   

First, let’s talk a little bit about data center and storage history.  Storage many years ago used to be housed with the CPUs.  The large vendors shipped computers with high end processors, packed with disk drives and called them servers.  As data storage grew faster than compute, the industry began to decouple storage from the compute, giving birth to companies like EMC. 

EMC and Hitachi Data Systems operated in the high end enterprise segment with very large storage arrays designed for high performance, availability, and reliability.  Because of how critical and difficult storage is, very few of the server makers chose to wade into the market.  In fact, most compute players would regularly OEM product from the specialized storage makers.  This led to a very happy symbiotic market with clean lines where everyone knew their place, and each of these vendors in fact OEM’d one another’s products.  For example, Sun and HP each resold HDS’s products.  Dell resold EMC’s products.  Brocade was built almost entirely on a channel model.  

A couple of moves really changed this panacea.  First, EMC got a hold of VMware and virtualization subsequently became the hottest trend in the data center.  This pulled EMC into the server side of the market and led them to rapidly expand beyond storage into systems management, software, and other layers of IT spend.  Second, Cisco announced they would be entering the high end server market.  This clarified their growing ambitions from dominating the router market into the compute part of the IT spend. Cisco announced a JV with VMware and EMC to complete their product vision late last year. Third, Dell bought Equallogic and HP bought LeftHand Networks, both signaling a movement towards owning IP for storage (albeit the mid market).  Dell had been partnered with EMC going back to 2001 and was a meaningful channel for EMC’s mid range products.  Very quickly everyone got a wake up call that their place in the stack was not secure.

So what’s happening now?  Every major data center platform vendor sees two major trends going on.  First is the rise of the dynamic, agile data center within enterprises.  This requires being able to spin up resources – compute, network, and storage – automatically in response to business demands.  Second is the eventual move of the data center to private and public cloud offerings.  In this model, the vendor no longer sells equipment to the enterprise, but assembles and runs all the parts as either a dedicated or shared service.    

In order to fulfill this vision, you need all parts of the stack working together seamlessly.  This is where 3Par comes in.  3Par was born during the great storage gold rush of the early 2000s.  Bringing their product to market took over $200MM in venture capital, including some recaps along the way.  They were one of many startups that were funded to build flexible, modular, high end systems, but one of the few to survive.  An enterprise’s lifeblood is storage and they would not trust startups lightly.  This required high burn to build the technology, and then high burn on the sales side to succeed in market.  To 3Par’s credit, they managed to get public and raise sufficient capital to sustain themselves to critical mass and profitability.  And now they benefit from scarcity value.

Looking at the landscape, 3Par is the only real alternative to EMC and Hitachi in terms of high end storage.  EMC has its own ambitions for data center dominance, while HDS is part of a much larger conglomerate.  If you believe you need to own storage and server, both to fulfill the vision above and to avoid partnering with a competitor, than 3Par is the only place to get this type of deep high end storage technology.  Given HP and Dell have a much larger sales channel than 3Par, these guys can immediately double, triple or quadruple sales from 3Par products overnight once it is part of their catalogue.  Both reasons afford the premium we are seeing.

Going forward I’d expect to see more data center consolidation.  There are some major battles brewing as companies compete to own the enterprise! Network Appliance has long been rumored as a fit for Cisco.  Plenty of other combinations make sense as well.  It’s clear to me, though, that the march is towards creating end to end solutions and masking complexity.  Should be a fun next few years to watch!

LTV: Another Metric in SaaS?

I recently had an interesting conversation with a very smart hedge fund buddy of mine.  We were of course talking about investment ideas, given many of us were holding either cash or gold, and I threw out Salesforce.com.  It is generating 15-20% free cash flow margins, growing revenues at 30%+, with a solid recurring base.  This led to a discussion of valuing SaaS companies.

As venture folks trying to build companies, we tend to focus on operational metrics like Annual Contract Value (ACV), Monthly Recurring Revenue (MRR), Average Selling Price (ASPs), and Churn.  Both Byron Deeter of Bessemer and Will Price formerly of Hummer Winblad have done very nice posts here.  My friend’s perspective was entirely different as a public market buyer.  He looks at everything through the valuation lens.  He said the metrics above are all interesting, but he and his peers tend to focus on Lifetime Value of a Customer.  Essentially wrapping many of the components above to look at the DCF value per customer.  It is very similar to how analysts look at cable companies on the overall value per subscriber.  An obvious point he made, but framed from an entirely different angle, was that small changes to churn assumptions would lead to drastic changes in the overall valuation and associated multiples of a company.  While one can focus on the revenue or FCF multiples, it’s really the LTV that he cares about.

[UPDATE: Many searching for specific LTV calculations come to this site – a great summary of the formulas to use can be found here by Joel York of Chaotic Flow].

As a venture investor, I had never really thought about the public market perspective on my companies.  But it got me thinking about adding it to the key list of metrics our SaaS CEOs think about, because someday, we hope they will be selling that LTV metric to the Street.  Its component parts are made up of all the metrics we track, but creating an explicit metric often generates focus, and it’s probably one to think about early on in building value.

What do you think?

The Entrepreneur’s SEO – “Startup Exit Optimization”

I was chatting with a start-up CEO today, who had received some early inbound interest from a potential acquiror.  Without any discussion of price, he asked me innocently enough, “Should I think about it?” 

I started thinking about the positioning of the Company and the phase, and offered the following.  I think most start-ups go through several brief natural local maxima, to borrow a calculus term, over its life (3-6 month windows of time over a 5 -7 year life) .  Those maxima are periods where, on a risk adjusted basis, it may make sense to exit early.  The trick is to recognize whether you are there or not, so as to know whether you are value maximizing. 

To be clear, this is not a post advocating early exits.  Heck, as many other people have observed, as a venture investors generally try to swing as big as possible across a portfolio of companies.  As a maximizer of *company* value, however, you have to be cognizant enough to realize when you are on one of these plateaus, pick up your head to look around, and see if someone might be looking at you through binoculars from afar.   You’ll always have to be “bought not sold”, and many people move from valley to valley never getting to a peak, but if you do, recognize it, assess it, and make an informed decision. 

Generally, I’d say an acquisition is value maximizing if it occurs in one of three periods: the “concept” pop, the “growth” pop, and the “IPO” pop.  In the “concept” pop, a company is acquired primarily for its radical vision or strategy, with no correlation to financial metrics.  (This is not in the context of a bubble.)  Think of a Series A company that seems to have a laser sharp vision for a particular space that many other people haven’t begun to understand.   The Company usually has visionary management, early mindshare in a rapidly evolving but undefined/unstable space, and the early positioning (and PR!) to objectively call it a “thought leader”.   In a normalized market, it’s probably just getting to revenue.  The multiple is the highest at this stage b/c the denominator (revenues) is low; conversely the acquisition price is also the lowest because the acquiror has no reasonable financial grounds on which to pay the price.  They just know this could disrupt, transform, or catapult their business and want to be on the ground floor.  This is usually the $50-100MM exit. 

The next major hill is the “growth” one.  This would be a Company likely past its Series B, generating $10-20MM in revenues, has clear market leadership by virtue of tangible numbers like customers/partners/ASPs, and a fully built management team.  In this case, a Company has built hard technology that works, has perfected how its sales machine works, and now is adding fuel to the fire.  It’s probably growing at unsustainable longer term rates of 100-200%+ but can project wonderful visions of grandeur.  Competition exists from a raft of “me-too” startups, but also in the marketing from large vendors as well.  From an acquiror standpoint, you can start putting loose financial multiples to the Company and assessing sales channel synergies.  While the multiples begin to come down relative to the first hill, only a fool would give up what seems like a rocket ship, and so the absolute dollars go way up.  Exit values are usually in the $150-300MM range.

The last major hill is the “IPO” hill.  The IPO hill is the company that has not only done all of the above, but has managed to stave off ALL competitors, large and small, and built a truly defensible position.  The Company has not only done that, but also met the inter-steller, global galactic, worm-hole inducing bar to go public by filing its S-1!  An acquiror at this point would be capitulating that they will not beat the company at its game, and moves in to take it out before it goes public.  The multiples here have to come way down and likely tie to some notion of “accretive” (within 2 years) for the acquiror, but again the absolute number is much bigger.  The universe of buyers is also much smaller given the magnitude of the exit.  This is usually the $400MM+ purchase. 

Why look to an “exit check” at each of those hills?  Well, typically, those hill peaks are followed by valleys of varying depth and visibility.  Doing a little more wont change the exit outlook; in fact, it’s more likely to cause you to be “in discussions” while on some kind of a non-optimal slope.   And while there are always larger, more lucrative, adrenaline producing hills ahead, you have to be fully prepared with better equipment, maps, resources, and a better set of lungs, while finding enough sustenance and staving off nipping animals, before emerging on another peak again.  In start-up terms, that means making sure the product works, figuring out sales cycles, successfully deploying at customer expectations, rising above the noise of ever present competitive slideware, maintaining price points, expanding the available market, raising venture capital (aka, dilution!), hiring and retaining great people, building appropriate regulatory and compliance infrastructure, and so on.  All are manageable issues, but companies inevitably move downward from a plateau when getting into the weeds of execution.  The numbers bear out how many make it through to the next hill.   

[As an aside, it’s why VCs love guys who have “done it before” – their lungs and maybe wallets are usually stronger to go the higher distances.]

How do you know you’re leaving one of these hills?  I’ll save for another day if there’s interest…