Privacy-Déjà Vu All Over Again

Another privacy “tempest in a teapot” is about fade away. See http://bit.ly/cjZ4Lj.  Ever since Internet users discovered the “evil” cookie way back in browser ancient history, the Internet privacy cognoscenti periodically get their knickers in a twist and manage to garner PR far in excess of consumer interest. “The people” (whatever nebulous mass of humankind that phrase represents) have voted with their mouse(s) and decided to ignore the issue. Why? Perhaps…

  1. It’s not important to them.
  2. They never read anything with “privacy” in the headline.
  3. They analyzed the issue in depth and decided the trade-off favored sacrificing some privacy for a better user experience.

I wish it were the last item but that’s highly unlikely. Most folks just don’t care enough to burn any calories thinking about it and maybe, just maybe, intuitively understand that #3 is true. The only thing that will change this is a privacy disaster on par with the Deepwater Horizon oil spill and even that may not have a lasting impact. After all, the real solution to minimizing future oil spills in the Gulf is for everybody to bicycle to work beginning tomorrow. Right.

Own the Exit Strategy

At one point earlier in my startup career when I was VP of Marketing at a 3D graphics startup, I was advised by a well-known Silicon Valley VC that I wasn’t to worry about the exit strategy. Our job was to build value and the exit would come. Basically, go away and let the smart folks (VCs) determine the exit strategy. For many years, I generally accepted this philosophy but 20 years later when the world of startups and venture capital is in the midst of major upheaval, I believe entrepreneurs need to own the exit strategy as a fundamental part of the business model from day one. The product decisions you make and the organization you build must reflect your exit strategy. More critically, it determines your capital requirements over the life of the company and quite possibly the investors you target.

The accepted world view is that there are two basic exit options for enterprise software startups that have taken capital from institutional VCs or angel investors—IPO and acquisition. Given the IPO option is off the table for the vast majority of startups, the choice comes down to the strategy for an M&A exit. One approach which I label the Oracle “Mini-Me” model under which you develop a feature-rich product and all the sales, marketing, tech support and F&A infrastructure that you would find in a big company. My general assessment is that this takes 5-7 years to reach exit, $20-40 million dollars of capital and, if all goes extremely well, an exit at 8-10X capital in. It fits nicely with the timeline and capital available to large VC firms. Many large acquirers have the capacity to process an acquisition of this type and many actually prefer to have risk-free market validation through several years of growing customer revenues.

The other approach is what I refer to as “portfolio completion” (I’m certain there are sexier labels but nothing comes to me at the moment). Under this model, a target acquirer is looking for new products or technology that can fill the gaps in their product line to give them a more complete solution for their customers. They have established distribution channels (direct sales or otherwise) and a customer base that can be readily leveraged. The need for extensive market validation via proven revenue streams over several years is less critical since the acquirer has already determined the need for the product and/or technology and actually prefers a much leaner organization without the other functions that duplicate what they already have. The startup objective under this model is capital-efficient delivery of a basic product with solid market validation. These types of exits can occur in 2-3 years with capital investments well under $10 million and possibly under $5 million. The multiples are probably a bit lower in the 5-7X range but the IRR can actually be higher because of the shorter term. Not all VCs can operate under this model but smaller VC firms and angel groups can generally handle this approach.

Large VC firms will push startups towards the Oracle “Mini-Me” model because of the partnership structure (portfolio company to partner ratio), fund size and management fees which enable these firms to deal with much longer horizons. Smaller VC firms and angels (groups or individuals) may be more appropriate for the entrepreneur who believes the “portfolio completion” model is a better fit for his or her business model. A spin on the “rich versus king” issue also comes in to play here since the “Mini-Me” model generally has at least one CEO shift over the life of the startup before exit and it’s quite unlikely the founding team will be in charge or even have a role in the company after 5-7 years.

It’s not an obvious nor simple choice. I’m biased towards the “portfolio completion” model since I’m not convinced that business model in an early-stage startup should be driven too excessively by external factors like the minimum size checks a VC fund can write. In reality, it’s probably a hybrid model that demands agility when the context changes. At the outset, I believe startups should employ the “portfolio completion” model since it reflects a customer-driven product focus as the startup strives to find a market fit. Once the market demand has been validated, the decision to seek an exit or swing for fences with the Oracle “Mini-Me” model can be made.

In the final analysis, the exit strategy will be driven by the product, market sector, investor demands, capital requirements and external conditions but my point is that it must be acknowledged in the startup business model from day one. Own the exit strategy.

Angels vs. VCs

An angel investor in Knowledge Reef Systems sent me a copy of Basil Peters presentation (no link at this time) to the Angel Capital Association Summit in San Francisco this month. Absolutely spot on with one minor complaint (see a couple paragraphs below). Basil’s key points:

  • Target an early M&A exit (get out in 2-3 years)
  • Build a product that a larger company can grow as part of their portfolio (leverage their expensive sales organization)
  • Aim for the sweet spot of the M&A market ($15-30 million)
  • Run lean (a cliché but true)
  • Seriously consider angel investors even if your capital requirements are in the $2-5 million range

This is stunningly contrary to conventional institutional VC wisdom that demands entrepreneurs build Oracle “Mini-Me” clones. Why do they do so? My assessment is they simply have too much capital that must be put to work, they need to limit the number of bets they make and management fees tend extend the exit horizon beyond what is reasonable for angel investors. VCs have no choice but to swing for the fences on every investment even if a more rational strategy of base hits wins more games. Is there a relationship between this “home run” approach and the dismal VC returns of the last decade? The answer is far too complicated for my pay grade…;-).

As Basil points out, angel investors may be more aligned with founders than VCs are. It certainly gives me pause for thought as I get ready to launch my fund raising effort for veloGraf Systems. The VC path is the default but my strategy for building the company is probably more aligned with angel investors. I enjoyed working with angel investors in my last company and if I can meet my capital targets with angel investors this time around, it certainly beats being forced into the wrong business strategy simply because of excess capital in VC funds.

My exception to Basil’s presentation was his discussion of the “weekender” startup. I know I’m an old war horse when it comes to creating value in startups but I remain convinced that it takes more than a couple guys in a garage over a weekend to build a meaningful venture. If it can be done by these, why won’t another team (or ten teams?) be able to do the same thing the following weekend? What is the barrier to entry to a startup product/service that can be developed and deployed in a few days, weeks or a couple of months? I can’t help but believe that this type of investing is like buying lottery tickets. Maybe you can win the jackpot but the odds are much higher that you will spend a small fortune on $10,000 investments and never hit the jackpot. A couple small wins perhaps but your overall IRR will be negative.

I am in 100% agreement with Basil that the cost of building software solutions is far less than what it was 10-20 years ago but it simply isn’t $10,000. This “weekender” myth (also called startup “boot camps”) drives me crazy because it makes angel investment look more like a weekend in Las Vegas than an effort at reasonable due diligence on the capabilities of the founding team, the market opportunity and differentiated technology with a sustainable advantage. Yes, angel investing is risky but investing in this type of venture seems to heighten the risk.

Oracle “Mini-Me” vs. “Cool-Tech” Startups

Why is it that so many enterprise software startups continue to be structured as “mini-me” clones of Oracle (or pick your favorite large, established software vendor)? In a world of agile development processes, alternative distribution channels and customers accustomed to employing open source software that demands “self-help” evaluations, you would think that new business models would emerge. Instead, we see these very small companies, most of who have yet to reach cash flow break-even, adopt an extremely costly customer-facing organization (direct sales and support) paralleled by a rigid, long product development and release cycle. This seems particularly true in the data warehouse/business intelligence sector that our company, veloGraf Systems, is targeting.

My observation is that these companies are caught up in a vicious cycle based on the unproven premise that success in this space demands $20-50 million in capital. Assuming that is true, then only VCs who can (and must just because of the mechanics of large funds) write large checks invest in this sector. Having committed big sums and believing they are competing with large, established enterprise software vendors, these VCs insist on bringing in executives whose first reaction to the apparent chaos in many early-stage companies is to build a structure that reflects the large organization from which they have been recruited. A self-fulfilling prophesy. The burn rate takes off, the organization becomes less nimble and even more funding is required to build competitive sales and engineering organizations. Maybe I’m just showing my age and having a flashback to a database startup I ran using this model during the Internet bubble era but I found several contemporary exemplars of this approach while undertaking a quick competitive analysis exercise recently.

Of course, at the other extreme, there are the open source enterprise software startups who practice the “build-it-and-they-shall-come” model on the presumption that if you simply make enough noise tweeting about your cool technology and preaching to the converted cognoscenti, the sales will materialize. While usually practitioners of agile product development, startups operating under this scenario frequently lack a disciplined customer development process so critical to converting technology interest to product revenues.

Somewhere between the Oracle “mini-me” model and the freewheeling “cool-tech” approach is a business model that acknowledges the need for structure and experience but avoids a heavy-handed approach of jamming an inflexible large-company organization into a small startup. As I noted in earlier posts, I believe Steve Blank‘s agile customer development process and Eric Ries‘ lean startup principles can be applied to an enterprise software startup. With the right discipline exercised by the leadership team and investors, capital requirements can easily be half of Oracle “mini-me” model and quite likely even less. Even more interesting is that a lean startup with a differentiated product that is cash flow positive without the burden of an expensive, field-based direct sales organization potentially has a higher value to an acquirer looking to extend its product portfolio.