The Dentist Office Software Story

I’ve been telling this fictional story about Dentist Office Software for years to describe why we are so focused on our “networks” investment strategy. Yesterday I told it at a HackNY event we did at the USV office and my partner Albert provided a finishing touch that really drives it home. Since I’ve never told the Dentist Office Software story here at AVC, I will do that and then I will add Albert’s alternate (and better) ending.

————-

An entrepreneur, tired of the long waits he is experiencing in his dentist’s office, decides that dentist offices are badly managed. So he designs and builds a comprehensive dentist office management system and brings it to market. The software is expensive, at $25,000 per year per dentist office, but it’s a hit anyway as dentists realize significant cost savings after deploying the system. The company, Dentasoft, grows quickly into a $100mm annual revenue business, goes public, and trades up to a billion dollar valuation.

Two young entrepreneurs graduate from college, and go to YC. They pitch PG on a low cost version of Dentasoft, which will be built on a modern software stock and include mobile apps for the dentist to remotely manage his office from the golf course. PG likes the idea and they are accepted into YC. Their company, Dent.io, gets their product in market quickly and prices it at $5,000 per year per office. Dentists like this new entrant and start switching over in droves. Dentasoft misses its quarter, citing competitive pressures, churn, and declining revenues. Dentasoft stock crashes. Meanwhile, Dent.io does a growth round from Sequoia and hires a CEO out of Workday.

Around this time, an open source community crops up to build an open source version of dental office software. This open source project is called DentOps. The project takes on real life as its leader, a former dentist turned socialist blogger and software developer named NitrousOxide, has a real agenda to disrupt the entire dental industry. A hosted version of DentOps called DentHub is launched and becomes very popular with forward thinking dentist offices that don’t want to be hostage to companies like Dentasoft and Dent.io anymore.

Dentasoft is forced to file for bankruptcy protection while they restructure their $100mm debt round they took a year after going public. Dent.io’s board fires its CEO and begs the founders to come back and take control of the struggling company. NitrousOxide is featured on the cover of Wired as the man who disrupted the dental industry.

—————

That’s the story. I hope to fine folks at YC, Sequoia, and Workday don’t mind me using their names in this fictional story. I picked the very best companies in the industry and my use of their brands is a compliment. I hope they take it that way.

This story is designed to illustrate the fact that software alone is a commodity. There is nothing stopping anyone from copying the feature set, making it better, cheaper, and faster. And they will do that. This is the reality that Brad and I stared at in 2003 as we were developing our initial investment thesis for USV. We saw the cloud coming but did not want to invest in commodity software delivered in the cloud. So we asked ourselves, “what will provide defensibility” and the answer we came to was networks of users, transactions, or data inside the software. We felt that if an entrepreneur could include something other than features and functions in their software, something that was not a commodity, then their software would be more defensible. That led us to social media, to Delicious, Tumblr, and Twitter. And marketplaces like Etsy, Lending Club, and Kickstarter. And enterprise oriented networks like Workmarket, C2FO, and SiftScience. We have not perfectly executed our investment strategy by any means. We’ve missed a lot of amazing networks. And we’ve invested in things that weren’t even close to networks. But all of that said, our thesis has delivered for us and we stick to it as much as we can.

So here’s Albert’s alternate ending (with my editorial license on the colorful aspects of this story):

—————

A young dentist, named Hoff Reidman, just starting up his own private practice, decides that he wants to network with other dentists. Because Hoff went to CMU before going to dental school, he’s pretty technical and he hacks together a site in Ruby called Dentistry.com. He emails all of his friends from dental school and they sign up. Every dentist wants to be on Dentistry.com and the site takes off. Hoff realizes he has to quit his dental practice to focus on Dentistry.com. Albert Wenger, who happens to be a patient of Hoff’s, convinces him to let USV do a small seed round of $1mm to help build a company around Dentistry.com. Hoff comes up with a product roadmap that allows patients to have profiles on Dentistry.com where they can keep their dental records, book appointments, and keep track of their dental health. It also includes mobile apps for patients to remind them to floss and brush at least twice a day. While Dentistry.com is free to use for anyone (dentist or patient), it monetizes with native advertising, transactions between dentists and their patients, and transactions between patients and providers of consumer dental health products, and transactions between dentists and providers of dental equipment and products. Dentistry.com ultimately grows into a $1bn revenue company and goes public trades at a market cap of $7.5bn. Wall Street analysts love the company citing its market power and defensible network effects.

————-

I hope you enjoyed this fictional story. I find it explains our network thesis simply and easily. I will keep telling it to groups I talk to, but now with Albert’s ending. I like it very much. Thanks Albert.

On Getting An Outside Lead

There are some “truths” in the venture capital business that I have been hearing since I got into this game in the mid 80s. One of them is that getting “third party validation” by going outside of the current investor syndicate to find a new lead is good for the investors. I have come to believe this “wisdom” is nothing more than lack of conviction on the investor’s part.

What “super powers” do VCs have that allow them produce above average returns year after year after year? Well you could argue that some of us have the ability to see things before others see them. That might be true but it is hard to sustain that for a long time. You might argue that some of us have brands that allow us to get into the conversations with the best entrepreneurs when others can’t. That is most certainly true. You could argue that some of us have a tight focus on an investment strategy and work it tirelessly and don’t veer from it. That is most certainly true.

But short of those three things, I am not aware of a sustainable model that produces above average returns on investing in “new names”. However, there are two “super powers” that VCs have at their disposal that can produce above average returns year after year if they use them correctly. Those are the right to a board seat and the right to invest in round after round after round. I talked a bit about the latter one last week.

Taken together, these two rights put VCs in a position to intelligently invest in their existing portfolio companies. I believe that you can turn an average portfolio producing average returns into an average portfolio producing above average returns by intelligently investing in your existing portfolio companies.

It is one thing to take your pro-rata, and I talked a lot about that last week. But it is another thing to lead the next round and increase your ownership. It’s this latter move that I think many of us in the VC business instinctively avoid for fear that we are “falling in love with our companies.” Anyone who has been in the VC business for a long time has made the mistake of believing too much in a portfolio company and supporting it beyond when you rationally should. I have made that mistake so many times I can’t count them on two hands. It is my signature failure and I have not been able to stop doing it.

But, I would argue, the worse mistake is to know you’ve got a winner in your portfolio long before anyone else knows it and you allow a new investor to come in and lead the next round when you easily could and should. The upside on your best investments is the thing that allows an early stage VC to take so much risk and lose money on so many investments. Increasing the upside on the best investments is a rational move in light of the distribution of outcomes in a VC fund.

I would caveat all of this with a few things:

1) You have to let the entrepreneur do what they think is best for them and their company. If they want an outside lead, then by all means you should support that and work as hard as you can to make it happen.

2) You have to think about the amount of “dry powder” the current syndicate has and make sure that you aren’t using all of it up by leading a round when you should really be bringing in a new investor.

3) If an insider is leading a round, you should put a very fair deal on the table for the entrepreneur and the company. An inside lead is not about getting a “sweetheart” deal. It is about putting in place a fair deal for everyone.

4) If the valuation expectations of the founder and the company are unrealistic, then you should suggest that they go test the market. If there is a better offer out there at a better price than you would pay, that is always a good outcome for everyone.

There is a lot of signaling risk in all of this. If you are known to be aggressive in offering to lead inside rounds, and you don’t make that offer, then that puts the entrepreneur in a tricky spot. Of course the entrepreneur can say that they don’t want an inside lead and they want to expand the investor base. But even so, smart investors may know. Truth be told, there is signaling risk in everything that the existing investors do and anyone who thinks otherwise is just not seeing straight.

Two of my favorite examples of this strategy are YouTube and our portfolio company Etsy. At YouTube, Sequoia led the Series A and as far as I can tell (I’m not 100% sure), they led every round after that until the company sold to Google. That allowed Sequoia to allocate more and more capital to what was an incredibly great company and investment and get a massive return on a sale that sure felt like a monster at the time. At Etsy, USV participated in the seed round with some angel investors. We led the Series A and the Series B and increased our ownership substantially by doing that. On the Series C, Rob Kalin decided to get an outside lead and we were totally supportive of that decision. In both cases, I expect (or know) that the VCs had a better idea of how things were going (well!!!!) than anyone outside of the company.

There was a meme in the comment thread on my post last week (104 comments) about “insider trading”. I’d like to say something about that without getting legal or technical. In my view, insider trading is taking advantage of someone buying a stock from you or someone selling stock to you when you know something that they do not. It is illegal and should be. Purchasing stock from a portfolio company is unlikely to be insider trading because how can anyone suggest that you know more about a company than the company knows about itself? I guess that’s possible, but it’s a hard argument to make with a straight face. So while this insider lead thing may smell to some as insider trading, I am very confident it is nothing of the sort.

So in summary, when you have conviction that one of your investments is doing really well, you should have the courage to offer to lead an inside round (assuming you have sufficient capital including future reserves to do that). You should make the case to the entrepreneur and the board why that is a good idea. And if they decide to go outside and find a new lead, you should support that decision and do everything you can to make that strategy a success. I don’t think enough VCs do this and I think they should.

Freemium In Education

We’ve been investing in the education sector for a few years now. We started our exploration of online education in early 2009 with an event called Hacking Education. The takeaways from that event have informed a lot of what we’ve invested in since then.

One of the key takeaways was that learning could and should become free. Our friend Bing Gordon said this at Hacking Education:

From an economic point of view, I would say the goal… is to figure out how to get education down to a marginal cost of zero. 

We have invested with Bing in online education. Bing and his partners at KP led the most recent round in our portfolio company DuoLingo. DuoLingo is the most popular language learning mobile app in the world. And one of the reasons for that is that DuoLingo is free.

So you might ask “how can you make money giving away a learning app?” This past week DuoLingo answered that question with the commercial release of the DuoLingo Test Center.

The DuoLingo Test Center is currently free but it won’t be for long. Give it a try if you’d like to see how it works. Once the DuoLingo Test is accepted at schools and employers, the company plans to charge $20 to take its test.

There’s an established incumbent (monopoly) in this market called TOEFL. If you’ve come to the US to study, you’ve probably taken this test. It’s a lot more expensive than $20 per test and DuoLingo is out to prove it can do this testing less expensively and better.

But what this example shows is something more than how one company plans to monetize its free app. It’s a model for freemium in online eduction. Provide the education for free but charge for the certification (testing). This is a very elegant implementation of freemium as its an easy on ramp and the customers who get the most value are the ones who pay.

I am pretty sure this will become the dominant monetization model in online education. We are already seeing it emerge in other sectors. A number of the attendees at Hacking Education predicted this over five years ago. It made sense to me then and it makes even more sense to me now.

Fun Friday: How Do You Take Your Coffee?

It seems like its been a while since we’ve done a Fun Friday around here. I’m not sure why that’s the case but its time to change that.

I’m sitting here in the Soho House in Berlin drinking a nice cappuccino and thinking about all the ways one can consume coffee.

image

I have one cup of coffee a day. No more because it makes me wired. No less because I’m addicted.

Because I only allow myself one a day, I’m obsessive about making it a good one.

I prefer espresso coffee and my primary drink is a Cortado which is also called a Gibraltar. Its usually a double shot of espresso with a small bit of steamed milk. Think of it as a mini Cappuccino. I generally get it in a shot glass. My favorites are at Kava in NYC’s west village, Blue Bottle Coffee in NYC and SF, and my absolute favorite is at Intelligentsia in Venice Beach California.

I do like an iced cappuccino on a hot steamy morning like we have in NYC in the summer. My favorite iced cappuccino is from Jack’s in the west village of NYC and Amagansett NY.

I have various coffee shop lists on Foursquare. This is my favorite coffee shops in Manhattan list.

So that’s how I like my coffee. How do you like yours?

Update: Wil suggests “post a selfie of you and your morning coffee in the comments”. I think that’s a great idea!

The Pro-Rata Opportunity

Mark Suster has a good (and long as is his wont) post up on the topic of the changing structure of the VC business.

Mark focuses on something important that is probably not getting talked enough about when people talk about the VC business these days. I like this slide from his post:

suster slide

“Capturing pro-rata” is sooooo important in early stage venture. You make 20 investments in a fund. One is going to return the entire fund. Two more are going to return it again. A few more are going to have strong outcomes and return it again. The rest are noise when it comes to fund returns (but you better not treat them like noise).

Guess what? Early stage VC is a lot like poker. You want to go all in on your best hands. And if you make a seed or Series A investment, you get something called the pro-rata right. That means you get to invest an amount in every private round going forward that allows you to keep your ownership at the current level. A pro-rata right in Facebook, Twitter, Dropbox, Airbnb, Uber, ……….. is worth a lot. And early stage investors get those rights for free in the early stage rounds.

At USV, we recognized this early on but did not know what to do about it. So we let our pro-rata rights go unused in Zynga and Twitter because we did not have the funds to take those allocations. Brad agitated about it. It bugged him. I was also unhappy about it but did not want to increase our fund size so that we could take these allocations. I strongly believe in small fund sizes. It’s a core of our strategy at USV.

So we came up with The Opportunity Fund. It’s a companion fund that is designed to “capture pro-rata” as Mark puts it. We raised our first one in late 2010 and our second one earlier this year. It has been a big success. It is now so much a core of what we do that we now raise an early stage fund and an opportunity fund as a pair. You can’t invest in one without investing in the other. They have different economics for the LPs because they require different amounts of work on our part and because we don’t want to commit to put the entire Opportunity Fund to work (we did not put the entire initial Opportunity Fund to work).

When a company hits escape velocity, the investors in the inside are the first (after the entrepreneurs) to realize it. And if you’ve watched hundreds of rockets go up in your career and dozens hit escape velocity, you start to be able to smell escape velocity coming. That means that “capturing pro-rata” is an opportunistic thing. Seeing something before others see it is one of the few legal and sustainable ways to make money that I know of in the investment business. And so having a vehicle to do this aggressively is a huge weapon in the hands of an experienced VC firm.

Yes it is true, as Mark points out in his post, that public market investors are also coming into the private markets in a big way to capture all of this valuation expansion that used to happen in the public markets. But they do not have the one thing that we have – the pro-rata right. And so using it becomes even more important.

I am glad that Mark took the time to write his post on this topic. It’s a big change that has happened fairly quickly in the early stage venture capital business (all post financial crisis) and the ramifications of it are important to entrepreneurs, VCs, public market investors, and LPs. I’m very pleased that USV has been early to this theme and a thought leader in it.

Independent Directors

Boards are important. They might not do the day to day work of company building but they set the tone at the top. The group that the CEO reports to has a big impact on the CEO’s mindset which trickles down.

If you raise capital for your business you are likely to get investors on your board. If you choose well you might get some good board members that way. But you might also get indifferent or worse.

The biggest piece of advice I give to entrepreneurs on the topic of boards is to get some independent directors on their board. Ideally these would be peer CEOs who have a lot of experience building and managing companies.

Recruiting board members takes time. Most entrepreneurs prefer to recruit people who work for them and can impact the day to day effectiveness of their organizations. And so they prioritize that.

What they miss by putting off the work of adding independent directors is that they should be also investing their time in improving the effectiveness of the group they work for.

If your board is you and your cofounder(s) and some investors you have a suboptimal board structure. Do yourself a big favor and recruit a few strong and experienced independents. It is well worth the time and energy you will spend on it.

Flurry

Yesterday our portfolio company Flurry announced it was being acquired by Yahoo!

I thought I’d provide a bit of history since this was an interesting investment for us.

Back when Apple was launching its app platform in the winter of 2008, we met with Greg Yardley who had teamed up with Jesse Rohland to build an analytics service for app developers. We had known Greg from his work with Seth Goldstein at Root and we were fans. And it seemed to be a smart idea to give developers the ability to see what people were doing in their mobile apps. So we provided seed financing to Greg and Jesse along with our friends at First Round.

Pinch launched the first iOS analytics service and got rapid adoption. But they ran into some challenges, the two primary ones were monetization and getting onto Android and Blackberry (which was relevant back then). And that’s where Flurry entered the picture.

Flurry was a pivot into the same business as Pinch was in. They were already on Android and Blackberry but were far behind Pinch on iOS. They were led by a hard charging CEO named Simon Khalaf who had big ideas for monetization. It was a match made in heaven. So the two companies merged and Flurry became the surviving company.

Flurry continues to lead the mobile app analytics business. According to Simon’s blog post yesterday, there are 170,000 developers with 542,000 mobile apps using the Flurry service.

And now Flurry becomes a Yahoo! branded offering. There is no question that the Flurry data and its advertising products (powered by Flurry’s data) will be a great fit for Yahoo!’s mobile ambitions.

So we have a happy ending to a startup story with a few twists and turns. This is an example of where 1+1 equaled a lot more than two. I’ve been involved in a number of “startup mergers”. Some work. Some don’t. This one worked beautifully.

Free International Roaming With A Premium Upsell

I just landed in Berlin after an overnight flight from the US.

In the past, turning on your phone after landing overseas could be an expensive experience as the phone downloads all the email you received since taking off at international mobile data rates.

I’ve used a host of techniques over the years to avoid the experience of landing, turning on my phone, and immediately getting a text message that I’ve blown past my international data roaming cap.

I’ve turned off mobile data and waited until I got to hotel WiFi to download my email but that meant no mobile data for directions to the hotel. I’ve bought SIM cards in airports. And more recently I’ve rented a pocket WiFi before traveling overseas.

But last year the Gotham Gal and I switched back to T-Mobile after they introduced free low bandwidth international data roaming for all customers in the US.

Here is the experience when I land. I turn on the phone, it finds the local mobile network, connects, and my phone lights up with notifications and emails start coming in.

In addition I get a text message from T-Mobile offering to upgrade me to an international data pass that offers 4G in 100MB buckets at roughly $10/100MB.

I buy the upgrade every time and am happy to pay for the higher speeds.

But the important thing here is the customer experience. No longer do customers have to fear turning on their phone. No longer do customers have to jump through hoops to procure an affordable mobile data plan. If you want faster speeds, T-Mobile makes it drop dead simple to upgrade right on your phone.

This approach to international mobile data should be adopted by all the mobile carriers. It’s a great experience.