VenChar

What do Golf, Startups, and Slots have in common?

They all conform to one of the fundamental rules of human behavior conditioning - provide random and variable rewards to reinforce repeated behavior. 

Ivan Pavlov in a series of seminal experiments in the 1900's established all of this and now the gambling industry uses the same principles to "hook" and "keep" people.  As Alan Krigman wrote in this post:

Nearly everybody knows of the experiments by Ivan Pavlov in the early 1900s. Pavlov started by ringing a bell and presenting food simultaneously. When he stopped offering the food, the dogs still salivated at the sound of the bell. Later, to keep the dogs responding to the bell, he reinforced the behavior by accompanying it with food at random, but frequently enough that the stimulus was not futile too often. B F Skinner extended this work during the 1930s using conditioning to train animals such as pigeons and rats to perform various tasks. Tom Creed, a psychology professor at the College of St Benedict at St John's University, says that slot machines utilize similar conditioning processes to produce player behavior characteristics desired by the casinos.

Like slots, Golf and Startups provide the same conditioning response (though the only good news is that unlike slots in which the odds are conditionally designed for you to lose, Golf and startups provide opportunities for truly skilled players to hit the jackpot).  How often is it that you play golf and go through 16 holes of hell but remember that one great shot in hole 17 in which you drive within 6 feet of the hole and one putt it for a birdie - in my case very often - and it is that one shot that makes you want to come out and play golf again. 

In Silicon Valley, startups have some of the same conditioning allure of the slots.  Slots are designed to be "loud" and "blaring" when there is a huge payout so that all the other players around the slot realize that someone has won and thus get reinforced that they could also win.  This motivates the other slot players to play more often.  The same thing happens with startups - think Google.  In Slots, the machines are designed to have many "close" outcomes to trick players into thinking that they almost hit the jackpot.  The same thing happens in startups (not by design but just by their nature) when the startup is close to being acquired or when they get a major deal.  Slots make periodic payouts that condition players to keep playing.  Startups get acquired or go public in quick enough time frames that they resemble "payouts" to the employees and thus motivate them to start or join another startup.

Now please don't mistake this post to mean that startups are a "con" like slots.  Far from it.  Startups offer a truly unique opportunity for people to pursue their vision to create fantastic products/services, delight customers and make everyone wealthy.  Unlike slots which are destructive for everyone (except the casinos of course), Startups actually benefit society.  I draw the parallel only to show why startups are addictive to some folks.  They share the same conditioning response with slots and golf.  Hopefully my wife now understands why I still play that god forsaken game of golf.   

Does Valuation matter?

You probably are thinking - Duh! of course it does. 

Sure valuation matters but is it the end all and be all of all venture transactions or is it just one piece of the puzzle? By valuation I am not just referring to the price but also to terms.  I was at a conference recently where a bunch of early stage venture guys were talking about how valuations have creeped up and how they were no longer seeing single digit pre-money deals.  That got me thinking - why are folks so caught up with valuation?

I do mostly early stage deals (Seed/Series A) so this reasoning is confined to the early stage (middle and late stage deals are a different cup of tea.)  My thesis is that if you are doing early stage deals the MOST important thing for you is to BACK a big winner.  Basically your goal is to shoot for a Amazon/Google/eBay/Juniper/Verisign and you want to do everything to maximize your chances of getting into one of those deals. 

Now here is the rub if you are shooting for one of these "verb" companies you are playing a high beta game which means that you are either going big or going home and in both cases valuation does not matter.  Because if the company becomes big, it would not matter if you did the deal at $5 pre or $15 pre e.g. Amazon was done at $27 pre, Google was done at $60 Million pre, Netscape was done at $21 Million pre, and eBay was at $27 Million pre, etc.  And if the company bombs then again valuation does not matter because you ain't gonna get much back.   

The coming DNS challenge

Om links to a Business 2.0 article on the dangers of a over-worked DNS and how that has resulted in the recent outages at Google and Comcast.  The article and the resultant press coverage on this topic highlights the growing problem with current DNS infrastructure. 

(Warning: tooting Globespan and our portfolio company's horn ;-))

We had invested in Nominum in early 2003 on the investment thesis that open source BIND will not scale and its nice to see that atleast once in a while we are right with our investment thesis.  Nonimum has assembled the world's top experts in DNS (Paul Mockapetris, David Conrad, etc.) and they have built the most scalable DNS engines ever.  If you are a carrier, ISP or an enterprise, you would be doing yourself a disservice by not upgrading your DNS architecture.  If they can't find you, they cannot buy from you.

(end tooting)

Update 1: Good comment by Jeff Nolan on the comcast outage:

that comcast outage wasn't due to overworked DNS but rather a move that the company made to consolidate their regional DNS servers into centralized data centers. Comcast screwed up their network through poor planning, and as evidence to prove my point that this wasn't a DNS scaling issue is that comcast users en masse started moving to Verizon's DNS servers (I did) and they handled the load just fine despite having more broadband customers than Comcast has.

I think there is a fair debate to be had about how to scale DNS, especially when we consider exponential scaling for VoIP to the masses and so on, but the other plane that this debate should reside on is distributed vs. centralized.

I don't know what happenned at Comcast and Jeff is usually right on these kind of things so I am sure it was due to poor planning.  What I do know given our active involvement in Nominum is that the DNS infrastructure is being taxed in numerous ways:

• DDOS attacks are dramaticallly impacting DNS availablity and BIND is not set up to handle that
• Pharming attacks are raising issues of what "DNS addresses" to trust and how to know you really are going to the right address
• Network operations are becoming complex and network operators want to move, centralize and manage their IP addresses and the current bubble gum and wire setup (usually a bunch of excel spreadsheets) don't let them do that.

Given all that, I think more and more enterprises and carriers are going to opt for a commercial DNS solution rather than rely on BIND

SAP Shindig on Netweaver or how I want to be a platform company

Thanks to Jeff Nolan, I got invited to a SAP Shindig in Palo Alto earlier today.  The whole executive board of SAP hosted a bunch of VC's this morning to talk about their "platform" strategy as well as to get our thoughts. 

I went with a fair amount of skepticism and walked away impressed and open-minded.  Some thoughts on the meeting:

• Henning and Shai did a very impressive job articulating the SAP platform - Netweaver.
• Shai is a terrific speaker - articulate, cogent, and skillful in his use of words
• Netweaver is a standards based platform built on SAP engines that 3rd party developers can build apps on.  The basic benefit is that if you build your app on Netweaver, it can semantically integrate with the rest of SAP's apps thus not forcing the customer into making a suite vs. best of breed decision (atleast in theory)
• They have established a set of rules around Netweaver such as:
  • Will not change the API's for 8 years
  • Will publish all the API's (no unpublished API's like Microsoft used to do)
  • All SAP applications will be built on the API's
  • Netweaver will be standards compliant
  • The application group will build applications on top of the API that will compete with partner applications
• The presence of the whole executive board reiterated the company's commitment to the strategy
• I talked to some of the board members informally and those conversation further reinforced SAP's commitment to this strategy.

Now am I going to rush out and get all my companies to port to the Netweaver platform.  Not really.  There are some companies of mine that sell into a largely SAP universe such as Steelwedge that can benefit from being Netweaver powered as large customers do integrate Steelwedge's planning and forecasting apps with SAP - See recent press release on how Air Products is using Steelwedge.  Challenges SAP still faces in getting ISV's to adopt are:

• Its not a "true" platform - I still need to make a database/operating systems/app server decision that is separate
• the platform does not offer a semantic level interoperability with the other platforms i.e. IBM, MSFT, etc.
• Most companies do not need an "another" platform - Open source is good enough and I do not need to pay a "tax" to use it
• Biggest value in joining an "ecosystem" is the sales and marketing push and unless SAP really invests in a "partner" program that creates some sales traction for their partners this program is not going to take off.

Btw they had Mark Feldman from Virsa on a ISV panelist who has benefited from the SAP relationship.  The guy was such an "ass kisser" that his credibility was zero.  Someone remarked to me that for a white guy he had a very brown nose ;-)   

Regardless, I do want to commend the SAP guys.  They made a strong case on Netweaver and were intellectually honest on what they do and don't do.  Any enterprise company targeting the global 2000 market should look at Netweaver - its definitely worth considering.

An Unified Theory of VC Suckage

Ah, Eu Tu Paul!!! First Joel Spolsky wrote about fixing venture capital and now Paul Graham offers his unified theory of VC suckage.  First a few caveats and disclaimers (I am a cowardly, sneaky VC after all ;-))

1. I enjoy Paul Graham's writings very much.  He is eloquent, insightful and logical and I aspire to write that way
2. I do not aspire to defend VC's.  Like everything else, there are good people and bad people, good Germans and bad Germans, and good VC's and bad VC's.

However I disagree with the argument that the structure of venture capital make VC's behave as they do.  Paul is kindly proposing that its the system that makes us the cowardly, deceitful, beasts we are:

I used to take it for granted that VCs were like this. Complaining  that VCs were jerks used to seem as naive to me as complaining that users didn't read the reference manual.  Of course VCs were jerks. How could it be otherwise?  But I realize now that they're not intrinsically jerks.  VCs are  like car salesmen or petty bureaucrats: the nature of their work turns them into jerks.

The nature of their work that Paul is referring to is the "fund structure" that VC's use:

The problem with VC funds is that they're funds.  Like the managers of mutual funds or hedge funds, VCs get paid a percentage of the money they manage.  Usually about 2% a year.  So they want the fund to be huge: hundreds of millions of dollars, if possible. But that means each partner ends up being responsible for investing a lot of money.  And since one person can only manage so many deals, each deal has to be for multiple millions of dollars.

This turns out to explain nearly all the characteristics of VCs that founders hate.

The system or the "fund structure" does not make people behave in a particular way, their arrogance, lack of skills or poor behavior is the cause. 

Let us consider the things that Paul feels VC's do that founders hate:

. . . VCs take so agonizingly long to make up their minds, and why their due diligence feels like a body cavity search. [2] With so much at stake, they have to be paranoid.

It explains why they steal your ideas. . .

. . . It explains why VCs tend to interfere in the companies they invest in.  They want to be on your board not just so that they can advise you, but so that they can watch you.  Often they even install a new CEO . . .  With so much at stake, VCs can't resist micromanaging you.

. . .VCs don't invest $x million because that's the amount you need, but because that's the amount the structure of their business requires them to invest.

. . . And of course giant investments mean giant valuations.  They have to, or there's not enough stock left to keep the founders interested. . .  You're rolling the dice again, whether you like it or not.

. . . Add up all the evidence of VCs' behavior, and the resulting personality is not attractive.  In fact, it's the classic villain: alternately cowardly, greedy, sneaky, and overbearing

Let us analyze the fund structure first.  The economics of venture capital are that most VC's get 2% management fee and a 20% carry on the funds they manage (some top tier firms get more carry but for the most part the management fee is the same).  The average venture fund these days is $300 Million so the venture capital firm gets $6 Million a year for 10 years in management fees = $60 Million.  This is a lot of money for sure but remember this has to pay for salaries, office, travel, due diligence, administrative staff, accounting, etc.  And most importantly the *FEES* have to be paid back to the limited partners.  The "carry" is only calculated on top of the $300 Million so the venture firm only starts getting carry after the fees are paid back.

Now let us look at the carried interest part of the economics -  if the venture firm triples the fund i.e. make $300 million worth $900 Million than the partners in the firm will make $900 - $300 = $600 * 20% = $120 Million.  This is even more money and you only have to pay "capital gains" tax on it versus the "income tax" you have to pay for the fees -  VC's are greedy bastards what do you think they will look to maximize?  Also institutional venture capital is about raising multiple funds and the way to raise future funds is to have stellar returns on the current funds.  So even if VC's were optimizing to manage big funds the only way they can do it is to get good returns on the money they are investing.  Ultimately you can only remain in the venture capital business if you have strong track records.

So the incentives of the system are set up for VC's to raise the *RIGHT* amount of money that allows them to maximize the "return" on the fund.  Now does that mean that every VC is doing the right thing - absolutely not!! Some firms especially those who are not focused on the long term have indeed focused on maximizing management fees rather than multiples.  However there are also some top tier firms who don't get a flat management fee but rather get a  budget based management fee depending on their expenses.

Now let us look back at some of Paul's other points:

a. VC's taking a long time to make a decision:  If a VC does not know the space, she is going to take  a long time to make a decision.  Trust me if you are starting another search company and you show up at  Mike Moritz or John Doerr's door, they will make a decision in less than 2 weeks.  However if you showed up at Mike's door with a biotech deal, he is not going to make a quick decision since he does not know that space well.  Diligence is a function of how well a VC knows an area and less of how much money he is going to invest.

b. VC's stealing ideas:  I am sure some VC's do steal ideas but for the most part this does not happen.  First of all ideas are dime a dozen - its the execution that matters and Paul himself wrote about that in his essays about doing a startup.  Also if your idea is so simple that all it takes is for me to know it to duplicate it then you don't really have a valuable business anyway.  The real issue is that ideas are not independent things that exists all on their own.  Every idea builds upon something else and therefore the lineage of ideas undermines sole ownership of any idea.  Malcolm Gladwell wrote this brilliant article about plagiarism that is worth reading.  I think the whole idea stealing concern is over blown.

c. VC's micromanaging: I think if you look at the history of the most successful venture backed companies - Amazon, Cisco, eBay,  Google, Oracle, Microsoft, Sun, Yahoo, etc. - they have all had the founders at the helm and the venture guys on those deals have not micromanaged them.  Good VC's get the value of not standing in the way.  Bad VC's don't.

d. VC's invest not what you need but what they want - again if a VC wants you to take more money that you need then she is a bad VC and you should find a different one.  This is not a function of the system but rather you are dealing with someone who does not understand venture capital.  The best venture capital returns have come from very small investments - Microsoft raised $1 Million in venture capital, Cisco raised $2 Million, etc.  Vinod Khosla has a great presentation on how his most successful deals have been ones in which he put a small amount of money first. 

This blog has turned out to be much longer than I first intended.  My overall point is that Paul does a good job of raising some valid issues with VC's but its not the system that's at fault, its the incompetence of the VC's in question.  Like everything else, there are good VC's and bad VC's - just try to find the good ones if you need money.

Age Old Questions

Some age old questions remain not yet answered:

• Which came first - the chicken or the egg?
• Is light a wave or a particle?

In that vein, the big question in Venture Capital is always

• Markets versus Team i.e. do you bet on big markets or bet on great teams

Clearly its best to bet on both but often you need to make that trade off and different firms have had different philosophies on that.  Arthur Rock was known for his focus on great teams.  He wrote a $250,000 check to Robert Noyce and Gordon Moore to form Intel on his pure conviction on the strength of the people.  Don Valentine is famous for betting on big markets even if the team is less than stellar.  Warren Buffet (one of my personal heroes) has this great line about teams and market:

When a management team with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact

My friend, Robin Bordoli, of Mobius has this great piece on the way he looks at deals and market spaces.  I take a slightly different approach to Robin.  While markets clearly matter and I agree that  M&A is going to drive most of the exits for VC's, if I had to tradeoff the two, I would go with the great team.  The rationale for my preference is driven by the following:

1. I am a young VC who is looking to partner with great people for the next 30 years so the more great people I partner with today, the better the leverage over my planned time line ( assuming my partners actually let me stay in this business for that long ;-))
2. Great people attract other great people so again over my planned time line I will be able to fund the alumni of my hopefully successful companies (the number of semiconductor companies founded by alumni of Fairchild or software companies founded by alumni of Oracle/Siebel are astounding)
3. Great people can usually figure out to make at least a single/double out of a bad market
4. People are a little easier to judge than market (this is a marginal point since both is equally hard)
5. Markets can change but people normally don't

So that's my answer and I am sticking to it ;-) ;-)

Emphasizing the Information we know versus the information that matters

Malcolm Gladwells's new book, Blink, has this terrific anecdote on the Cook County emergency room.  Turns out the Director of the  ER wanted to figure out a better way to diagnose when people show up to the ER complaining of chest pain whether they are having a heart attack or just a heartburn.  Since the costs of being wrong in the diagnosis is catastrophic, physicians tended to be conservative and keep patients in observation for a day if they had the slightest doubt.  This resulted in lots of folks staying overnight (personal inconvenience) and a lot of hospital beds lost unnecessarily (major financial and health inconvenience). 

A young cardiologist (then) by the name of Lee Goldman (full disclosure: he is a colleague of my wife) developed a decision tree that, using only four factors, evaluates the likelihood of heart attacks.  Here is a summary of the results using Goldman's decision tree:

For two years, data were collected, and in the end, the result wasn't even close. Goldman's rule won hands down in two directions: it was a whopping 70 percent better than the old method at recognizing patients who weren't actually having a heart attack. At the same time, it was safer. The whole point of chest pain prediction is to make sure that patients who end up having major complications are assigned right away to the coronary and intermediate units. Left to their own devices, the doctors guessed right on the most serious patients somewhere between 75 and 89 percent of the time. The algorithm guessed right more than 95 percent of the time. (pp. 135-136)

Goldman's decision tree needed drastically less information than the usual physical exam and questioning.  In fact additional research showed that extensive exam and questioning by the doctors actually made their diagnosis WORSE.  Turns out that the additional information obtained by the doctors led them to weigh it more than the simple 4 item criteria laid out by Lee Goldman.

This is not surprising.

As a venture capitalist, I do various kinds of diligence on prospective companies.  Occasionally I meet a company who is in a market or whose founders are intimately acquainted with someone I know.  In those cases, I reach out to the contact and ask him/her for their opinion on the company or the person  I end up weighing their opinion very highly in my decision making even though the importance of that information is not clear.  I am weighing more heavily the information I can access versus the information that *MATTERS*. 

Of course the trick is knowing what is the information that MATTERS.  There is no easy answer here but its important to be cognizant that just because you don't know what is the information that really MATTERS does not mean you should value the information you have received much higher than other pieces of data.

IRR Calculations

One of the blogs I track is Concrete Covina by Jim Lejeal.  Jim has a recent blog on IRR calculations

He talks about the "First Chicago" method of calculating IRR's and how various top tier firms use a scenario based model (probability based outcome) to calculate IRR and if a certain threshold is reached then they will do the deal everything else checking out okay.

This definitely flies against the way I work (yes I know maybe that why I am not a top tier venture capitalist ;-)) I have never made an investment decision based on an IRR model.  As a firm we use a financial model as part of the investment memo but its done more to get a general sense of how this company's business plan looks.  We also use the financial plan to check assumptions and understand how well the entreprenuer has thought about his/her business.  The only thing I know about financial plans for startups past 18 months is that its going to be wrong (mostly on the downside but sometimes on the upside).  Excel sometimes makes people confuse between precision and accuracy . . .

Experimentation and Failure

Last weekend I attend the Stanford Entrepreneurial Conference.  The lead keynote speaker was Jeff Bezos of Amazon and he did a terrific job.  He talked about historical innovations and innovators.  Some of his examples were:

1. The guy who invented toilet paper
2. The woman who invented windshield wipers - prior to her invention people just stopped every mile or so and wiped the windshield
3. The woman who invented "white out" - she was an executive assistant who made a lot of mistakes while typing and was annoyed there was no quick way of correcting her mistakes.  By the way "white out" was nothing but white paint - just shows you don't have to always invent cutting edge stuff to be successful

Then he talked about Amazon and how he tries to instill a culture of "innovation' within Amazon.  He said the two important factors that help drive innovation at Amazon are:

• Cost of Experimentation is low - its easy to run experiments in an online business and check to see effectiveness.  Amazon runs experiments all the time and evaluates which of his innovations are more effective
• Cost of failure is low - again another terrific element of online businesses is that the cost of failure can be controlled since you can run these experiments without a significant cost if it fails.

The combination of these two factors also result in an open non-hierarchical organizational culture at Amazon.  Even front-line folks can run a experiment since the cost of doing and the cost of failure is low.  These two factors are not unique to Amazon, they apply to all online businesses and good online businesses take advantage of them - the folks at Plaxo (full disclosure:  portfolio company) are masters of this.  Rikk, Todd, and Cameron and the other engineering folks constantly experiment, test and iterate on their new feature set before releasing it.  No wonder they are at 5 million users. 

The allure of big VC rounds

A lot of good discusson in the blogosphere about Webroot's recent $108 Million round.  Arun Natarajan blogs about it and provides a couple of different thoughts on the financing from Robert Cringely and Fred Wilson. 

I don't buy Robert's argument that its the fear of losing management fees that drove the Webroot financing.  I don't know any of the details of the financing and have no secret source.  However the people who did the financing (Accel, Mayfield, and TCV) are some of the smartest folks around and really understand the security space (full disclosure: Robin Vasan was on the board of Trigo Technologies - A company I co-founded).  I suspect that unlike traditional VC financings in which VC's invest their money in the company, a part of this transaction was done to buy secondary interest from the founders.  This is way for the founders to get some liquidity without necessarily selling the company.  This provides some risk mitigation for them and allows them to shoot for a big outcome.  The founders and investors probably believe that they can build a huge security company starting with the base of spyware/virusware and then expanding into IDS/IPS/etc. 

Can this company fight off Symantec /McAfee/Microsoft in this space?  We will have to wait and see. 

On a side note Brad Burnham has a post on private companies that have raised over $100 Million in venture capital and its not a pretty history.  Hopefully this one will have a better outcome