Posts from October 2008

I’ve detected a bit of irritation, and even cynicism about the motives of Sequoia, Benchmark, Ron Conway, and others (including me perhaps) in the venture capital business who have been publicly and privately advising their portfolio companies and entrepreneurs everywhere to be cautious in light of the market meltdown and the potential for a long recession.

Kara Swisher titled her post last week "Irony Alert: Bubble-Making Venture Capitalists Start Popping Them" and started it off by saying:

Is it just me or does the sudden prospect of venture capitalists–the
very investors who fueled the Web 2.0 valuation insanity with their
typically egregious overfunding of start-ups–lecturing about the bleak economy and the need to tighten belts seem just a tad ironic?

Bernard Lunn from Read Write Web posted this comment on my blog a few days ago:

Fred, this is one of the rare times that I disagree with you. Cannot argue with Sequoia’s track record. Their advice is good. Of course companies should keep their costs as low as possible. That has been the obvious for centuries. So last week the advice was “spend like drunken sailors?”. Seriously, this kind of boom one day, gloom the next reminds me of the crazy behavior that got us into this mess. My beef is with this suddenly flurry of VC advice way late in the game of advising their portfolio companies that the economic cycle has turned bad. That was obvious a year ago. Two years ago it was probable. The VCs that I know knew that. Why the sudden flurry of advice after an obvious meltdown? Better than still being in denial I guess.
I know this is bad form, but we have been giving measured advice on the changes in the economic cycle on ReadWriteWeb for over a year now. Entrepreneurs/managers need time to execute these kind of changes, so a bit of thinking ahead of the curve is what they expect from their financial advisors.
Clever slides, great perspective, good data, good data but a year late IMHO.
Bernard

Even some other VCs are commenting on Sequoia’s presentation. Alan Patricof is quoted in The Deal saying:

The comments made by the partners of Sequoia Capital at their recently
held ‘CEO Summit’ have been widely covered by leaks to numerous
bloggers. These bloggers have disseminated the details and spread the
contagion of the sentiments to the public at large, unfortunately
running the risk that the words become a self-fulfilling prophesy.
Without challenging the comments, which expressed a heightened degree
of doom and gloom for the economic prospects of young start-up
companies particularly, I do think it calls for a somewhat more
restrained response on the outlook and required action before throwing
the baby out with the bath water.

Alan’s comments are actually very good and I agree with almost everything he says. But I think everyone is shooting the messenger (ie Sequoia and to a lesser extent the other Silicon Valley VCs) who are raising the caution flag.

To Kara and others’ assertions that it was Sequoia who fanned the flames of the bubble, I call bullshit. I was on a panel with Mike Moritz in the summer of 2007 and he said then:

Adam [Lashinsky] is asking Moritz about frothiness of venture valuations. Still true?

Moritz: Undoubtedly, he says. Best time to invest is when people are
cowering under their desks. Everyone has the strut back in their walk;
everyone is walking tall. Returns paltry for long time, but money keeps
pouring into the area.

Here’s the deal. Everyone, including Sequoia, Benchmark, Ron Conway, etc, are still planning on investing in startups. They’ve been at it a long time and know that VC is a cyclical business. In fact, Moritz understand that the best time to invest "is when people are cowering under their desks".

But we have a responsibility as investors, board members, fiduciaries, and advisors to our companies to tell them what we’ve seen before, that acting now decisively will make it easier to survive tough times.

This is not some coordinated cynical attempt by VCs to talk down valuations or put entrepreneurs on the defensive. We are not spreading the contagion of gloom and doom. It’s all about acting responsibly and making sure we all survive to fight another day. Because in the end, survival is what darwinian capitalism is all about.

“ My recommendation to all of you entrepreneurs out there is to get off the negative sentiment treadmill, step up, and lead. The people working for your company are likely confused, concerned, and overwhelmed with all the noise in the system. In the near term, building your business will likely be more challenging on a number of dimensions. So what – that’s the normal cycle of business. You don’t need to be a blind optimist and spout happy talk, but you do need to have a clear sense of purpose and goals for your company. Leadership 101. When I look back at the dotcom apocalypse that was 2000 – 2002, I realize some of the best companies I’ve ever been involved in were created during that time. In the midst of this, I remember the endless stream of “the Internet is over” and “the information technology business in now a mature business and there will never be innovation again.” Yeah – whatever. Get some exercise, take a shower, eat a good breakfast, and get out there and build a great business. —Brad Feld – OK Entrepreneurs, It’s Time To Step Up

I’ve always felt that Sequoia was the best venture capital firm in the business and this slide show shows exactly why that is. It’s chock full of data and charts and advice. Kudos to the team at Sequoia who put it together.

Over the past week (eight plus days actually), I’ve been promoting this Donors Choose Giving Page on this blog and twitter. During that period, 26 people have given a total of $6055. We are basically on a path to raise about as much as last year when almost 100 people donated about $20,000 through the AVC giving page.

Given how much I’ve been promoting this contest, I started wondering how well my marketing efforts are converting.

I use bit.ly links for all my twitter posts so I can track them. The donors choose giving page has generated 422 clicks this month to date as follows:

So the posts I did on twitter using bit.ly generated a total of 422 clicks to the giving page.

I use mybloglog to track the outbound links on this blog and they tell me that there has been 145 clicks to donor’s choose from this blog since Oct 1st.

So the posts I’ve written promoting the AVC Donors Choose Giving Page have produce a total of 567 clicks so far this month. And we’ve collectively made a total of 26 donations (I’ve made one and will certainly make more).

That’s a 4.58% conversion rate. I think that’s pretty good but I am not positive. I hope the e-commerce experts out there will know and weigh in via the comments and let us all know.

It would be really neat if I could put a tracking code on the Donors Choose Giving Page and share that tag with bit.ly and mybloglog and find out which channel converts better. My gut says this blog should convert better but I really have no data to proove that.

The big point is blogs and microblogs are good vehicles to drive e-commerce. We need better ways to track thesse channels.

My partner Albert calculated early last year that it takes about 1/10th the hardware, software, bandwidth, storage, and other expenses to build a web service compared to what it took in the 99/2000 time period. That was just as services like Amazon Web Services, Google AppEngine, 10Gen, and other "cloud computing" platforms emerged as real options. It’s gotten even less expensive now. As Albert pointed out in his cloud computing talk at Web2NYC, the first 5mm page views on Google AppEngine are free. It doesn’t get less expensive than free.

It’s a lot less expensive to build, deploy, and scale a web service than it used to be. Open source software makes it less costly and easier to build an app. Tools like Get Satisfaction make it cheaper and easier to provide support for a web app. Blogging and Twittering makes it cheaper and easier to get the word out about your web app.

There’s been plenty written about how all of this threatens the venture capital model. A two person team can go to Y Combinator, get a little bit of capital, work for three months, launch a web service, and be in business. It’s not just Y Combinator, there’s TechStars in Boulder, Seedcamp in London, and a bunch of other such programs.

I don’t think this model threatens venture capital at all. I explained why in this post back in December 2006. We’ve embraced the "less expensive" model in a big way with investments like Delicious, Tumblr, Disqus (Y Combinator), Zemanta (SeedCamp), 10gen, Adaptive Blue, Etsy, Outside.in, and Pinch Media. That’s about half of our current portfolio and in each case, our first investment was small, the team was small (less than 10), and the monthly burn was well below $100,000 per month. In some cases, the burn was (and still is) well below $50,000 per month.

On Tuesday we had our Union Square Ventures portfolio together for our annual portfolio summit. During that meeting I pointed out that a number of our portfolio companies have figured out how to build web services that reach 10mm to 20mm unique visitors per month with a total team of less than five people. Tumblr is probably the best example of this. David and Marco are still the only developers at Tumblr. They have a customer service person and several part time members of the team. Tumblr powered blogs reach about 20mm unique visitors per month. There are about 500,000 Tumblr users who collectively generate 150,000 new posts per day. Tumblr is a big web service with a tiny team. It is incredibly capital efficient.

My question to the rest of our portfolio was simple. What can the rest of you learn from this approach? How can you get more capital efficient? And I’ll ask the same thing of all of you who read this blog. Can we harness this massive reduction in capital requirements to figure out how to survive and thrive in the coming downturn?

Om Malik reported yesterday on his blog that Sequoia brought it’s portfolio together this week and gave them a talk about cutting costs and preparing for a downturn. Ron Conway sent an email to his portfolio suggesting to them that they cut expenses so that they can survive another three months. I’ve written recently with my advice, not just to our portfolio, but to everyone who reads this blog.

I received an email this week from the CEO of a company who I have known for a long time. He and his senior team made some adjustments this week. They let a few people go, closed all of their open hiring slots, cut off low ROI marketing programs, froze salaries, and made several other adjustments. All in all they cut between 5 and 10% of their annual operating expenses. And this is a profitable company that is growing and doing well. That’s what good experienced managers do in times like this. That company will continue to grow, but they know growth will slow, the sales cycle will be longer, and they want to be sure that they will remain profitable.

Much has been written about how the "nuclear winter" of 2001-2003 led to many of the innovations we’ve been tapping into since. Clearly the capital efficiency revolution was fanned in the nuclear winter. When capital is scarce, smart people figure out how to do more with less. So first and foremost, let’s all take advantage of this capital efficiency to get our costs down and build businesses with even more operating leverage. And hopefully there are new tricks out there that we can use to get even more capital efficient.

It’s never pleasant to face the truth about darwinian capitalism. The bad companies die. But that harsh fact forces all of us who want to survive to evolve, adapt, and innovate. The time has come to leverage capital efficiency, not just to make it easy to do a startup, but to survive a downturn. Capital efficiency has found its moment and we must embrace and extend it.

The teacher is asking for a set of classic novels, including "The Adventures of Huckleberry Finn" by Mark Twain, one of my favorites. I can easily recall the thrill of reading Huck Finn for the first time. The cost is $518. It’s a compelling case, and it’s from a Bronx middle school; early in my career as a journalist, I spent a fair amount of time in Bronx public schools, including several in areas where most residents lived at or below the poverty line. Many of the kids are immigrants or the children of immigrants, and providing great American literature resonates strongly. So this donor chooses.

Tom Watson, Author of CauseWired

If you want to choose like Tom did, please visit this blog’s Donors Choose giving page

Image by Getty Images via Daylife

The Treasury, the Fed, and Warren Buffet have been the only buyers in this meltdown and have been largely focused on financial companies. Meanwhile the rest of the market has gone down 30% year to date and very few, if any, stocks have been spared.

What do we look for next? Does the market just keep going down endlessly? What will bring this to an end? Clearly not government intervention. While possibly necessary (we’ll see), the splurge has clearly not put an end to selling in the markets.

We need to see more Warren Buffets stepping up. And my bet is they will eventually. And they will be corporations buying back their own stock, large private equity and buyout firms doing going private transactions with all equity cap structures, and possibly foreign companies seeking bargain acquisitions in the US.

What’s interesting, as Howard pointed out repeatedly on twitter yesterday, is that corporations have not yet stepped up to stock buybacks.

Microsoft announced last month that they plan to buy back $40bn in stock over the next five years. They have $25bn in cash and short term investments and are currently earning about $20bn per year in operating cash flow. Microsoft’s stock is trading at about 11x operating cash flow.  It’s market cap is $227bn and institutions own 60% of it, meaning there is about $130bn of $MSFT stock in the hands of institutions. If Microsoft wanted to, at the current price, it could purchase all $130bn of that stock from institutions with its current cash balance plus operating earnings over the next five years. If Microsoft is confident about its business prospects going forward, it should be an aggressive buyer of its own stock at these levels. And maybe it is. It’s stock is only down 3% in the past month while the S&P has been down 15%.

What about Google? $GOOG is down almost 50% year to date and the company is valued at $115bn. Institutions own roughly 60% of its stock, roughly $70bn of it. Google is earning about $7bn of operating cash per year and has $13bn of cash and short term investments on hand. So it would take Google longer to buy back all the stock institutions own, more like eight to ten years. But still, that’s a lot of purchasing power and the market is asking the same question Howard did yesterday.

The silence of $goog into this meltdown is just as deafening with all their cash.  I am not going to be run over.

In bad bear markets, like we are in, investors look to corporations to defend their stock and Google has not yet shown an interest in doing that. That’s something to look for. When you net out Google’s cash, it’s trading at $100bn, a mere 12x operating cash flow. That’s value territory.

Let’s look at News Corp. Rupert Murdoch’s company, the best managed media company out there, is down 56% in the past year and is now trading at a mere six times operating cash flow. News Corp is also about 60% institutionally owned. So that means Rupert could buy out his external investors with four years of his cash flow. But we have yet to see him do that.

I could go on and on. Apple is worth $67bn after you back out the $20bn of cash they have on hand. It earns over $5bn a year. That’s another value stock right there.

And those are some of the best US companies right there. The list goes on and on. Starbucks trades at 7x cash flow, Walmart trades at 10x cash flow, AT&T trades at 4x cash flow, and Comcast trades at 6x cash flow.

You could buy all of America’s best corporations for somewhere around eight to ten times cash flow. Someone is going to start doing this.

Maybe it will be the large private equity and buyout firms who have been stuck on the sidelines while the debt markets have been closed for the past year. If good companies get cheap enough, they can buy them with their cash, without debt, and own them for however long the markets take to work the issues out.

Or foreign companies will come in. I am particularly interested in the asian companies. Will a company like Dell be an attractive acquisition for an asian manufacturer flush with cash? It’s only trading at 5x cash flow after you back out the cash on hand.

I read this history of the panic of 1873 yesterday after seeing a twitter post by Mary Hodder that referenced it. It’s worth reading. There are two really interesting points in it. The first is that panic was precipitated in some measure by the US’ emerging prowess as a player in the global economy and a lower cost one at that:

Wheat exporters from Russia and Central Europe faced a new
international competitor who drastically undersold them. The
19th-century version of containers manufactured in China and bound for
Wal-Mart consisted of produce from farmers in the American Midwest.
They used grain elevators, conveyer belts, and massive steam ships to
export trainloads of wheat to abroad. Britain, the biggest importer of
wheat, shifted to the cheap stuff quite suddenly around 1871. By 1872
kerosene and manufactured food were rocketing out of America’s
heartland, undermining rapeseed, flour, and beef prices. The crash came
in Central Europe in May 1873, as it became clear that the region’s
assumptions about continual economic growth were too optimistic.
Europeans faced what they came to call the American Commercial
Invasion. A new industrial superpower had arrived, one whose low costs
threatened European trade and a European way of life.

But possibly even more interesting was who emerged as the winners of the panic of 1873:

The long-term effects of the Panic of 1873 were perverse. For the
largest manufacturing companies in the United States — those with
guaranteed contracts and the ability to make rebate deals with the
railroads — the Panic years were golden. Andrew Carnegie, Cyrus
McCormick, and John D. Rockefeller had enough capital reserves to
finance their own continuing growth. For smaller industrial firms that
relied on seasonal demand and outside capital, the situation was dire.
As capital reserves dried up, so did their industries. Carnegie and
Rockefeller bought out their competitors at fire-sale prices. The
Gilded Age in the United States, as far as industrial concentration was
concerned, had begun.

We have yet to see the Carnegies, McCormicks, and Rockefellers of China, India, Russia, and the Middle East emerge as capitalists on a global scale. But with prime assets like I mentioned above on sale at bargain basement prices, it’s just a matter of time until we will.

Eventually this market meltdown will be over and stability will return. But things will not be the same. There will be big winners and big losers. We have already seen many of the big losers emerge, but we have not yet seen the big winners emerge. I think we know where to look for them though.

My friend Howard was visiting me a few weeks ago and he said to me "free is over, I am only investing in services that customers pay for". He said "freemium is dead". I reminded him that freemium is a paid model, but he wasn’t buying it.

There’s a movement afoot by investors to back web services with a real business model instead of the pervasive "give it away for free and hope for the best" approach that’s been in favor for the past four years. Don’t count me in that camp, but the movement is happening with or without me.

Roger Ehrenberg, another angel investor friend, says in a post about how he’s changing his investment approach:

I have added a few criteria to my check-list:

• Initially sells to the enterprise for branding, credibility, awareness and early revenues
• Can get to revenues within 6 months, tops
• Is sold on the basis of ROI, e.g., helps generate revenues or reduce headcount/costs

As I noted in the comments to Roger’s post, we’ve struggled with early stage investments in enterprise oriented web services. Sales to enterprises often require expensive sales teams and it’s much harder to know if you’ve nailed the product/service with feedback from a limited number of enterprise customers.

It’s much better, in my opinion, to go with the freemium model, give a version of the service away for free to all comers, get a lot of users, get good market feedback, then develop a premium version of the product/service for sale to enterprise customers. If your free version is popular with a lot of users, your customer base is the target for the upsell and you might be able to live without an expensive sales force initially. And, of course, keep your costs really low until you start to get revenues.

In summary, freemium is far from dead, in fact it may be the business model de rigueur.

My friend Tom Watson has written a book on "peer to peer philanthropy" called CauseWired. It’s not yet out but you can pre-order it at that link.

Tom gave me a preview of it and I am going to blog some quotes from it that relate to Donors Choose throughout the month of October as a cool way to remind readers of the Donors Choose Bloggers Challenge.

Here’s the first one:

"I thought there must be a helluva lot of people who want to improve their public schools but figure if they write a hundred-dollar check to the school system, it just goes into an institutional black hole. So why not let them choose the project, see where their money was going, and hear back from the classroom….that was the genesis." Charles Best, Founder of Donor’s Choose

And if you are so inclined and haven’t done so already, please pick a project of your own to "write a hundred dollar check" to.

NOTE: We’ve fully funded nine out of the initial eleven projects on the AVC giving page. Thanks! I’ve added five new projects we can fund and they’ll appear on the giving page shortly. Again, if there are projects you like the sound of, please alert me to them and I’ll add them to the AVC giving page.