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When Facebook goes public, the Russian venture capital firm DST, will be one of the largest investors in the most significant technology IPO since Google.Posted by Rory O'Driscoll on November 15, 2011And what it means going forward – A post in four parts
When Facebook goes public, the Russian venture capital firm DST, will be one of the largest investors in the most significant technology IPO since Google. DST could make $5 Bn on one investment. A question for any LP to ask the US venture capital industry is, how the heck did you let this happen? Someone walked in off the street and scooped the big pot. If this were Vegas, the casino floor manager would get whacked.
It began with the bubble
The bigger story is that the DST investment is emblematic of a wider change in the venture industry. The story began in the dot com bubble when hundreds of immature technology companies went public, and then promptly ran out of money before ever showing a dime of profit. The Nasdaq declined by 80% between 2000 and 2002, and it is still 50% below its 2000 peak. At the same time, regulatory overreach made IPO’s harder to get done. Sarbanes Oxley was designed to solve the Enron problem, but the high fixed costs of compliance ended up hurting early stage companies proportionately more, even though outright fraud was minor to non existent for venture backed companies in the tech boom. Enron, Worldcom and Tyco were all big established companies who lied about the past. Very few “dot.com” companies lied about the past; instead, at worst, they exaggerated the future. However the result of regulation and risk aversion, was that venture backed IPO volume plummeted, from a high of 200 plus in 1999 to a low of 9 in 2009.
Who loses when IPO’s don’t happen?
The economy definitely loses big time. Fewer IPO’s means less recycling of scarce venture capital and thus fewer new startups. Venture dollars invested in 2011 are still only 30% of the 2000 total, and all those extra invested dollars created jobs.
Does the venture business lose? The conventional wisdom would say yes. Venture capitalists are in the capital gains business, so if you cannot take companies public, it is harder to realize a big capital gain. However, a closer look would show the impact of the IPO dearth on venture backed companies, and ultimately on venture returns, has been more nuanced. For companies in intrinsically high burn rate businesses, like biotech and clean tech, it has clearly been a disaster. For these companies IPO’s are a necessary financing, not an exit, so no IPO’s has meant no money, and thus the closure of many promising opportunities.
But for many technology companies the picture has been different. The story that the “internet is capital efficient” has been overdone but it is true that companies in the internet space can get substantially de-risked, and even get to cashflow break even on relatively little capital, amounts of money that are within the capabilities of the venture industry. Here the closed IPO window was not a matter of life or death, instead it simply meant that companies spent more of their early middle age (for lack of a better term) as private companies, than would have been the case in the 1990′s. For the investors this has translated into longer holding periods. What in turn does that mean?Key point, Fewer, Bigger Winners, more Losers
As holding periods got longer, something very interesting happens. Dispersion sets in. Mary Meeker used to prepare an annual report at Morgan Stanley showing the fate of every technology IPO since 1980. Every year the big picture conclusion was the same. After the IPO, many, sometimes most, tech IPO’s underperform. Fifty percent or more of them trade below their offer price forever, and almost all the overall gain comes from a small handful of companies. However, the gains from these few companies massively outweighed the losses on many smaller deals and overall, investing in technology IPO’s, has been a good business. Microsoft, Cisco, Oracle and Apple covered a multitude of sins and a basic index fund strategy across the category made money. It is the same pattern of winners and losers that is seen at the start up stage, except played out for bigger dollars, in the public markets after the venture capital investors have exited. The table below shows the calculation for twenty years worth of IPO’s (1980-2000), showing that 78% of the post IPO value was created by 50 IPOs, approximately 3% of the total number.
This process of winnowing, and continually separating, the winners from the losers, is independent of whether the companies are public. It is a basic part of how technology markets operate. With the IPO window shut, all that happened is more of this process took place in the private markets. Some companies that reached $100 MM in revenues and would have gone public, instead remained private, saw their growth rates decline and got sold for minor sums, others went on to have $ 2 BN in revenues, and are now valued in the many billions, all the while still private.
Venture Industry is healthy, many firms, not so much
The result for the venture industry is that for a long time the industry as a whole looked sickly. Holding periods extended, IPOs were sparse and returns were dreadful. Capital left the industry. Meanwhile the underlying assets were compounding merrily, and now the returns from the small number of huge exits, are starting to swamp the losses, the management fees and the small profits from the earlier smaller exits. Just as Ebay, Cisco, Microsoft and Oracle more than covered a multitude of mediocre IPO’s in the 1980’s and 1990’s, so too will Facebook, Linked In, Groupon and Zynga wash away the pain of lots of $5M bad outcomes for the industry. If Facebook is worth $ 100 Bn, the venture investors will probably make $ 30 Bn covering, in one deal, almost two years invested capital for the whole industry.
However the result for individual venture firms can be harsher. In the 1990’s world everyone got to put some points on the board, and no one’s points were that much bigger than anyone else’s. Because companies went public earlier in their life cycle, most firms had winners and even the great companies went public at sub one billion valuations (EBay, Amazon). The dispersion took place once public. In the current world some firms get to put huge points on the board and some firms get to put none. Pretty scary. Figuring out how to survive in that reality, required new thinking and no one figured out that better than DST. In the next post I will lay out what the “right play” was, why DST was positioned better than anyone else to find it, and why that opening has now been filled.
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I recently had to give a talk on trends in SaaS and the cloud. Attached is the full Powerpoint.Posted by Rory O'Driscoll on August 15, 2011
I recently had to give a talk on trends in SaaS and the cloud. Attached is the full Powerpoint. Some of it is plain vanilla, but doing it helped crystallize in my mind what drove the last ten years and what are the key trends that will matter over the next ten years.
This slide shows what I would say are key learnings from investing in SaaS over the past ten years.
First, SaaS is a business model, and a computing architecture, it is not a market. CRM is a market, web analytics is a market, ERP software is a market. A great software business model like SaaS, in a mediocre or slow growth software market, like manufacturing software, will probably result in a slow growth company. SaaS is not pixie dust.
Second, the markets that work best for SaaS are ones that actually leverage the SaaS architecture which is based on having all the computation in the cloud and leveraging the browser as the free client. Applications like CRM (Salesforce) or Expense Reporting (Concur), serviced large numbers of clients, many of whom were dispersed outside the four walls of the enterprise. Here SaaS had a clear competitive advantage. Accounting software has small numbers of users, most of whom are deskbound. Here the SaaS advantage is much less. This explains, I think, why Salesforce and Concur are huge companies and Netledger struggled until it became Netsuite and offered an integrated product.
Third, GAAP is not flattering for SaaS companies. The sales expenses come up front, the revenues are recognized over time and the result is that high growth SaaS companies have horrible looking GAAP income statements. Three or four years ago this was a real cause for concern amongst investors. Now the markets have figured out that provided that the sales efficiency is high and the combination of gross margin and churn makes the math work, up front losses are acceptable (for example, Cornerstone IPO).
Fourth, these deals are compounders not rocket ships. Beyond say $10M in revenue it is extremely hard to grow greater than 100% per annum and almost no companies have done so. The kind of exponential growth seen in internet companies is not possible in enterprise software. Fortunately the kind of exponential growth decay (see sticky growth factor post) that happens to unsuccessful consumer internet companies is less likely here also. These companies simply keep on compounding which is why the Street has grown to love them. They rarely blow up and miss badly.
Finally, the key in these investments is to play to win, even at the expense of short term losses. The winner gets almost all the returns. In each market here the number one is 2x to 10x the size of the number two player.
This slide shows the dollar value created in SaaS since 2000. The data supports the conclusions above. The behemoth is Salesforce, that has compounded steadily and played to win since being founded in 1999. There have been at least eight outcomes in the one billion to five billion dollar bucket with more to come. The majority of these companies fall in the “leverage the architecture” bucket focusing on inherently cloud-centric and large number of user-centric applications. All of them had steady early losses before bursting into profitability at scale.
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The SaaS business has now hit early middle age and the best way to think about it is to compare it to the client server revolution in the 1993/1994 time period.Posted by Rory O'Driscoll on July 6, 2011
Saas at middle age
The SaaS business has now hit early middle age and the best way to think about it is to compare it to the client server revolution in the 1993/1994 time period. At that point the model was well understood, the dominant winners were clear and the next five years were about filling in the open spaces.
Big Niches
A phrase that stuck in my mind from a 1994 software report, was the description of the business software market as a “land of a thousand niches”. It is a helpful way to understand what is happening now.
Business software, unlike either the consumer internet business, or the technology infrastructure business, is not a monolithic market, but instead is a series of separate vertical and horizontal opportunities. This makes sense because Business software automates business practices and a bank’s business practices are very different from those of a manufacturing company. What a HR department needs to automate (payroll, performance reviews) is different than the automation needs of a marketing department. Contrast this with the technology infrastructure market, where the operating system or networking requirements of the bank, the manufacturing company, the HR department and the marketing department are all the same. Everyone buys basic technology from Cisco and Microsoft, but they all purchase different business applications from different vendors.
As a result there will be many medium sized, ie $1.0 Bn plus, SaaS technology companies built over the next five years to satisfy these various needs. It is unlikely that any of them will ever catch up to Salesforce, who will be the Oracle or SAP of this generation of business technology. However I continue to be surprised at the breath and upside in both verticals and in horizontal markets other than CRM. A great example to me of a vertical is that has massively exceeded what I would have guessed as its potential is Real Pages. The company focuses on automating the process of managing residential apartment buildings. My gut would have been “niche vertical, not that interesting”. Turns out I was wrong. Real Pages has a $1.8Bn market capitalization and $200 MM in trailing revenue! I believe this is indicative of what will be a multi-year wave of SaaS based application software companies in specific verticals or functional areas, generating $1Bn valuations.
As a result there will be many medium sized, ie $1.0 Bn plus, SaaS technology companies built over the next five years to satisfy these various needs. It is unlikely that any of them will ever catch up to Salesforce, who will be the Oracle or SAP of this generation of business technology. However I continue to be surprised at the breath and upside in both verticals and in horizontal markets other than CRM. A great example to me of a vertical is that has massively exceeded what I would have guessed as its potential is Real Pages. The company focuses on automating the process of managing residential apartment buildings. My gut would have been “niche vertical, not that interesting”. Turns out I was wrong. Real Pages has a $1.8Bn market capitalization and $200 MM in trailing revenue! I believe this is indicative of what will be a multi-year wave of SaaS based application software companies in specific verticals or functional areas, generating $1Bn valuations.
Consumerization with conditions
In the category of overhyped but still real, is the discussion around the consumerization of IT. The idea is that expectations of what business applications should look like and how they should work, are being driven by how consumer applications like Facebook work. I think this is a real trend, but on its own, it would not be a game changer. Just because business workers want great intuitive software, does not necessarily mean they will get it. For example, take a look at the software that most airline employees still use, to run the flyer check-in process. Masked on the web for the consumer, it is truly dreadful and arcane for the average airline check in employee. The reality is that if “the man” can jam mediocre software down the throat of employees he will, because mediocrity is usually easier to implement, even in saas. However if the desire for a better work based software experience goes along with the ability for individual employees to actually go out and get that software directly, then the voice of the business consumer can be heard. This is most likely to happen if the business process being automated is personal to a single employee or a small group and does not required full corporate buy in.
Early on this was true for Salesforce, now it is true for products like Box.net (disclosure we are an investor), where an individual can adopt Box for free, and a small group can roll it out for a relatively trivial amount, before ultimately you get the enterprise adoption that allows the vendor to make real money. There are four entwined threads within the above, fairly simple example, that need to be understood separately.
First, there has to be value in automating the business process at the individual level so that individuals or small groups will want to adopt the product, even if the company as a whole has not adopted it. (Yes to Box, Yammer, Docusign and simple CRM, no for the payroll system).
Second, that individual user has to be able to easily adopt the product either because it is available as a free download, (the old shareware model) or because it is available on a SaaS model either for free (“freemium model”) or at a nominal price per user.
Third there has to be an upsell model that allows the vendor to make money by charging more based on usage (10 Gig for $ 4.99) or enterprise wide features (“admin rights for $ 20 per user”). If this is lacking the vendor ultimately runs out of cash despite delighting users with free software.
If these three conditions hold true, then that next generation SaaS model, built on freemium users and a clear upsell model can apply. If not, the more traditional SaaS selling model that worked just fine for companies like SuccessFactors and Athena Health, is the way to go. We will happily finance both.
Dirt Cheap Computing
Finally the key enabler of all this is the advent, via the cloud, of “dirt cheap computing”. A business model based on giving away a service to users with the expectation that as few as 3% of users will become paying customers, has to be accompanied by a cost structure that allows that math to work. Ubiquitous, cheap cloud based computing, accessible to anyone with basic IT skills via Amazon or the PaaS vendors, is the key enabling technology of the next generation of SaaS vendors. I would argue (and may do so in a subsequent post) that it is in fact the key technology trend of the next ten years, across all markets. Cheap computing will be like cheap energy in the early 20th century, the key enabler of growth for the entire economy.
As investors we continue to be excited about the Saas opportunity. We believe that alignment it enforces between software vendors and their customers makes for better software, happier customers and ultimately better investments. The money from the great Marc Benioff “aha moment’ of No Software has been made, but there are still markets and models that will allow for billion dollar outcomes. If you have an opportunity you think is right for us, feel free to email me.
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The Old Gray Lady is worried about a bubble in tech, and did a nice graphic comparing the valuations of Facebook and four other social media deals, to the valuations of the crop of 1999 tech IPO’s.Posted by Rory O'Driscoll on March 30, 2011
The Old Gray Lady is worried about a bubble in tech, and did a nice graphic comparing the valuations of Facebook and four other social media deals, to the valuations of the crop of 1999 tech IPO’s. Nice graphic, wrong comparison. Given that Facebook is reported to have had revenues last year of $2B and growth of over 100%, a more helpful comparison would be looking at Facebook, versus some of other great technology companies of the last two decades at a similar stage.
The table below shows five of the most successful technology and internet companies of the last twenty years, and the year that each of them first passed $2B in revenue, Microsoft (1992), Cisco (1995), EBAY (2003), Yahoo (2004) and Google (2004). The table shows some key performance and valuation metrics for the companies, starting with the revenue and revenue growth year for the $2B+ year as well as revenue growth and valuation five years later. Then for comparison, the table shows current numbers for Facebook, based on publicly leaked information. The key points are:
These were all amazing, high growth companies. In the $2B year, the slowest growth company was Microsoft at 50% in trailing revenue growth, and the highest growth companies were Yahoo at 120% and Google at 117%.
The companies were never value stocks. Trailing revenue multiples ranged from 7.5x for Microsoft to 21x for EBay. The market capitalization of the companies ranged from $19B for Cisco to $50B for Google.
The companies continued to growth after crossing the $2B revenue threshold but at a slower rate. The revenue growth rate for the next five years, was, in every case lower than the revenue growth rate for the $2B year. Growth always slows at scale, hence the old Wall Street aphorism, “trees don’t grow to the sky.” As a rough and ready metric for this, I have calculated a number I call, Growth Stickiness, which is the ratio of the average growth rate for the next five years, to the growth rate in the year crossing the $2B level. For example, if a company is growing at 80%, and the growth stickiness is 50%, that implies the average growth rate over the next five years, will be 40%. For these companies, Growth Stickiness ranges from an impressively high 80% (Cisco), and 68% (Microsoft) to approximately 40% for Google and Ebay and a wholly lame 10% for Yahoo.
It suggests that technology centric plays like Microsoft and Cisco compound more slowly, but keep growing more consistently, while internet companies have exploding growth rates but level out more quickly. This makes sense. Many of the internet companies have strong network effects and low friction for revenue: they get what they can get fairly quickly, and then level out.
Changes in valuation levels, separate from operating performance, can really impact investment return. Microsoft and Cisco were valued at going in revenue multiples of sub 10x revenues. For the five years after the $2B year, Microsoft and Cisco had consistent revenue growth (34% and 53% CAGR’s), but because the timing was now late in the tech bubble, they also had seen enormous valuation multiple expansion. The result is that the overall value of these companies had gone way up at the five year mark. These stocks were goldmines to own, with an average annual return of 51% per annum for Microsoft and 81% per annum for Cisco.
By contrast, Ebay, Yahoo and Google all saw revenue multiple contraction, in the next five years after crossing $2B, ranging from a 50% contraction for Google to a 90% contraction for Ebay whose fifth year ended in Dec 2008. The result was that investors lost money in Ebay, lost money in Yahoo, and made 28% per annum in Google. This points to the risks of investing in high growth companies. Three things can go wrong at the same time. Growth can turn out not to be sticky, the valuation multiple then contracts and, sometimes the overall markets can contract at the same time. It is worth noting that Google was able to “ride out” the multiple contraction because it was swamped by the revenue growth, Ebay and Yahoo were not.
Now put Facebook in context here. If the numbers as rumored are correct, the company did $2Bn last year with a CAGR of 158%, the highest of the entire group. Having the highest CAGR, it also had the highest revenue multiple, at 25x trailing revenues and so was valued at $50B. Assuming growth persistence of 40%, (the same as the other great internet companies, Google and Ebay), implies a five year growth rate of 63% (still the highest growth rate of the entire group reflecting the high going in revenue growth of 158%) and revenues in 2015 of $23B. Assuming a revenue multiple the same as Google’s in 2009,(7.2x), the company will be worth approximately $166 M for a 3.3x return in five years and an annual return of 24%.
Thus an investor can expect to make 3x their money in five years if Facebook turns out to be, or continues to be the fastest growing $2B + revenue company of the last twenty five years, and if the company is then valued at the same multiple as Google was in 2009. A compound average growth rate of merely Microsoft proportions (34% per annum over 5 years) will result a 1% return. Anything less will be a disaster. It is not yet a bubble valuation, it is credible compared to other world class companies, but it is priced, perhaps justifiably, as the best high growth company in the US today.
These companies are all among the most successful equity investments in history. Every one of them yielded early stage investors, returns of 1000x their investment. In every case, for multiple years, doubters who felt the stock was too high, or the market too small, were spectacularly wrong. But in every case, the growth rates slowed inexorably over time, and the valuation multiples usually declined also. At some point the math takes over. Surprisingly (to me) I can still see the upside for Facebook at $50B as the high going growth rate, overcomes the inevitable drags of growth slowing down and multiples contracting. However what is overwhelmingly clear is the “ten bagger” returns in the public market, available in the 1990’s for Microsoft and Cisco, will not be available when Facebook goes public. It looks like a public investor buying into the most successful Internet company of the last decade, will make 3x to 1.5x depending on IPO valuation. The big money has been made.
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Venture capital returns are going up. That is the clear conclusion from two recent press releases: the 2010 fundraising data from Dow Jones, and the 2010 review of exits from the NVCA. Neither release reads that way but the laws of supply and demand make it, from here on in, pretty inevitable.Posted by Rory O'Driscoll on January 21, 2011
Author’s Note: A version of this article first appeared here in The Wall Street Journal’s Venture Capital Dispatch.
Venture capital returns are going up. That is the clear conclusion from two recent press releases: the 2010 fundraising data from Dow Jones, and the 2010 review of exits from the NVCA. Neither release reads that way but the laws of supply and demand make it, from here on in, pretty inevitable.
Looking first at cash invested into venture funds themselves, the Dow Jones press release shows that funding fell to “a seven year low” of $11.6 Bn in 2010. The real meaning of this becomes clear if you take a much longer perspective and look at venture capital funding over the past twenty five years and compare that to the overall size of the US economy. The assumption is that the best way to think to think about the supply of capital is in relation to the size of the overall economy and thus, the overall pool of likely opportunities.
The single slide below tells the story. From 1986 to 1994, annual investor commitments to venture capital funds calculated as a percentage of GDP were under .1% of GDP. The result was a positive investment climate when venture funds delivered significant returns to investors. The average return of the top 25% of funds, (i.e. the return of the best funds) was 5.3x in that period. Call this the real Golden Years of venture capital. In 1995, the rules changed with the Netscape IPO, and the result was the Gold Rush period. Even though the capital invested doubled, the hugely strong IPO market meant that returns soared to 9.3x invested capital, an almost unheard of rate of return for any asset class. Capital poured in until inevitably, the rush of hot money killed the business off. In the year 2000, capital invested was 1% of GDP (or ten times the rate it had been only a few years earlier) so once IPO’s stopped, returns plummeted. Most of these funds have not yet returned the capital invested in them, and our estimate here of a 1.7x for the top quartile strikes most LP’s we talk to as optimistic.
(source: Scale Venture Partners )The eight years from 2001 to 2008 has been the period of the Great Slow Reset. Unlike the public markets which can mark to market every day, private equity has ten year commitment periods and four year “re-up” cycles as venture funds seek new commitments. It also takes at least five and maybe ten years for it to be clear that an investment strategy is working or not. Throughout this period, every existing venture firm raising money has been able to justify the often abysmal 2000 fund by referring to their funds from the mid late 1990’s that delivered off-the-charts performance. Faced with this, most LP’s have understandably chosen to hang with the asset class. As a result, dollars raised as a % of GDP fell sharply in 2001-2002 as the obviously bad or new venture funds were killed, but then from 2003 onward, capital inflows roughly stabilized. Any existing fund with a decent 1990’s track record was able to soldier on. Throughout this period, capital raised as a percentage of GDP ran around .2% of GDP, still twice the relative amount raised during the Golden Years. The result, we believe, will be really solid returns from the top quartile of funds but probably not equivalent to the returns from the 1985+ time frame. (The 2.25x felt high when we first built this slide a year ago. It feels a little low now, but 3x is probably the upper bound estimate).
The game changed in late 2008. The Lehman collapse brought home to investors the real cost of illiquidity when you actually need the money. In addition, the warm afterglow of the venture success in the 1990’s faded as the decade slowly disappeared from the ten year return statistics which are used by many institutions to decide whether to invest in the asset class or not. In 2009, venture funds raised $13.5 Bn, well below .1% of GDP. The big question at the end of 2009 was whether the funding numbers represented a one-off dip in a dreadful year or a trend?
Now we know. In 2010, despite being a better year for equities and for technology, the result was a further reduction in venture funds raised to $ 11.6 BN, equal to .07% of GDP. I believe that the venture capital industry is due for a multi-year period where the dollars raised by the venture industry will be at or below the .1% of GDP level. The same institutional realities that made the industry slow to correct over-funding in the last decade will make it slow to correct under-funding in the early part of this decade. Those forces, driving lower capital commitments to the venture industry, will not change until the returns send an unequivocal “reinvest” signal back to the investors; in other words, more money will come back to the system only once the returns show sustained improvement.
An implicit assumption here is that the opportunity for innovation remains roughly constant relative to the size of the overall economy. I clearly believe this is the case. GDP growth, driven in large part by technological innovation, has been pretty consistent for as far back as meaningful economic data has been recorded in the US. It is always possible that this has changed, but I doubt it.
On the exit side, the NVCA press release elegantly describes the situation as having improved “from abysmal to viable”. The base numbers support this. I believe that the “real” exit environment, or more accurately the pace of value creation in the venture business, is significantly better than is shown in the exit numbers, (and may try and explain this in a later post), but the numbers shown in the press release make the case adequately for now. The total value of M&A outcomes for venture backed companies was $ 18.3 Bn in 2010. If you assume the venture investors owned 70%, on average of these companies, this would imply that $12.8 Bn of value was returned to the venture investors. On the IPO side, 72 IPO’s raised $7 Bn. Again, using rough math of a 25% dilution from IPO, and a 70% pre-IPO venture ownership, the result is a further $14.7 Bn of venture value creation. The result overall is approximately $ 26.5 Bn of value realized, well above the amount committed in 2010, but probably only keeping pace with the commitments in the 2006-2007 period when these investments were originally made. We are slowly climbing out of the hole.
What this adds up to is a commitment level of dollars to the venture industry that is now at or below the level that has previously generated compelling returns with no sign of that changing quickly, and an exit environment that is improving but is not yet anywhere close to a bubble. The result has to be a prolonged period of scarce capital, and scarce capital makes profitable capital – just as plentiful capital in 2000 made wasted capital.
This conclusion seems contrary to a number of recent articles. Fred Wilson has written a great post about bubble valuations and how his firm is thinking about it. There is widespread talk about a Super Angel bubble and more broadly, a Web 2.0 bubble. I would agree that the two “hottest” trends right now are: (1) Super Angels doing ultra-early stage investments looking for the next 1000x first round investment in Facebook, and (2) former purely early stage venture firms and as well as crossover investors looking to get access at perceived Web 2.0 winners at almost any price, (see Facebook, Groupon, Twitter). Even if you assume that both of these trends represent “bubbles” (and I am not making that call in this post), in aggregate, it amounts to maybe 20% of the total venture industry.
Across the whole venture industry including clean tech, life science and information technology, there are markets that are cold where prices are plummeting, parts that are lukewarm, and parts that are super hot. Price is doing what price is meant to do within the industry, sending a signal to invest less in solar panels and more in social networks (the market does not make value judgments). At the same time, price has done what it is meant to do for the venture industry as a whole, it has sent a signal to investors to withdraw capital – they have done so – and the result will slowly but inexorably be better returns for the industry as a whole. Venture returns are going up.
Post by Rory O’Driscoll, data from Scale Venture Partners, Dow Jones and the NVCA. Invaluable assistance from my partner Kate Mitchell, current Chairman of the NVCA. All opinions are solely those of Rory O’Driscoll and are not endorsed by anyone, even his immediate family. Comments welcome, in particular arguments against. I really believe the above is correct and I am investing my capital and my time accordingly. If there is negative data, I want to know.
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I simply love Goldman Sachs. The Facebook deal is a brilliant poke in the eye for just about everybody, and proof, yet again, that money, like water, finds its own level.Posted by Rory O'Driscoll on January 8, 2011
Author’s note: An earlier version of this article ran at TechCrunch .I simply love Goldman Sachs. The Facebook deal is a brilliant poke in the eye for just about
everybody, and proof, yet again, that money, like water, finds its own level. If there are buyers and sellers to be matched, and a fee to be made in the process, the fine folks at Goldman Sachs will figure out how to bridge that gap. So much the better if there is regulatory friction to arbitrage against, it simply raises the fee.For the last seven years, the venture capital industry has been saying that the IPO process is broken and start ups are the losers. In a fine display of Wall Street’s can do attitude, Goldman has gone and produced an alternative to an IPO; one where the clear winner is the start up. Make no mistake; this is a great result for Facebook. Consider the alternative. Going public is hard, and being public is harder. This is true for a company like Facebook, not because of the cost of Sarbanes Oxley compliance, which would be more than manageable, but because of the insidious nature of being public and having a focus on quarterly earnings, governance and the stock price. No matter how hard you try to avoid becoming short term focused, the constant drip of analyst meetings, quarterly updates and daily stock price tickers takes its toll. Your earliest and best employees, fully vested and now fully liquid, leave, and instead of building a company, the CEO is getting on quarterly analyst calls.
The best reason to go public was to get the money. Conventional wisdom used to say that the only way to raise $1BN plus, at an attractive valuation, was to provide investors in return the transparency and the liquidity that being a publicly traded stock entails. The company puts up with the analysts, the information requests and the quarterly filings in return for getting the cash. Goldman has given Facebook all of the benefits and none of the negatives of a public offering. They should have a happy client.
It is of course axiomatic that the other clear winner here at least in the short term, is Goldman Sachs . They have made a bet with their money that will either work or not in the next two years, but along the way they will make many hundreds of millions in fees. From all accounts, their retail client base is happy to be offered the chance to invest in Facebook, and Goldman will make a 4% fee and a 5% carried interest on the deal. If they sell enough, and can sell down some of their own piece, they can be money good day one. The demand sounds like it is there.
The clear losers here are the stakeholders in the IPO process, namely the exchanges (NYSE, Nasdaq), the SEC, and arguably the large institutional investors who are restricted to investing in public securities. The dearth of venture backed IPOs in the last ten years can be looked at in reverse as a loss of market share for the “IPO and beyond” team. There are numerous privately held companies that would, in an earlier time, be public and want to be public (because the Goldman Facebook option is not available to them) and are instead still private, because the IPO process is hard and the public market investors have been gun shy. Although this has been presented as a negative for the private investors, the reality is that it is arguably a bigger negative for the exchanges and investors. The exchanges have left trading fees on the table, and the public investors have not participated in the creation of value, that has instead taken place on the private side. Anyone with a 401 K should be wishing that Facebook had gone public at a $ 5BN value three years ago. The subsequent $45BN of value creation would be dispersed across thousands of 401k’s and not concentrated here in Silicon Valley.
What about the new investors here, are they winners? The honest answer is who knows and who can know? Would Facebook trade today at $ 50BN in an IPO? I don’t know. Could it be worth $100BN in the future? Quite possibly. All you can know for sure is that, because this investment is illiquid and will not be filing quarterly financial updates, the investors will not suffer the torture of knowing their investment is “under water”, if such should happen, along the way. No news means no bad news. Not, it would seem, that some of the investors care. In a wonderful quote from today’s Wall Street Journal a Goldman client said; “It’s hard to imagine how this thing is going to make money, still the deal is an attractive opportunity”. All the SEC regulation in the world cannot save people like that if they don’t want to be saved. Maybe it is best that instead, they just enjoy the privilege of being a special Goldman client.
The reality is that this is not a trend, it is a singularity. There are not ten Facebooks out there, instead there is, roughly one Facebook every ten years. As a small part of the fun of being an utterly dominant company, each decade’s winner gets to slap around the IPO process. Microsoft made the underwriters cut their commission, Google ran a Dutch Auction, Facebook for now has contracted out of the process entirely. None of this represented a trend that others could follow. For almost every other deal out there, this kind of financing is not an option and the IPO process will continue broadly as before. For those of us in the investing business who did not invest in Facebook, the only good news from this could be if the competition does sharpen the “IPO and beyond” team up a bit. The only bad news could be if the SEC, in an understandable effort to amend the rules to prevent this from happening again, changes them in such a way as to impact venture firms with more typical LP/GP structure. It shouldn’t happen, this really is a one off, but the SEC has got to be thinking dark thoughts about expanding the rule book.
Failing either of these outcomes, I am left saying bravo to the great vampire squid and the unstoppable chutzpah they have shown.
[UPDATE: The Squid Steps Back]
I wrote the above post and disappeared on Thursday into the maw of distraction that is Las Vegas for CES week. More has since emerged as the investment document gradually leaks to the press (pointing to a key difference again between this process and an IPO, where the information is available to all). Because the document slowly leaks the coverage evolves as more facts become known. It appears that Facebook has stated that they would “disclose or go public” by April 2012 because of the SEC’s 500 investor rule.
It raises an interesting question. Did they make this announcement because they were already going to hit the 500 investor limit before this deal and will have to comply with SEC regulations on disclosure anyway, or did they announce it because they never intended this “special investment vehicle” to be treated as a single investor and knew that the SEC would balk if the company took that position. Some of the early coverage seemed to imply that the company’s position was that this SIV, really was a single investor but, upon reflection, my gut is that the company and Goldman knew that this financing would not stand up as a single investor for regulatory purposes, and thus stated in the financing document that by April 2012, Facebook would disclose or go public. Given that, the timing of this financing is absolutely not an accident. The rule stated that a Company has to disclose financials 120 days after the end of the fiscal year in which the company goes above the 500 investor rule. This deal will close in early January, thus absolutely maximizing the “private time” before disclosure in April 2012. If it has closed a week earlier we would be seeing Facebook disclose all in April 2011.
The other point to note is that Facebook, contrary to some summary headlines, did not say it would go public by April 2012. It said it would go public, or comply with SEC disclosure requirements, in that time period. Facebook could easily choose not to list on the Nasdaq, but instead simply publish quarterly financial statements and thus discharge their obligations to the SEC. No analyst calls, no daily stock price, no continuous liquidity for investors.
In the end, Facebook, will almost certainly go public, because at some point it is probably less hassle to have Nasdaq manage your shareholders, than doing these more complex private deals. But the point this deal makes plain, is that for a market dominant company like Facebook, going public is not the only option and clearly, for now was not the chosen option. A world class company has been able to raise $1.5 BN plus in two days, on great terms, with little or no disclosure, road shows or any obligation to have the stock traded on an exchange. That is an amazing result. It should make the “IPO and after” crowd pause, when their best marketing approach is “go public or the SEC will get mad at you.”
Note: Goldman Sachs “Vampire Squid” Moniker Courtesy of Matt Taibbi in RollingStone
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The most basic question anyone should have of us is what kind of deals do we like to do? Where are we the right investor and, just as usefully, where are we not?Posted by Rory O'Driscoll on October 25, 2010
When I write these blog posts, I have a clear audience in mind: someone who wants to do business with us, and wants non sound bite answers to questions about how we think. That person can be an entrepreneur, a potential co-investor or a possible Limited Partner. The most basic question anyone should have of us is what kind of deals do we like to do? Where are we the right investor and, just as usefully, where are we not?
Scale invests in technology and healthcare companies anytime from product launch and later. We look for companies that are in early revenue and are starting to scale – hence our name. We believe that the value we bring to the table as investors and as board members comes from our backgrounds as sales and marketing executives in the industries we invest in. Our partner Lou Bock has called on doctor’s offices in the Bay Area selling Genetech’s first drug, Rob Herb was the VP Marketing at AMD the third largest semi conductor company in the world, Rob Theis was the founding VP Marketing at Neon Systems. We have seen and been part of big, game changing companies, that grew quickly and made a difference to people’s lives.
We like to finance companies with big ambitions that have validated their product vision with early customers. We are comfortable working with other venture investors who have helped get these companies this far along. We are equally, maybe more excited, by entrepreneurs who have gotten to customer revenue, under their own steam.
We tend to focus on particular markets within the overall Information Technology and Healthcare markets, that we have identified as having big and near in upside. This allows us to better focus our efforts and not waste your time as an entrepreneur. Your objective is to get funded, not to give anyone a 101 primer on your business. Most of the deals we turn down, we turn down, not because the deal will not work, but because it is in an area that is not our focus area.
We try and add value where we can in our portfolio, while at the same time making sure that we let the CEO drive. As you would expect our value is around taking products to market and growing revenue. We help companies recruit and partner, we benchmark companies against other winners we have seen and we organize events to help our portfolio companies to network and leverage each other.
We do make some exceptions to our launch or later focus. Specifically in healthcare we will finance clinical stage companies where we believe there is compelling evidence that the drug or device in question has both safety and efficacy benefits. In technology we will finance companies where there is a level of adoption that is a clear proxy for subsequent revenue growth such as IT adoption for an open source product, or committed repeat users for an internet service.
We really enjoy what we do and take it seriously. The entrepreneurs we back have committed one hundred percent to building a successful company and pursuing their dream. The investors who have backed us have entrusted us with their hard earned capital that they need to grow, to pay for pensions, fund education or help their charitable objectives. We have put our own capital on the line also. For all these reasons we want to win. We believe that success in this business requires a combination of vision and conviction about the future, coupled with an objective realism about progress towards that goal. We don’t always get it right but we get up every day determined to keep getting better.
We also believe in wider involvement with the community in which we work. Our partner Kate Mitchell is a member of the NVCA Board and the incoming Chairperson. Many of our other partners work on industry Advisory Boards.We would welcome a chance to work with you. Please contact us if you think, based on the above, that we could be the right partner for you.
I can be reached at rory@scalevp.com. My other partner’s emails are all on our website, www.scalevp.com/team -
Venture has lots of rules of thumb, short summaries of received wisdom passed down. One of the most common is “never do a COO search”.Posted by Rory O'Driscoll on October 18, 2010
Venture has lots of rules of thumb, short summaries of received wisdom passed down. One of the most common is “never do a COO search”. I heard it when I joined the business, I’ve lived it when I tried to do COO searches and failed, and I have passed it on. Upon reflection I think the rule is wrong, or more accurately, it is mainly right, but it oversimplifies at the expense of producing a very occasional but very expensive wrong answer.
The wisdom in the rule is clear. Most times when a board, especially a venture backed or even outside investor dominated board, is doing a COO search, they are doing it because they are dissatisfied with the CEO’s performance and are either unable or afraid to change the CEO. Hire a COO is the compromise choice. The search is hard because the candidate who will solve the board’s dissatisfaction is someone capable of being a CEO themselves. For these candidates, the choice between being a number two sandwiched between a CEO who does not want them and a board who does not want the CEO, is a no win situation. If they are any good, they will be sitting on CEO offers at the same time, which they will invariably take instead of the poisoned chalice on offer. The result is nasty adverse selection, the good candidates don’t want your job, and the ones who take it may not be any good. Far better, so the venture wisdom goes, to man up and replace the CEO, which is what you really need to do.
Any yet. As the New York Times points out, it seems to be working for the Facebook investors . In my portfolio I have some deals where the CEO/COO combo has been a home run. Zonelabs, a company we invested in in 2003 was run by a CEO Gregor Freud, and a COO Irfan Salim until it was sold to Checkpoint for $ 300 million. In our current portfolio, the Box.net CEO Aaron Levie, recently hired a COO, Dan Levin and I could not be more happy with the company’s performance. When I ran the rule of thumb by Aaron at Box, he responded with a cogent list of highly successful companies where the CEO/COO combo was working well.
Oddly enough I still think the rule is usually correct. What all the exceptions have in common is a few things. First in all the successful cases, the decision to hire a clear number two was driven by the CEO, not imposed by the Board. CEO’s who can do this, are comfortable in their position, and in what they do well as a CEO, comfortable enough to ask for help where they need it. The usual situation is when a CEO has a clear technical and business vision for where the company can go, but does not have either the experience or the inclination to handle the managerial part of the CEO’s role. If all the CEO has is the technical vision, then perhaps hiring a CEO and becoming the CTO is the right option, but when the CEO has both the product vision and the clarity around business strategy, then a CEO/COO can work.
Second the opportunity involved has to be big enough for the COO to prefer it over a CEO role at a smaller less exciting company. The reality is that top class executives can easily get a CEO job, the trick is getting a CEO job at a winner company. The opportunity to be the number two executive at a world class company can be more rewarding and more remunerative than being top dog at another ho hum venture backed deal. There is enough winnings both financial and psychic, for two leaders to share. This will not be true in a smaller or less faster growing company.
Finally, my observation is that the two executives have to continually work at it. It involves constantly checking in with each other to ensure that there is clarity between the executives and with the rest of the team, as to who is doing what. This need for constant communication is why an outside board imposed solution fails over time. You can pretend to your board that “you will get along” but you cannot fool each other day in and day out. This is why many of the best combos emerge from existing trusted relationships and are not filled by a simple executive search process.
CEO/COO combos sometimes work, and as I said at the start, assuming they never do can be an expensive mistake. Even if they work in a small percentage of deals, it will be the best deals; and the combo can turbo charge the return in precisely those deals that in any venture fund, dominate the outcomes.
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In every technology market, the number one player gets disproportionately rewarded.Posted by Rory O'Driscoll on June 13, 2010
In every technology market, the number one player gets disproportionately rewarded. The winner obviously has the most revenue, but in addition, that revenue, and the associated profits, are more highly valued by the public markets. Salesforce.com trades at 6x 2010 revenues, while SaaS companies on average trade at 4x revenues. The same is true across the entire technology industry. In the consumer internet space you tend to see businesses where a network effect generates the winner. Once you have the network effect it is yours to lose. In the enterprise software space, a strong network effect is often lacking. So how can make sure you win ?
As a new enterprise software market starts to emerge, you frequently have two to four viable contenders, all slugging it out to be the market leader. Couple this with the SaaS business model, where the sales and marketing investment model is very capital intensive upfront, and what it takes to win, is a combination of a profitable units sales model (see magic number post) and a willingness to spend what it takes, to get to the number one position. I have been in that position twice, in the last ten years, where I have been on the board of a company with a direct head to head to competitor, in a great high growth SaaS market, and the decision we had to take was, how aggressively to invest and when.
In the period 1999-2003 I was on the board of Placeware which was a company in the web conferencing market, competing with Webex. The market was exploding and Placeware grew from $ 4M in 1999 to $ 51 M in 2002, 12x growth in three years. In the same period Webex grew from $ 3M to $ 81M, 27x growth in the same period, and went on to grow to $ 300M in revenues. Placeware was acquired by Microsoft for $ 200M in 2003, a good outcome for the investors. Webex was ultimately acquired by Cisco for $ 3.6B, a far better outcome. The key difference, Webex raised and spent capital more aggressively on sales and marketing, than Placeware, and as a result was able to grow more effectively and establish market leadership. Note I said effectively and not efficiently. Webex may have sacrificed efficiency, but it made up for it in effectiveness. A key part of the Webex win, was getting public in that last open window in August of 2000 before the final implosion of the tech bubble.
Chart 1 Revenues 1999 2000 2001 2002 2003 2004 2005 Growth Multiple
1999 -2002Exit Value Exit Year Webex $3 $25 $81 $140 $189 $248 $307 54x $3,600 2007 Placeware $4 $20 $36 $51 12x $200 2003 Webex as % Placeware 59% 130% 227% 273% In the period 2006-2009 I was on the board of Omniture, competing head to head with WebSideStory, in the web analytics market. Same situation. Here WebSideStory in 2002 was almost 4x bigger than Omiture but went public earlier and committed to Wall Street that it would maintain and increase profits. Omniture stayed private, raised money from Hummer Wimblad and my firm Scale and instead opted for growth at the expense of profits. WebSideStory grew 4x in four years, Omniture grew 22x in the same period. While WebSide roughly broke even after 2003, Omniture’s losses accelerated in 2004 to 2005 before transitioning to strong profits in 2007 as the advantages of scale were realized. Omniture ultimately acquired WebSide in 2007 for 14% of the combined entity plus a $ 50 M cash payment. Again the value was created by the aggressive winner, fortunately for me, this time, I was on the winning team. The numbers below tell the story.
Chart 2 Revenues 2002 2003 2004 2006 2006 2007 Growth Multiple
2002-2006Exit Value Exit Year Omniture $4 $9 $21 $43 $80 $143 22x $1,557 2009 WebSideStory $14 %16 $23 $39 $55 4x $282 2008 Omniture as % WebSideStory 27% 53% 91% 109% 145% Operating Income 2002 2003 2004 2006 2006 Total Loss Omniture $(1) $0 $(2) $(17) $(5) $(26) WebSideStory $ - $(10) $(4) $(2) $(1) $(18) I have become convinced that winning in SaaS is not complex, just hard. There are only two steps. First of all you need to be absolutely sure the sales model works, (pithily described as nail it before you scale it). Note that forgetting this step is like hitting the accelerator on a sports car, without learning first of all how to steer. Someone will get hurt. However assuming you can steer, then you need to get the capital, and the mandate to invest aggressively, and “damn the torpedos, full speed ahead”.
A recent investment we made at Scale, is in a company called ExactTarget which opted for this approach. The company had grown extremely well and was already the largest company in its market when we invested. The company was considering going public and had an S-1 on file, before opting instead to raise a round from Battery Venture and ourselves to continue to stay private and invest more aggressively. The company plans to maintain and increase its leadership position, and go public later on, not just as the largest company in the market, but the largest by a significant margin.
For Webex, going public early was a savior, for Omniture and hopefully for ExactTarget, waiting to go public was by far the better move. This illustrates the reality of “life on the Street”. Being public provides capital, and often cheap capital which is good. In return, like a relative who lends you money, Wall Street wants to interfere in your life and thinks it knows best. At times the Street will push you to focus on short term profits over growth, even though growth will mean more profits in the long term. At other times, it will tell you to spend, perhaps to excess.
The only way to deal with this is to remember that Wall Street, does not know your business nearly as well as you do, and may not have your long term interests at heart. You are building a ten year business but some hedge funds trade shares in ten milliseconds. You are not aligned. If you can get the cheap capital without letting Wall Street dominate your agenda, it is well worth while. However if the cost of getting that capital, is having to run your business for the ten second trader guys, you will end up in a modestly profitable second place position to a competitor with more patient capital and a long term focus.
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Entrepreneurs, especially experienced ones, often have a fairly jaundiced view of venture board members. A recent survey showed that venture board members think that entrepreneurs value them as a mentor, while the same survey showed entrepreneurs actually valued them for their follow on money.Posted by Rory O'Driscoll on May 26, 2010
Entrepreneurs, especially experienced ones, often have a fairly jaundiced view of venture board members. A recent survey showed that venture board members think that entrepreneurs value them as a mentor, while the same survey showed entrepreneurs actually valued them for their follow on money.
source: http://fis.dowjones.com/VS/2009boards.html – (slide 24).I have been on thirty plus boards and while I cannot comment on what the CEO’s think about me, I have developed my own way of simplifying how I should do the job of being a board member. You have to start by recognizing that it is a job. Like all jobs it has an objective, which is guiding the company to make money for the shareholders. It starts with a job interview – with the CEO – where the CEO invariably asks one really good question, followed in my view, by one fairly misleading one.
The good question is, what do you bring to the table apart from money, the misleading one, almost invariably in the next sentence, is tell me about the contacts you bring? It is misleading, because the second question often becomes the answer to the first question, in other words, the main thing the investor should bring, apart from money is contacts. Contacts can be hugely valuable to a start up – and clearly from the survey above both management and venture investors value them highly -but they are most emphatically not the most important thing that investor brings to the table, and not what the CEO should be focusing on at the interview stage.
When the CEO is interviewing a potential venture investor board member he or she is about to make the oddest hiring decision they ever make. They are hiring someone to be part of the committee that is their boss (important distinction, the board member is not the employer, the board is), they are hiring someone who, in taking the job, will have both fiduciary obligations, and significant corporate authority, and they are hiring someone who will have a significant economic interest in the company, that is in part aligned with theirs and in part not. Finally they are hiring someone they probably can never fire. How that person perceives the job, and how they will do that job, is what the CEO needs to understand.
At the broadest level the objective is clear, to help guide the company to make money. At the most mechanical level, the processes are clear and widely understood around compensation committees, board authority etc. It is in that middle section between grand strategy and pure mechanics that the discretion comes in and where a good or a bad board member can make the difference.
I think of my job as a board member is simply to guide the company so as to avoid bad things from happening, or fix them if they are. The management team can then make all the good stuff happen. Three bad things can happen to a start up. First the strategy or the core business can simply be wrong. Second the team, led by the CEO, can be incapable of executing the strategy. Last, the company can run out of money. If, the board can avoid these three outcomes, the management team will make the investors money, most of the time. If the board member does not focus on these three issues, all the contacts in the world will not save the investment.
As the entrepreneur, if you believe this, you need to figure out are you and the potential board member aligned around the business and the strategy. If the exact business is still emerging, do you think that the board member will be additive or subtractive to the process of figuring it out? Additive is great, subtractive but passive is survivable, subtractive but active is fatal. Do you want this person judging your strategy? Even more starkly, do you want this person judging you? Hiring, compensating, and if necessary firing the CEO is the job of the board. Do you trust the potential board member’s judgement enough to give him or her, a vote in that decision. You do not simply want a yes man who will “vote for you”. Sometimes replacing the founder can be a great decision for the company, and if you as the founder, are a large shareholder, being replaced can be great for you. However sometimes it can be a disaster, replacing commitment and raw talent with “professional management” that turns out to be an empty suit. We have a bias to backing strong founders, not out of charity, but because we have found that we make the most money, when the founding team goes all the way. However we have also had to make changes at times and that can be hard. Think hard, as the entrepreneur, about the person who is joining your board, would you give him or her, that authority over the start up that is your baby.
Finally will that investor board member be supportive of the company with money when times are tough. If your existing investors are not supportive in tough times, attracting outside money is almost impossible. Assessing that conviction up front is hard. Circumstances change and sometimes the right investor decision is to pull the plug. However there are also times when the plug gets pulled because the firm is out of money, or the GP in question no longer has the juice to get a deal through, or – and in my view a very common outcome – the GP did not have real deep conviction in the deal but chased it because it was hot only to abandon it when it seems cold.
If you can get a board member who understands and can contribute to your strategy, and whose opinion you will listen to, even when it is critical of you, and who will be there with the cold hard cash when times are tough, grab him or her and go for it.
- RT @scalevp: Scott Dorsey @ExactTarget on their path to IPO and impact of #Jobsact on entrepreneurs #venturescape2013 t.co/O8VPmMd1ZH
- RT @wienbar: #venturescape2013 honors @katedmitchell of @scalevp t.co/i8etsiPGGb
