iPods, Networks, and Instant Gratification

I am a parent. I am a parent of two children (and one on the way). Parenting today seems to involve a steady flow of advice from the daily local TV news, Dr. Phil, my local newspaper, any number of "Better Parenting" books, People magazine, etc.

While I can't absorb all that is broadcast at me I do try and listen keeping some and discarding some. Some of this information is not only good for guiding children it is, in my judgment, good for the reader - me and others in my position. One thing I contemplate regularly (that is discussed in the "Better Parenting" literature is the notion of adolescent development and instant gratification). Based on my readings it seems fair to say that parenting pundits believe that instant gratification experienced regularly may have long-term negative consequences (see the famous "Marshmellow Experiments" (http://en.wikipedia.org/wiki/Deferred_gratification. ) Common sense seems to support this.

A few months ago I bought an iPod. Over these few months I have noticed a change in my alertness regarding music. I used to hear a song and perhaps think (I like this song and if I can remember - I might go to the record store and purchase the CD). I would then abruptly forget about it. With an iPod...I operate differently. I hear a song that I would like to own and don't forget about it. I burn the notion of buying that song in my mind because I know I can go on-line and buy it though iTunes. I know that if I just hang on long enough to get in front of my computer...I am going to get that song. iPod has thus changed my behavior. I can, relatively speaking, receive a form of instant gratification. So the possibility of instant gratification has changed how I occupy my time and use my brain cells. As a side note...I haven't seen a record store in two years.

A Closer Examination of Instant Gratification

Pursuit of instant gratification is more prevalent than ever. The world can get you things and tell you things real fast. There are many examples in the information technology world.

A Positive Example - Some types of instant gratification certainly are good. Web MD (www.wedmd.com) helps you diagnose your symptoms without the anxious process of going to see a doctor (please do this at your own risk).

A Negative Example - Some types of instant gratification are addictive and bad. YouTube (www.youtube.com) is conceivably such an example. This is a website where one can conveniently posts homemade videos. It works sort of like this...I put videos up myself on YouTube (as millions of others have)...I then wait to see how many views I have had and then use this as a measure of my self worth. Google just decided this social/emotional feedback loop was worth about $1.6 billion. It is bad in my judgment because I perceive it to place the power of determining one's self-image into the hands of others and away from the self. "My opinion of me is based on what I perceive others may think of me......"

Yes...... we are a culture of instant gratification...the addictive character of instant gratification is why we talk too often on our cellphones, try out on American Idol, do a double take on advertisements that promise a graduate degree in 9 months, and otherwise quit so frequently when things get too hard to complete.


What Does This Mean?

Yes...I have noticed above...there are good and bad forms of gratification. While I can't mathematically weigh whether or not higher speed gratification is, on the whole, good or bad...I do believe that instant gratification drives a greater appetite for more instant gratification. It goes faster and faster. A result of this is that obtaining and using the tools for instant gratification occupy more of my focus...as a result of feeding my addiction...I spend more time doing and less time thinking...

Believe it or not...this has ramifications on, among other things, the products and services we demand and on the way software is designed and networks utilized (I had to work this in). Some basic beliefs of mine:

• By virtue of our cultural changes....software and networking systems that provide more instant gratification will be more attractive to potential buyers and win market share. This can come in the form of better visualization, faster visualization and analysis (real-time), and ease of deployment. It seems obvious that the faster the information...the more demand for the information technology.
  

• End Users will be more into self provisioned software...in other words...they will do a search on the web..find what they think they need that provides requisite business functionality...download and start using it (credit Tyson Weihs) . This is happening all around you.
  

• Customization will have to wait. End Users will end up trading functionality for immediacy. If a software package does 60% of what I need but is available today vs. next year (as might be the case if run through IT)...then so be it. Greater functionality will be built later.

• As a result of the point immediately above...software will become more disposable. 60% capable software will survive for awhile then be trashed while a more competent system is procured/deployed. Think of this...software will become more disposable...this is starting to sound like service oriented architecture (SOA)...use the service...dispense with the service.
  

• Some of this will mean that software will be broken down into smaller pieces contrary to the huge monoliths such as SAP and Oracle. So we are sort of going back to best of breed.
  

These statements reflect a necessary change in product architecture and philosophy, marketing message, pricing strategy, and requisite product functionality.

Self Check

Nonetheless....I am sure that more and more of my time and braincells will be directed toward the pursuit of instant gratification...I need to make sure I stop and breath to make sure that I do things like calculate and reason. Someone please contact George Orwell.

The Unforeseen $2.3 Billion Phone Bill

Within our investing activities, we look very closely at data networking technologies, data networking devices, and the cost of energy. We also look at energy efficiency.

In observing energy usage patterns, we have learned that the more energy efficient we humans become, the greater our demand for energy. An example of this is mankind's improvement in various battery technologies and microprocessors. Batteries have become more capable of delivering power over longer periods of time...and microprocessors more capable of using less power during that period.....this is why I can walk around with a handheld computer that doubles as a cell phone with four hours of continuous usage (this is a form of becoming more efficient).

A couple of quick facts - There are currently 219 million cell phones in the US and the average cell phone uses about 9 kilowatt hours of electricity per year.

Several years ago I went to see the Hoover Dam. The stories of its construction, how it works, and what it does are a mind bender. So I started to wonder...How much power consumption does the country's population of cell phones consume as denominated in number of Hoover Dams required to power that population? Based on a couple of different approaches, I estimate that about 60% of Hoover Dam's power output is used to keep our cell phones up and running on a continuous basis. Interesting...

The cost-to-complete Hoover Dam in 1936 was $165 million or $2.3 billion in today's dollars. Hold that thought. Now think about the different number of devices that have been introduced to us over the past several years that consume electricty. Here is a brief list of things you may have added to your home over the past three years: iPod, Internet-enabled Cellphone, DSL/Cable Modem, Wireless Networking Access Point, Tivo Box, iPod Basestation Jambox, Portable DVD Player, Some GPS device, Home Theater Accessories, XM Radio Receiver.

Lets just assume for a moment that each of these 10 devices had the same popularity and power consumption needs as the cell phone above. This assumption implies that we would require 6 Hoover Dam-power-generating-equivalents to keep these devices up and running. Last I checked, the number of Hoover Dams going up every year is not keeping pace with what my imagination tells me is the increased electrical demand of these little power-hungry rodents.

Now lets turn away from the consumer market and think about industry. The increased use of internet protocol as a networking scheme combined with improved computer chip design and software design is causing the number of commercial and industrial edge devices to go nuts. Five years from now we are going to be monitoring and connecting everything to and from everywhere. Your iPod is sort of an example of the first step toward this end - better networking technology, good software design, all on a tiny little thing that can plug into the network from anywhere.

If I go back to my analysis of Hoover Dam and the $2.3 billion (in 2005 dollars) cost-to-complete, I then estimate that it requires $6.50 of investment to create power generation infrastructure capable of powering one cell phone (yes...this is all a little loose). I then start multiplying this by the number of little devices that exist in my consumer life and I wonder who is going to put the money up to build the power generation capability to support my new high-tech electronic lifestyle. Then I realize.....ME. It is going to come in higher rates over a sustained period because the planning, permitting and labor required to build more power producing infrastructure is going to take years and years and will be chasing an ever increasing target.

Then it hits me. I have got to invest in things that make for more efficient use of power so I can lower my overall usage. I then realize that the more efficient I become using power (like those batteries and microprocessors referred to above), the more alternative uses I can find for power (like my iPod) and the more power I will demand pushing the prices back up. I can't stop shopping at Best Buy.

How do I get off of this ride?

No One Starts Out Wanting to Provide Bad Service.

Most people on the planet have a shared set of physical, intellectual and emotional needs. These needs are identical at the “physical” level (i.e. food, water) and similar at the “emotional” level (i.e. security, acknowledgment, etc.). We humans fulfill our physical and emotional needs in many different ways and at different times. We physically labor to meet the physical requirements of survival…to earn money to buy food and drink. The time commitment required to labor during the work week to meet our physical needs is not inconsequential. You know this. We generally spend much more time conscious with our co-workers than we do conscious with our loved ones. The emotional needs of the humans do not pause between the hours of 9:00am and 5:00pm….as a result we need and seek emotional and intellectual fulfillment during our physical work hours.

The emotional needs of the American enterprise are as genetically similar across organizations as they are among humans - corporations consist of humans. It is arguable that most of us like praise and will work for it. We want to do good and we want to be good. These are atomic-level truths.

As a result, I believe that we manifest our individual work tasks and environments to provide for emotional aspects of our very human needs. Since these atomic-level aspects are bouncing around in the organizational consciousness…and organizations are collections of people…how is it that some organizations just end up providing bad service (which is a perfect mechanism for acknowledgment and thus emotional fulfillment). Now certainly these organizations don’t start out intending to provide bad service… they don’t sit down in the Board room and declare [bad service] as a strategy…furthermore most organizations would deny their possible inclusion in the list of bad service providers…yet….we see it and live it every day.


Bad Service and the Proprietary Network

I have seen the connection between the evolution of bad service and the proprietary network too many times to not comment on it. OK…what am I saying?? Many times, when there is a technology shift the new form of technology either becomes open standard or proprietary. In the instance where the technology becomes proprietary, the customer develops a weird sort of dependence on the technology. As this relationship lengthens it is, in my experience, not atypical for the technology or technology-based service provider to convert to a cash harvesting mode reducing development in research and development.

What then happens is that a newer, potentially-displacing technology develops and the market begins to see new things and want new things from incumbent service providers. The process has a tendency to creep slowly in most instances. The incumbent though has built a revenue model and compensation scheme that would be put at severe risk if the newer technology were adopted wholesale by the incumbent. Since the underlying technology doesn’t evolve, the incumbent becomes unable or unwilling to meet product development requests whose origin derives from the attributes of newer technology (i.e. I wish your product could do this or that or the other). After awhile, employees of the incumbent service provider become overly proficient at repeating the word “no” to customers. When lack of R&D investment forces the customer-facing employees to repeat the word “no” excessively…those customer-facing employees no longer get to see smiles and hear words of congratulations from customers. In other words, they lose the ability to get their daily affirmation from the market, the acknowledgment they want and thus the emotional fulfillment they need. After a while people that can’t get what they need develop bad attitudes…I know I do. Then comes the bad service.

A Specific Example

I know of a company that provides mission critical data services. This data has historically been provided over a proprietary network. The data provider would come in and sell its equipment and servers, etc. as infrastructure over which to deliver the data. Initially this is what the market wanted and customers loved it. The company was nearly the only game in town and it made a ton of money. Its compensation structure revolved around proprietary data transport mechanisms. The problem was it made too much money off of the transport to want to change…life was good and they were getting fat.

Along came the Internet.. a cheap way of getting data from point A to point B. This open transport standard allowed new things to be done with data..these are new things that customers started to think about and request of incumbent service providers. However, the old technology inhibited their ability to provide these things. They were forced to say “no” too many times. This repeated “no” began to take on an almost angry tone. The lack of internal product development was killing the company not only by virtue of diminished comparative product features but the resulting negative attitude cast on its customers by its customer-facing employees. I know of at least four examples of this.

My point is this. I think the flexibility of internet protocol has caused non-adopting companies to fall from grace for reasons I would never have envisioned. Technology providers who didn’t adopt early enough developed bad attitudes and alienated customers. Who would have thought this was going to happen?

Did Someone Here Order 90 Space Shuttles?

I saw this graph the other day. It plots the age distribution of various industry workforces. It suggests that the Oil and Gas industry has the highest age workforce.Telecom has the youngest age workforce and airlines are sort of middle of the pack

Oil's workforce age distribution reflects a higher mean than others for several reasons: (i) operating experience is the most important thing in this industry and this comes with age, and (ii) the oil industry has a clubishness about it that supports the notion of "tenure"...almost in a professorial way, and (iii) America's youth has had a declining interest in pursuing a career in oil.

One could argue that the oil industry will someday have a manpower issue. By looking at the graph one would conclude that this industry is not alone. An average human may find comfort in the notion that "all industries" are in trouble. But the relative magnitude of distress to be experienced by each of these industries compared in the graph is, in my opinion, substantially different.

As US labor has learned from its highly-capable manufacturing competitors in China (among other locations), substitution of one workforce for another is not overly disruptive to the manufacture of many types of products. It is, in fact, encourage for those products based on labor-dollar efficiency. This has the positive result to US labor of allowing those workers substituted to pursue a higher complexity calling and thus higher real earnings. However, maybe not every labor sector depicted is in the same boat "manufacturing"....what's different about oil?

Difference: The location and extraction of hydrocarbon-based fuels is highly scientific and multi-disciplinary. In addition, this science is augmented substantially by accumulated experience. As a result, workforce substitution is not that easily performed. That's why we and the Russians raced after so many German scientists near the end the end of WWII (See Werhner Von Braun..."Operation Paperclip"). They had the best rocket scientists in the world. If these scientist had been lost to another country...our space program would have lagged for years. Same thing in Oil. When this workforce starts retiring en masse we are going to have some problems unless we can increase the work capabilities of those left standing to super human levels.

The current day rates for offshore drilling rigs are at all-time highs. There are currently nearly 90 offshore drilling vessels under construction (www.coltoncompay.com) that can be deployed over the next 4 years. While this may seem to be a solution to declining production curves of today's reserves...my question is this..."who is going to staff these rigs...and who is going to teach those intended to staff these rigs how to operate them?"

This is a picture of a drilling control room. A drilling rig is a highly-technical piece of equipment. Imagine, as an example, an additional 90 space shuttles showing up off the assembly line ready for our use...imagine the incremental infrastructure and training required just to get an additional shuttle operating at the same time as our other active space shuttles. I would think that the value of knowledgeable shuttle crews would go up substantially. Likewise, owners of drilling rigs would pay substantial market premiums to rig crews in order keep their rigs active....so as to make the interest payments to the bank that loaned for their construction. While this will, in fact, attract more oil industry labor pool applicants...it will not solve the implicit labor shortage for a long time.

So my conclusion is that the degree of labor shortage problem indicated by the graph is much greater than meets the eye. What is really going to happen on the rigs is that the better crews are going to go onto the better rigs. The older rigs are going to have to live with the "less-better" crews. As a result, the drilling contractors with the older fleets are going to have to buy the new rigs to get the better crews back...and they will pay premiums to do this.

Furthermore, the increased number of rigs will scatter to drilling plays all over the world rather than reflect a few geographic concentrations (as was the case in the Gulf of Mexico for so many decades) which exacerbates the problems of training crews and managing projects. As gravity attempts to pull the energy industry from its historical epicenter in Houston, Texas...what are companies based here going to do to prevent this? How will they manage against increased competition?

Ferrari - The World's Most Efficient Automobile?

Americans have among the cheapest gasoline prices in the world. In other parts of the world they are substantially higher primarily as a result of taxes. If one studies a sample of March 2006 European/East Asian Retail unleaded fuel prices, one would note that substantially all the variance in prices between underlying regions derives from variance in gasoline taxes. The history and motives behind the various taxing strategies among regions are difficult to ascertain.

Nonetheless, I decided to recklessly ask the question..."What would happen if our national gasoline taxing strategies looked liked everyone else's? (i.e. they were much higher) If they did and this impacted consumption...what might the impact be? To answer these questions...several calculations were required. These calculations looked at (i) regional gasoline taxes relative to raw gasoline prices in those regions ("Tax Ratios"), and (ii) total gasoline consumption across the total population of "cars" (within those same regions - Source EIA). I was looking for correlation between Tax Ratios and gasoline usage per car (let's call this relationship "Tax Impacted Consumption" "TIC")). There is no doubt that there is a relationship.

I then looked at this relationship and interpolated what US oil consumption by "cars" might be if we experienced TIC similar to these other regions. The following graphic reflects the decrease in total daily US oil consumption based on these interpolations. As an example, if the US experienced TIC similar to that in Italy, US oil consumption per car would decline and total US consumption would thus decline about 13.4% or 2.7 million barrels/day. WOW - THIS IS KIND OF A BIG NUMBER.

Now this is just rough math here and there are any number of caveats, qualifications, and exceptions. BUT.....it feels right. And it shows the significance of what a change in price could have on our daily consumption. As a side commentary I believe it reflects an overall American behavior pattern of excess more than a reflection of our geographic expanse.

Human behavior takes years and years to change. The data above narrowly suggests that an immediate federal tax increase would have the impact of curtailing usage substantially- but would probably include a mob setting fire to the District of Columbia so this is not going to happen. So if we can't really change behavior through taxation what should we be advocating as a solution and thus - what do we do as investors ---where is the money? --- If you need the investment return to occur in the next 10 years...the opportunity is NOT in the wildly popular notion of alternative energy.

Realistically...it is in things that allow consumers to not have to reduce consumption of current sources. This implies investment opportunity on the supply end of the equation (getting more out of the ground faster or to market on a less costly basis) and on the consumption end of the equation (better car engines, lightbulbs, etc.).

I believe the current investment frenzy around alternative energy is a kneejerk reaction to high prices at the pump and thermostat. Alternative energy is popularized as an alternative to a perceived "supply" problem that will not be willingly offset by a revised national federal taxing strategy. If the logistics problems are solved, current strategies using alternative energy will become less necessary and alternative energies will not have investment importance within the lives of their financial backers.

We have plenty of raw energy sources (coal, oil, natural gas) right now...PLENTY. Converting these sources to usable forms and moving them to end-users is the problem. I am not saying demand vs. supply is not a developing issue but rather logistics is more responsible for current "beltway" politics.

We (SMHPEG) are investing in (i) finding efficiencies that get current forms of raw energy from its source point to its use point at a lower cost, (ii) lowering the cost of converting raw energy into applicable power, and (iii) dealing with all the associated risks of points (i) and (ii).

What will happen when we all learn that we have much more of a distribution and conversion problem...than a supply problem per se?

Move to Italy (which would not be so bad).

You Don't Have to Jump

CNet posted an article today.."Software Stack Wars" http://news.com.com/Softwares+stack+wars/2100-1012-6062557.html?part=dht&tag=nl.e703. The article discussed how companies like Oracle and SAP are orienting their product offering to provide the complete "stack." By "stack"...they mean everything from the operating system, to the database, to data integration engines, to business process features.

The implication is that these companies are consolidating their markets to be a one-stop shop for everything their customers want. So is software Venture Capital Investing a threatened proposition? I want to make a couple of observations regarding this:

This shift by the Majors represents the counterswing to the best-of-breed market dynamic over the past ten years. The positioning is that best-of-breed created too many data sets that are too hard to integrate, there was no composite view of the enterprise, and it is thus time for a change. There is an element of truth to this and makes sense for applications that are long-standing where process doesn't ever really change. While this may all be a nice corporate line...the best software salesmen within the Majors will regardless prey on best-of-breed features..not the "stack."

Yes...the Majors are changing their tune from best-of-breed to "we can do it all" BUT innovative, small best-of-breed companies will not be frozen to death. Business Units generally drive software selection not IT when it comes to user-facing apps. except for more mundane stuff. Business Units are not going to let IT decide what is best for business. Software innovation generally comes from small, very focused companies. So best-of-breed solutions will generally derive from some place other than the one-stop shop. Every one of the companies referenced in the table above was, at its origin, the best-of-breed for something. When they lost their capacity to either manage or spark innovation beyond their core, they started buying this innovation...it is how the software world works. I believe they could get so mired in integration (e.g. Oracle) that innovation will be further stifled.

However, one-stop shops will be able to disrupt the sales process of best-of-breed software vendors. As long as a possibility exists within the mind of the Business Unit that the one-stop-shop might have a solution...then they become the competition because they are allowed to be drawn into the sales process even though they may not have any relevant competence. BUT since they are putting themselves into position to become the monolithic data repository...then they may get into position to sell the customer that one-stop-shop should be hired to customize to the customer's needs so as to maintain system integrity. THEN...if they hear the request enough times from the market via this disguised form of market research...they can go build the software knowing there is a market for it. This potential for invasiveness does negatively impact the venture world BUT then again...it has always been there in some way shape or form.

NOBODY Expects the Spanish Inquisition

Today March 28, 2006, I was thoroughly interrogated by a limited partner in SMH PEG I, L.P. (“PEG I”) (http://www.smhpeg.com/). This specific limited partner (“LP”) was not in a particularly good mood and decided to pan sear me via a very intense line of questioning. When talking to me he held in his hand our latest quarterly report on PEG I. I noticed that on his copy of the report (which I thought was pretty favorable) there where several notations in the margins, words circled, and some exclamation marks. Several of these notations were not very complimentary. This was starting to remind me of certain days during my academic career.

This LP has made a lot of money in the oil field. He is experienced. This experience is not to be taken lightly. When verbalized it can be intimidating, it is authoritative. One of the comments he made while I was on the witness stand was that none of the portfolio companies had any significant hard assets and thus no backstop for investors if things went south. The implications here may have been that our investing model was flawed – I assumed this..I didn’t ask. He seemed fairly upset that we had put him into something with no hard-asset backstop. He made an interesting point. The perspiration was starting to flow. He wanted to know exactly when the money from one of our portfolio companies was going to start flowing back to him…his RPM was increasing with each question.

I will not go into the obvious counterpoint debate against LP’s observations (i.e. all the details about why software companies can be valuable despite the absence of material hard assets or current dividends). What I will say is that this is almost EXACTLY why we are investing the way that we are. What we are doing is generally not recognizable to LP. It is not recognizable to most of the venture world. If it was… …it would be “conventional”. So I love his angst…it is based on the fact that there is no established history of energy-focused general IT companies making investors piles of money (see “What is Happening in Front of Me”, November 2005 at http://www.energyit.blogspot.com/).

This is validation to me. If there were such a history, the sector would be full of money, pre-money values of companies seeking capital would be high, talent to run these companies would be difficult to recruit and too expensive, etc. etc. Our investment thesis would sound like everyone else’s and managing PEG I would be approximately no fun whatsoever.


OK…if you’re so smart what exactly is your investment thesis? OK…I’ll lay it out:

1. The energy sector’s production capabilities are stretched and it is going to only get worse if some form of mitigating action isn’t taken by its participants– they know this.
2. The energy sector needs to replace manpower deficiencies with information technology – they understand this.
3. The rest of the venture world has never really spent any time in the energy sector or in Houston, Texas - this is not a competitive market at all.
4. There is a great opportunity to bolt together quickly an ecosystem of leadership talent.
5. Energy sector’s spending on IT is going to take on unprecedented levels – this is happening now.
6. Other large IT companies are going to wake up to this and find out they have to buy their way into energy sector – must be present to win in the oilfield sector.
   
   A really smart investor once told me..”you never make money by running with the crowd…always bet against the crowd.” I have played this in my head over and over during my career…this statement is right so many times. As a result…when people start agreeing with me en masse too soon…I get paranoid and nervous…I become uncomfortable….I start looking for an exit. But based on today’s re-creation of my own Spanish Inquisition….I am inclined to sit very still and feel much better about what we are doing.

Man's Search for Meaning and The Current Popular Practice of Blogging

Sometimes I am embarrassed to refer to my blog. Many times it seems an act of hubris to suggest that one's insights and perspective are grand enough to warrant public interest. My judgment is that blogging is rapidly becoming a cheap cliche'.

In my search for truth, I began to investigate other VC blogs. I wanted to know what they [others like me] wrote about...and how. I was doing this to calibrate my self-opinion. I found sites that I liked and those I didn't. For those I liked, I sent the authors emails describing what I liked and why - I wanted to acknowledge the human being. I sent about seven such emails.

Interestingly...I heard back from only one blog author among the seven sites I visited - ONLY ONE. It made me start to wonder...why are people doing this...why I am doing this? It is a fair assumption (I think) that authors are doing this for public consumption and that somewhere in there...is a need on their part for feedback and acknowledgment - as opposed to divine world betterment. The Internet is, in fact, the most public medium ever created and therefore public consumption is implicit. I think VCs are particularly vulnerable to the need for acknowledgment as their entire world is about testing the theory, testing the theory, testing the theory. In addition, they have to wait years to see if their investment theories translate into investment successes.

If a peer's perspective judgmentally and expressly is supportive of the authoring VC's theories...it seems that some type of further human exchange would develop between the proud father of a new theory and his admirers. Get two passionate hobbyists in a room talking about their common interests and you can't shut them up.....but not here...why?

We live in a world of diminished individualism. Among the insecure human race this trend is harmful...individualism is a mechanism for acknowledgment which shouldn't be stifled. Publishing via the web should be a tonic through which in the individual raises his head above the noise and declares "I exist and look how smart I am." The problem is that the blog medium is losing its unique capabilities do to overcrowding. The noise level has been simply raised by this fast moving medium. Perhaps this is why the response rate to my emails was low. Perhaps the authors have figured this out. The once promising "blog" no longer offers the hope of recognizing individual achievement. If this is true...man can no longer find meaning through his blog........and if this is true.... then...... blogging just died.

How's Your Deal Flow?

It is typical for prospective limited partners to ask the question: How's your deal flow? It is an appropriate question. It contemplates the issue of how fast capital can be put to work and thus returned to investors. Deal flow volume is of course relevant to the question. Like other established firms...we have very substantial deal flow volume.

The older I get...the dumber I become. I am becoming less enamored of the volume of deal flow that walks through the door. If one stands in the same place long enough and says "I have money" deal flow will find the money...it will find you...trust me.

So I take deal flow volume as a given. I currently don't measure the ability to put capital to work by means of deal flow volume. I look at it differently. My ability to put capital to work is a function of the volume of people I know who can make things work. In my judgment the right question from prospective investors is: "How many people do you know that can come into early-stage land and make it work?" There are tons of good ideas. There are limited numbers of people who can "make it work."

So if one thinks about this question it seems there is a set of deeper due diligence questions to be asked by prospective fund investors:

• What is your model (Mr. VC fund raiser) for developing and maintaining a system for leadership talent?
• What is the market opportunity now for developing this system in your geography or market vertical?
• How are your going to protect it?

These questions sound remarkably like the questions that we ask prospect companies. Answers to these questions (if put to us by prospective investors) have to be supported by the broader investment thesis as well or they will not hang together.

The other day one of our portfolio companies named World Telemetry Inc was able to recruit and retain John Lee as CEO. I have known John for years. He ran Oracle's Process Group in North America and a similar division for SAP and has been through early-stage land. We previously hired one of his protege's (Trent Derr) to run another portfolio company who seems to be shooting the lights out. Simply put...John makes things work. Another VC firm for whom I have a lot of respect called me and said.."we want in since John is there."

I have never seen a slide in a VC fundraising presentation that recognizes the "system of developing and maintaining leadership talent" as THE business model...and maybe never will. But anyone who has been doing this long enough has become dumb enough to know that this IS the investment. This not only helps investors get the money to work quickly (which is the basic premise of the overall question asked in the title)...but it also makes sure that the money comes back with returns commensurate with the risk taken. Again..this may all sound obvious when put in writing but we've been doing this type of investing a long time and seen tens of VC firm presentions...and they almost never look at the world this way. So with that said.......How's your deal flow?

Road Signs for Software Company Investing

When investing in emerging software markets, it is difficult to make a lot of money unless you own one of the top three companies in a particular segment. One simple reason is that there are usually not more than three or four meaningful public players that would have an interest in and be in position to acquire you. The “strategic acquisition” binge in the market typically happens quickly and then the universe of would-be acquirers moves on. As a result, it is very important to be in a position to be visible to would-be acquirers.

It is typical in an emerging market for technology providers to show confusing signals to the acquiring community. In most instances the early-stage emerging market will demonstrate market parity among solutions providers making one indistinguishable from the other. Why does this happen? The regular explanation is that customers in early-stage emerging markets have not, on average, had enough time to think about the broad scope of their new initiatives. What this means is that they regularly put out RFPs for technology that reflect narrow and immature ways of thinking. In this context, products whose functionality is narrow but can fit the market’s currently narrow needs are highly competitive. These products can also be sold for less as they require less payroll to develop given their narrower scope. Which product would you rather buy….? …The one that does what I think I need today and costs a heck of a lot less than the other one. We see this all the time. This is why so many technology providers can plausibly declare victory early on (and most try to).

So in the early-stages of an emerging market…many companies can favorably and equally answer the question..“Who is you customer?” They can do so because of narrow scope issues explained above and the fact that software price is still a heavy consideration to buyers. At this time…it is too early to sell or even try and sell you company- generally because price competition among solution providers is still too relevant.

Price competition is still a factor because... .there is an undereveloped connection. The scope of the average RFP (usually drafted by operations personnel) is much narrower than the vision of company’s senior management (i.e. this is the underdeveloped connection). At a time when the RFP more thoroughly includes senior management’s vision, price ceases to work well among competing software vendors and thereafter technology leaders start to emerge. Something about the technology then comes into play in the acquisition price (i.e. ease of implementation, adoptability, etc). It is not much longer after this that companies get bought. In my opinion if you go more than 18 months where price is the competitive driver, you are in a bad space for any number of reasons.

What's Wrong With This Picture?

A Short History of the Film Processing Industry

Network Design #1 - It used to be that strip mall architecture included a small drive-thru booth in the parking lot. The business purpose of these drive-thru booths was to gather photographic film from consumers and distribute photos back to them - usually in about three days. Film booths were located in strip malls due to their proximity to consumer traffic. Film was gathered and then delivered to a central location which housed processing equipment that was large, technical, and complicated to maintain. This system of gathering, processing and distributing was essentially a “Hub and Spoke” network. The network processed content slowly.

Network Design #2 - During the mid- to late-eighties, film processing became the domain of the one-hour processor. One-hour processing came into being partially because of advances in technology - processing equipment became smaller and easier to operate and maintain. These machines were smaller than their predecessors and cost-effective enough to greatly increase the number of locations where they could reside profitably. Their positioning correlated to retail establishments of frequent, recurring consumer traffic (e.g. grocery stores, drug stores, Wal-mart, etc.). For some consumers, the attraction was speed of service. For others, it was the convenience of geographic proximity to their daily routine. This was conceived as a “Distributed” network that processed content nearly Real-Time.

Network Design #3 - The other day, I read an article in the Wall Street Journal regarding Hewlett Packard’s (“HP”) new strategy for digital photography. HP previously focused on at-home photo processing….a focus which has not met company expectations. The reasons are (i) the variable cost per picture is a little high; and (ii) the cost for a commercial quality printer is still significant.

HP intends to package its at-home technology into a commercial-grade offering. The practical implications are that retail film processing is going to become real-time and pervasive (closer to wherever the consumer happens to be). More specifically, processing in real-time means that a consumer doesn’t have to contemplate a return visit when mapping where to have film developed. In addition, HP’s small-footprint technology can physically go just about anywhere. It simply needs power and a phone line in order to bill your credit card. This will be a “Highly Distributed” network that can process content in Real-Time.

A Basic Observation of Networks

So let’s observe what is going on here. Technology advancement enables certain types of networks to cost-effectively increase the number of end points along the network edge. So as things get more efficient and economical they have a tendency to proliferate along the edge – the network can become more populous and reflect greater geographic distribution. It is all based on cost effectiveness – nothing else. This happened with computers, movie distribution, ATMs, TV’s, IP vs. Frame-relay networks and is the story for so many other technology evolutions. This basic law of network physics repeats itself over and over again.

Evolution of Photo Processing Networks

---- Network Design-----Technology Attributes--------Primary Business Model Factor
#1 Hub and Spoke------ Largest, Most Expensive------Basic Service
#2 Distributed---------- Smaller, Less Expensive-------Preferred location, Time Convenience
#3 Highly Distributed--Smallest, Least Expensive----Ubiquity and Greater Time Convenience


Back to Metaphor Building

So what if the photo processing technology had never evolved from the early days but consumers insisted on having film processed when and where they wanted it? Cost would go up astronomically. Perhaps this would be OK if the associated costs could be passed on to family members who wanted to see photos at any price. But what if they didn’t and still wanted photos processed when and where they wanted?

Applying Network Evolution Observations to Energy

To use a meticulously fabricated metaphor, oil companies are changing the locations where they want their photos developed. Oil companies are uniformly moving into more-remote locations and thus the exploration and development network has jumped to a more Highly Distributed state. As some proof of this - the graph to the right reflects the decrease in concentration of the worldwide mobile rigfleet away from the Gulf of Mexico over the past six years. What one can't see is that the rigfleet also seems to be moving around faster and faster. If all this is true it prompts me to wonder….…….”What technology advances per se can we observe that have enabled this network to change its distributed state?" Answer…none really (thus far)...not in a network management sense.

At Some Point Between Now and the End of Time

The cost of labor, drilling rights, rig rental, etc. is going to continue to go up which can decrease fundamental profitability of the industry. As this happens….this extremely cost-conscious hydrocarbon seeking animal will look at the state of its geographically expanded network topography with greater cost consideration - old photo processing technology will be anywhere and everywhere…put there because consumers insisted on having film processed when and where they wanted.

The oil industry’s manufacturing network is at its farthest possible geographic edge. It is now time to backtrack and call in “HP” to provide technology advances to make this physical change in network state adhere to our observed laws of networks. To develop a means by which the required changes in network layout are supported by cost effective management advances rather than an ability to pass through all costs to consumers. Commodity businesses simply are not stable enough to rely on pass-through-longevity. In the way that oil prices spiked during 2005 as a result of force majeure, what if they moved at the same speed and force in the opposite direction? Can the current cost structure of the current network state support such a change? One could make the case that the rope could be drawn very tightly very quickly and, all other things held equal, it would tear dramatically. If you think about it...this has very specific investment implications.

A Side Note I Couldn’t Fit Anywhere Else

At the February 2006 Society of Petroleum Engineers Bytes and Barrels conference in Houston, Texas I heard three main categories of observation and complaint: (i) how do we get more data on a real-time basis; (ii) how do we organize the data for future use once today’s need has passed; and, (iii) how do we get corporate structure and people to change in such a way as to make the availability of data a useful thing.

Technology is Allowing Us to Isolate

I have a handheld PDA/Cellphone. I am addicted to it. The design purpose of this device is to help me stay better connected to people and processes. At a certain level, this works. I make contact about 75 times per day via email and maybe there are 15 phone calls. The more I use this device the less I actually see other humans....why?

The need to respond to the high volume of written communication requires that I focus. In order to focus I need to be alone. So it is sort of interesting that in order to effectively communicate with other people I need to be alone. I have two theories that extend from this:

Theory #1: Quality is Deteriorating

We are over-communicating. The number of communications I have with a given individual via email per work task is increasing. Each communication reflects incrementally smaller units of knowledge and feedback than was the case before.

Let's think about this......I've noted that my work flow is broken down into a greater number of components. I know that my pace of task completion is going down due to the start/stop traits of this new process management paradigm. I am doing this [sending mid-process emails to get feedback] in hopes of lowering my error rate per task completed - thus hoping overall to increase my productivity (i.e. gains in quality more than offset increased time requirements). But the problem is that the person from whom I am requesting the feedback is mired in the same high-volume communication swamp in which I am mired. As a result, his ability to provide high value feedback which otherwise should lower my error rate is diminished. Therefore we have this unanticipated result of lower quality output to which we have tacitly agreed...so I am not sure I have met the qualitative requirements of output to support a case of true productivity increase. The illusion is that the increased physical activity in my email-based feedback loop is, in fact, increased productivity. Ok.....enough.

Theory #2: Modern Portfolio Theory Isn't Working for Me

I also use my PDA and its various communication capabilities to widen the circle of people with whom I communicate. What is the value of this? I think that part of my motivation is that it is not "what I know but who I know." The premise to this is that knowing more people creates more options. Thus by communicating via email and expanding my volume of touch points...I am creating more options for myself.

So let's consider each of these options an investment. I thus have a larger portfolio of options - a form of diversification. Is this investment strategy paying off? Some investments theorists look at diversification as a path to mediocrity. The design purpose around diversification is to manage uncertainty of individual investment positions. Some days I feel that my current chosen strategy of keeping the network wide open to an average communication flow of 75 emails has the actual result of creating more uncertainty not managing it down.

Technology is, in my judgment, often process-centric not people-centric. I believe that the value of my options should be driven by the human relationship. By getting so involved in the process of processing processes I don't "see" the other person. As a result, the value of each of my options in this diversification strategy is less than it might be in a more narrowed investment strategy. I communicate less effectively because of the device that was designed to help me communicate more frequently. This is nuts.

In conclusion:

A company is, among other things, an implicit contract between people. The complexity of this contract is great and requires substantial and frequent human contact to prompt understanding and attainability of its objectives including commercial objectives. There is a minimum threshold of human contact required to create real potential value for any one of my portfolio options. My communication device takes that away from me. As an investor, I am looking for the application that manages around these issues. If I find it, I am not sure I will know exactly how to value it.

"From the Edge" with Richard Yoo - Founder of Rackspace

In our business, we regularly seek perspective from those who are at the forefront of technology. In this posting, we are looking for some insight from Richard Yoo, founder of Rackspace Managed Hosting (www.rackspace.com), one of the largest private hosting solution providers in the US. As a founder of Rackspace, Richard has had the opportunity to peer into the IT infrastructure and IT challenges of a very wide variety and sophistication-level of companies that outsource application management. Richard is a native Houstonian.


Energy IT (Question): Who is Richard Yoo ("RY")?

RY (Answer): I'm a technologist. I'm an early adopter of new technology... Whether it's a new gadget like a cellular phone or TiVo, or something very abstract like teleportation - I've probably read quite a bit about it or actually played with it enough (if it actually exists) to understand how it does (or may) fit into our future lives.

Also... I'm an entrepreneur - I've started a few companies, one of which [Rackspace] generates over $200 million in annual revenues currently. I find lots of opportunities in the tech sector since I'm exposed to things so early in the game.


Energy IT: Tell us what you're thinking about these days in terms of IT?

RY: Impact.

It's amazing how many companies exist today that don't spend any time thinking about IT. This occurs in both larger and small companies, but I find it the most shocking with the smaller companies since I feel that they need it the most. It's not uncommon for smaller companies to think that spending time and money on IT is for "the big companies"... Particularly since they believe that IT spending is expensive.... But even a simple accounting system like QuickBooks or implementing CRM like Salesforce.com can have a huge impact on both productivity and customer experience.

Energy IT: What opinion/observation do you have currently about IT that is most contrary to popular opinion?

RY: People shouldn't try to build everything from scratch. I'm a huge fan of COTS - "commercial off-the shelf" stuff. Business spends tons of money - and more importantly, years of development time, trying to build tailored systems that need to be rewritten due to changes in the business. There are countless COTS systems available for various problems that are inexpensive and simple to implement. It's true that it won't solve your problems completely, but an 80% solution for 20% of the cost of developing it in-house is huge... And often times, the vendors will take any feedback you're willing to give them to improve their product - which in turn may give you the final features you require for your particular needs.

Of course there are exceptions to the rule - FedEx was the very first courier that implemented such a detailed level of package tracking... So yes, to be first FedEx had to make the huge investment to make such a feat come to life... But if you're a FedEx competitor, it would also be silly to think that such systems aren't available turn-key these days.

Energy IT: What's the most important thing about IT?

RY: IT is the new assembly-line. Back in the day, when Ford started producing cars in a system-like fashion, it changed how people manufactured all sorts of things. Now, it's ridiculous to try to build something without an assembly-line system. These days, all companies need to spend IT dollars to streamline their businesses... Whether it's lead tracking for sales, or inventory tracking for supply chain management... Or even automated reporting for daily snapshots on how the business is doing. Ultimately - anything that can be automated, should be.

Energy IT: Richard - thanks for answering our questions. We look forward to hearing from you in the future.

RY: You're welcome!


Commentary from Energy IT - Regularly we give the world too much credit. Reasoning and common sense suggests to us that everything that could have been automated has been automated. We wonder how a very large company hasn't already done X or Y via software and systems and we approach the investment possibilities with skepticism. Our skepticism is regularly toppled with the facts. Early in my venture capital career I was informed by a highly successful veteran software salesman that...."a lot of money has been made off of adequate technology." The subtext of Richard's comments regarding automation seem to jibe with our experiences...there is tremendous greenfield opportunity to automate business process to increase productivity. IT is a large component of that opportunity within the energy sector that is just now embracing general IT en masse.

What if You Just Reconciled Your Checkbook?

You're Kidding....Aren't You?

Imagine you own a large physical network like a data network. Suppose this network served a mission-critical function similar to your corporate network. You could not "live" without it. Now suppose your network administrator came to you and made the following statements regarding delivery of data from your network nerve center to your desktop computer:

We are losing 7.5% of all data shipped across the network...it just evaporates as a result of the network design ("Evaporation");

We are losing around 2.5% of all data shipped across the network to theft ("Theft"). We are not sure who is stealing it; and

We are losing around another 6% of all data shipped across the network because your computer doesn't want to use the data efficiently ("Apathy").

You would consider these statements fairly unbelievable. You would wonder how your network could possibly lose nearly 16.0% of all the data shipped across it. You think to yourself, "if General Motors lost one out of every five cars it produced somewhere between the factory and customer they would go out of business instantly." The prices they would have to charge to cover these losses and still produce a profit would be non-competitive. Once you got off the floor the next words out of your mouth would be, "you're fired."

As unreal as this may all sound...if the statements above were repeated by your local power company they would be fact. Almost 16.0% of the electricity produced in this country is victim to these types of losses. In analyzing the components of US electricity loss, we can identify that:

• Evaporation (as defined) is a function of choices we've made regarding system design (1);
• Theft (as defined) is a function of the absence of good visibility across the system down to the power-user level (2); and
• Apathy (as defined) is a function of human habit (3).

Maybe There's a Silver Lining

Now here's what I like about these causes - they all sound like problems that can be dealt with by humans. This suddenly relieves me from my fear that the Sun is going to burn out tomorrow and that we are otherwise in some irreversible downward energy spiral caused by years of gluttony and neglect.

Approximately 86% of the coal in the US is used to produced 50% of the electricity (http://www.clean-energy.us/facts/coal.htm). If we were smart enough to cost-effectively eliminate the 16.0% waste referred to above, demand for coal by volume could conceivably decrease by 15% (all other things held equal). Imagine what would happen to the price of coal. What collateral impact would this have on the price of natural gas (which is also used in substantial volumes to produce electricity - about 18% of all power produced)? Just as an example of market tightness, the table to the right reflects the impact on prices of a decrease in the supply of US oil during the fall of 2005. A 20% peak decline in supply resulted in a 35% peak increase in gasoline prices - just an example.

I am NOT saying that any of this electricity waste avoidance could happen, should happen, or will happen. I am simply observing that there seems to be substantial room to contemplate conservation and efficiency in the world of energy. Now what I am saying is that if solutions are found to address these issues then investing in these solutions will make money long before alternative energy. I've seen this happen before.

When we had an energy crises in the early 70s (see Arab Oil Embargo), investors did not make a killing in solar and wind farms and other renewables - I don't know anyone that did. They didn't because there was a lot of fat (i.e. waste) in the system. This fat was shaken out in the form of better gas mileage, new-design lightbulbs, improved home insulation, power management systems, etc. Change to efficiency is how money was made by stockholders (e.g., Japanese car manufacturers took a substantial share of the US market by manufacturing cars with better mileage) not new sources of energy per se....more of a market shift than market creation.

Most times investment success in technology reflects "incremental" change rather than"displacement". Technology investments that displace existing systems rather than supplement them are difficult to capitalize upon because they run against human habit and vested economic interests. So when I observe material levels of "waste" combined with a refreshed national energy concern, I see an opportunity to invest in waste reduction more than "alternative energy" per se. This is where I think the money is going to be made. At a level, this perspective puts me at odds with a lot of other investment funds.

Endnotes:

(1) http://climatetechnology.gov/library/2003/tech-options/tech-options-1-3-2.pdf

(2) Just about every utility in the US relies heavily on theft reporting by upstanding customers to identify theft of electricity (just "google" electricity theft). More advanced systems use some form of SCADA systems to watch their geography for irregularities in consumption. The balance of theft is believe to be identified by observation of meter tampering, etc.

(3) http://www.consumerenergycenter.org/homeandwork/homes/inside/appliances/small.html

The Quiet Voice of Current Capital Spending

I like this table. Its data is not really subject to interpretation...I can't turn it inside out and bend its meaning to reflect my own experiences (sorry for the existentialism) making it unrecognizable to you. It is cash. The table reflects cash deposits of several energy companies. The current rate of cash accumulation in the energy sector is fairly close to mind blowing - the ten largest companies have nearly $100 billion of the stuff on their balance sheets (see table above). It feels like a Ron Chernow novel. Good for them. For anyone who was around in the early 80's oil bust..it is a well deserved payday.

A Question Worth Asking

Cyclicality of the energy industry is inextricably embedded in its DNA. Today oil closed at $65 bbl. However in inflation-adjusted dollars oil is inexpensive relative to its long-term history. The recurring news from the industry creates the appearance that these are the best of times for energy shareholders - all times. It makes me wonder...under the current set of extraordinary economics (as defined by cash accumulation), why would any energy company waste its time ever thinking about and spending money on any sort of technology that wasn't focused on extracting more oil sooner - why bother? Interesting question.

A Little Hedonism

I believe that most humans would likely not continue their employment relationship if they were so fortunate as to win the powerball lottery. So if the energy sector has in fact won this lottery (repeatedly)...then why would it lift a finger to do anything else but print the money (i.e. such as invest in more rote IT - based on human nature...it doesn't quite make sense)?

• Hypothesis: Maybe they don't believe the lottery is going to last. Maybe recent history has not played the antagonist's role sufficient to erase memories.

What's the Message?

Position A (downcycle) - The energy sector has put off self-improvement (capital investment) in many areas for years - why---it didn't have the money. Now it has the cash resources to plan and invest to make operations more cost efficient. The distribution of spending reflects this (See "Market Research from Energy Insight" in this web log). Is the industry's history speaking to us - is it saying "we are planning for the downcycle?" There must be at least a partial "yes" to this question. The energy industry is mature and extremely cost-conscious and must believe it is going to get a return on investment (i.e. there is going to be a downcycle which renders the investment fruitful) sufficient to redirect dollars away from the drillbit directly or as dividends from shareholders as the case may be.

Position B (volatility management) - The energy industry is using information systems to obviate huge hiring (cost) increases where it can in this upcycle - interesting. I also hear that folks want to avoid the pain of letting employees go in the next downcycle and IT is likewise assisting this aim by avoiding the need for more bodies (which may be terminated later).

Whether it's Position A and Position B, either one reflects trace elements of risk...the risk that things may be bad again. Right, wrong or indifferent the industry is starting to say these things and spend for these stated reasons (in many areas). The industry is saying things with its check book......we are trying to interpret what it is saying.

China puts first Ice Cream Cake into Orbit

On January 16, 2006, a Chinese company named Baxy Ice Cream set the world record in Beijing for the largest ice cream cake ever made - the cake weighed several tons and was put together by a score of Chinese ice cream technicians working for less than one hour to complete their task. The record was previously held by a US company named Carvel. I saw an announcement of the new record on network TV causing me to reflect upon a childhood guilt trip - "You have to eat everything on your plate because there are children starving in China."

My knowledge of Chinese culture, industrialization, and politics is inadequate and slanted. Even today while I sift through statistics and video that crisply measure the commercial march of China I hear the echoing refrain that prompted me to eat my vegetables. This lingering verse haunts many of us cerebral minions to "push the last pea" that we may free ourselves from our imposed anxiety disorder.

After doing some research I have come to learn that China is generally viewed as the largest growth market on the planet for all things dairy. I did this research trying to form an opinion as to whether the new record was a cultural signal or a government-designed publicity postcard (see "The Rapid Rise of China's Dairy Sector", Iowa State University, May 2005:
http://www.card.iastate.edu/publications/DBS/PDFFiles/05wp394.pdf). The research suggests to me that the record was a cultural signal.

The ratio of US-to-Chinese per capita ice cream consumption is currently about 10-to-1. However, Chinese consumption of ice cream is growing at a rate of 10% per year. All other things held equal the Chinese will equal our per capita consumption in a little over 7 years. I am now getting nervous. I am starting to feel smothered.

Had it been the world's largest military tank or an ICBM I would not have felt as negatively impacted. I can understand these things, I have a better sense of how to measure them...I have lived with them longer. They protect our freedom to design and build the world's largest ice cream cake. However....China holds the record now....how do I measure the meaning of this?

I am thinking about this because in my judgment there are few examples of cultural and industrial redirect so poignant as Baxy's ascension to the planetary ice cream throne. I believe there is a high degree of correlation between current ice cream consumption trends and prospective energy consumption trends (this has some statistical validity based on a sample of twelve countries where I could obtain good data).

I am now shocked into an irreversible belief that China's industrial needs are going to push the entire energy industry to unprecedented performance and output requirements. I also believe these factors are going to push the industry to unprecedented capital spending levels and that IT will benefit enormously from this push. While the investor in me is excited by this prospect I have an unresolved nervousness that my children's adult lives will be remarkably different than my own.