Tuesday, October 20

What is Technology Investing?

For the longest time I have been affected by a certain discomfort I've felt in my job. As a human I am regularly subject to all the discomforts and neuroses that plague mankind but I have one certain area that has distracted me for some time.

By way of background, my day job involves searching for and investing in certain types of "technology" companies.   According to The New Oxford American Dictionary,  technology is:

"the application of science for practical purposes."

By deduction, this would mean I invest in companies that transform science into products and services that have some practical and economic purpose.  My problem with this deduction is; however, that I rarely (in fact never) perceive that our portfolio companies are in the business of converting science to its practical applications.  In fact, when I step back and ponder "technology" companies in general [ in which I would consider an investment] , the word "science" nor mental images of "science" ever come to mind.  Absolutely never.

When I think about "technology investing" I feel this unshakeable sense of being surrounded by urgency and "speed".  When we talk of "technology" there is a subconscious assertion of things moving quickly. Isn't "technology" itself generally promising more time (or less time as the case may be) to its users and isn't this much of the basis from which new technology is sold or bought into?

When I think of technology companies I think of the need for several large things to happen quickly.

  • Large Thing Number 1: Since technology itself has implicitly a brief half-life,  its developers need to organize themselves quickly in order to provide plausible commercial life to a new technology.  So Large Thing Number 1 is the act and effectiveness of organizing a group of people whom you are paying to do a thing.
  • Large Thing Number 2: Since new technology generally displaces an old way of doing things, developers/marketers of new technology need to convince a meaningful number of consumers to CHANGE HUMAN BEHAVIOR. So Large Thing Number 2 is trying to convince a group of people to change its behavior and pay you to do so. 
Try and recall the time that you needed to organize a group of people to do something, anything - say form and stay in a line. It wasn't that easy was it?  You had to explain to the group that they needed to get in line, why they needed to get in line, and why they needed to do it exactly at that moment. Lots of explaining.  Now layer on top of that memory the notion that you had to get people to pay you in order to be in that line.  The value of what is on the other end of that line just came under serious scrutiny and the degree of difficulty just went up about 10x.  This is pretty much how mob violence is triggered. Welcome to technology investing.

What accomplished venture investors are good at doing is this:  Identifying and scoring pools of people capable of Large Thing Number 1 with a minimum degree of waste, and having a good sense if the positive results from Large Thing Number 1 are suited to cause Large Thing Number 2.  Said another way they must be skilled in making assessments about pools of people more than anything else which would render them, in a way, more research sociologists than technologists per se.

Now...did I just produce the perfect working definition of "technology investing"? No. But I feel I am getting closer to a working definition of its essence.  Technology is simply a medium around which certain role players may chose to organize. Many venture funds have fallen for the slight of hand caused by the shiny technology bauble (myself included) and too often think of ourselves as technology-centric Zen masters when in fact we are playing inside of a larger equation whose primary variables are group dynamics.  It really makes me wonder what type of educational background is required to prosper in this business.  One thing is for sure....one needs to have extremely good hearing.

Thursday, July 30

Discussion on Different Sources of Scale for Software Companies



There are many ways to determine "scalability" of a growth-stage software company. Scalability comes in several forms including the capacity of the company to sell a certain dollar amount of product per annum and repeatedly increase that amount in later periods. Increases in revenue can come from different places: (i) improvement in direct sales techniques, (ii) increased pull from the market, and (iii) price increases for products sold. I am focused here on the capacity of the firm to raise prices and hold those prices while depending primarily on a direct sales model.
The evolution of a software product/solution can take many shapes with many different results. Generally a company declares evolutionary leaps through something called a "version release". Version releases reflect some major change in the product significant enough for the vendor to say so. Version releases are the product vendor's periodic chance to justify to the market why old prices don't apply and new higher prices are justified. Some companies are extremely adept and well-known for developing hype around version releases (e.g. Apple, Microsoft). Most times media hype is software-speak for ("here comes the price increase"). The question becomes, “will the price increase fly or fall flat on its face?”
In software, there is a natural course for version releases divided between feature/functions and architecture. Early on, features and functions are the sales focus. "Our product can dig round holes relieving you from needing a shovel to do 1, 2 and 3." Later, architecture becomes economically relevant. Feature/function releases are designed generally to empower customers to do more. Architectural releases are mostly designed to empower customers to do more on their own: "With XWZ Product Version 7.0, our hole digger now runs on solar power so that you don't have to worry about the high price of oil."
In my experience the price-increase testing laboratory opens up after a company's first major architectural release. About 80% of what the market needs at that time is currently inside the function set and the vendor is now trying to get right with the IT department. Architectural releases many times are, in effect, a migration of their customers’ deployment services budget over to the product license budget – hopefully the release requires fewer resources to render useful. They should be oriented toward increasing a customer's independence (which is ironic because the increase in independence regularly causes the customer to "depend on this vendor for independence"). Many times the revenue line starts to lift dramatically (if there is really a market). The question is: "what happens next?"
Software companies that prosper are good at adding meaningful functional execution capabilities on top of initial core functions. You can track pricing momentum between version releases to see if creative genius and effective customer listening are occurring or if they have left the building. If a company has the ability to persistently raise prices for incremental version releases then you, as the investor, are on to something (manufacturers of high-end automobiles seem to be really good at this). Many times the starting point for all of this (the initial core functions) is hit or miss. In other words, the initial function set had to do something in a particular way in order to get the customers seeing and properly verbalizing additional functional requirements that lead to higher prices. Said another way, there is enough case history for the vendor to quantify value add, ROI etc...and communicate this in a way that sticks.

What makes this analysis particularly difficult is that most software deals over $300,000 are negotiated. As a result, comparing one deal to the next (enterprise vs. limited-use) for purposes of a finely-pointed pricing momentum analysis is complicate but it can be done.You really don’t have to know a lot about software to properly interpret the meaning of increasing price inelasticity. You just have to be aware that it is very indicative of the design and selling capabilities of a prospect company. Necessity will help you figure out what to do from there.

P.S.  Once more selling comes from the channel, price can come down but the motive should be to increase volume.  Therefore, the metrics watched should include volume variances per salesman.

Monday, July 13

It May be Just the Opposite

Being a good venture capitalist requires not only being able to see new technologies that have a meaningful commercial future but more importantly being able to see when that future may occur. Truth be told...it really is not so difficult to predict that some new software will develop into something commercially viable. You will know a venture capitalist is thinking along these lines when he mouths the following words, "hey...I think this makes a lot of sense" and starts nodding affirmatively. A lot of this just comes from keeping one's head in the technology game for a sufficient period.

The big rub is that so many of us get involved in start-up endeavors but incorrectly estimate timing on the respective company's market. I have my share of deals where I was too early and cash went to ZERO way too fast. I got sucked in by some empirical false positive and believed that a new market may be starting to trickle my way. But...I was too early. Eventually I was right but I was too early. So the question I am considering is what was the empirical false positive that created the vacuum pressure that drew me in?

This is going to come across as very odd but I can't shake feeling that pleasant customer testimonials of very early-stage software companies is a big-time false positive with regard to market timing - why?..you ask. Don't you want customers to say really good things about the software company into which you are about to make an investment? The answer is "yes" but within limits.

As software companies mature their customers make more demands and complain loudly. This happens because customers have an increased dependency on the underlying solution. At any point in time, most budding software companies are better today at what do for customers than when they were younger. They advance and get better. This should mean, by deduction, that customers that complain today had louder complaints before - provided they really needed the underlying software solution. Taken a step farther it can be reasoned that, early on, customers were not "ecstatic" (which some due diligence calls may suggest) but rather were "tolerant" of the software provider. The tone of tolerance suggests that the customer of the early-stage software company has a significant need and he is tolerating the youthful incompetence of this stumbling vendor.

Earlier in my career I would listen to a due diligence call and get this very pleasant report on an early-stage software vendor in which we might be considering an investment. My internal messaging would go something like this:

"Wow...what a great company...the timing must be right to invest in this area."

The more experience I gain the more I consider that, within certain parameters, positive customer feedback is a negative and a negative customer feedback is a positive. Specifically stated, I want to hear more people complaining. The more tolerance I hear the more I know that a real problem exists and I am speaking with someone whom is counting on the software vendor to solve the problem. The more verbally angry they are, the bigger and more immediate their problem (yes this sounds crazy). I am starting to believe that this may be one of the better clues that it is time for this start-up to begin.


Monday, July 6

Theories on Why Venture Capital Doesn't Scale

We continue to drift in the middle of a chaotic venture capital market that many say is "broken." I have been thinking about this and I am trying to understand the factors that add up to this "broken" state. To me, "broken" means that as an asset class venture capital is not performing well relative to the risks taken and the performance of other asset classes given their risk profile. (By asset class I mean the venture industry taken as a whole.) This industry's turmoil reveals itself in many ways but its root cause started as too much cash and now seems to be too little cash. Cash comes from several places including raising new funds or decreasing investment rates and operating expenses.
Raising new funds is not all that easy because the industry's recent track record is not exactly stellar. Decreasing our investment rates has been easy to manage and we cut operating expenses where we can. At the end of the day...the only true source of oxygen is "the next fund."
There are different reasons new funds are not so easy to raise for so many firms. One principal reason is that funds in the late 1990s and early 2000's were ambitiously large. By this I mean that firms used these funds to substantially expand their operations and investing scope. We saw many funds triple in size over the predecessor funds. Now if a new fund was three times as large as any predecessor fund...it had to likely have thrice as many "hits" as its predecessors in order to perform at least as well. In order to generate three times as many hits, venture funds recruited additional players en masse. This is really where the problem starts.
In my opinion, venture capital is much more artful than it is scientific. The best venture capitalist can not simply codify his instincts and experiences in such a way that they are highly transferable to other humans. The best venture capitalists are simply instructors who provide tools to a school of students some of which prosper many of which do not. There are good schools and there are not-so-good schools. Good schools take time to develop. As a result, it is very difficult to scale this business. No matter how many students Roger Federer enrolls in his tennis academy it is unlikely to produce the next Roger Federer. The odds against it are great.
A good venture capital firm probably has at any one time three or four natural athletes. Each firm can talk about this process and that process and proprietary secret investment formulas but I don't consider those plausible ingredients for achieving scale. It is marketing lingo for "it's ok to give us right now 3x more money than we can handle." The core team can put to work only so much capital and watch it effectively in a way to achieve results consistent with the risks undertaken. The school takes time to develop. Nonetheless...our current tendency is to continue trying to raise gargantuan amounts of capital well beyond any plausible management scale. This is, in effect, investors making the bet that a successful venture capitalist can transfer his skills with an efficacy that results in two Roger Federer's by the end of next year.
The other issue is this: there are only going to be so many big winners per period. By winner I mean investments that generate a lot of return. Since late 2001, the number of winners seems to have dwindled but the number of venture capitalists has sky rocketed. This means that a large body of professionals has really not had close contact with winners in such a way that they can understand what happened, why it happened and imbibe enough experience of success to plausibly create another success. This is not one of those life experiences where the only learning comes from failure..
There are many exceptions to this perspective..but there are many more points of proof than there are exceptions.

Wednesday, June 24

In Search of "Now"

I am observing the current, rocket-like ascent of "Twitter". Twitter is, among other things, a one-to-many text messaging system. The "one" is you or me. The "many" can range between a limited size, private group such as your friends or a universally large, public audience such as CNN viewership. In its smaller setting, group members use the system to keep others informed of daily activities...(sort of a never ceasing human exchange). In the more public setting, Twitter is a real-time news reporting tool.

The meteoric climb of Twitter is based, in my opinion, on its popularity as a medium for the "never-ending human exchange". I have seen this previously in many other electronic forms. Despite their visual differences each of these sort of does the same thing. Here are some examples:
  • Facebook: An organizational tool for building a personal profile that may be shared with a few or many.
  • Youtube: A publishing tool for letting all comers have a visual understanding of you...who your are...what you can do...etc.
  • MySpace: Same as "Facebook".
  • Twitter: See above.
I remember for awhile...when YouTube was racing upward as a platform for gaining celebrity. YouTube was a hotspot for coming out of nowhere into fame. It seemed to me YouTube was almost as famous as the fame it created for others. YouTube is still there...where is all the star-generating power? Separately, I read today that MySpace is laying off 30% of its workforce...huh? Wasn't it valued at something like $400 grillion...a lot of smart people got behind this thing..what happened?

The popularity of these mediums reminds me closely of the fashion industry. Each year designers are required to create new themes and visuals that satisfy the eye and offer a slightly vanguard way to humans for expressing themselves. The great design houses can completely change the user experience from season to season. The designers know the user experience needs to change because the old experience ceases to satisfy the user as an expression of the self.

The whole concept is a derivative form of something called "attachment" whereby we humans entrust things external to our selves with the power to determine whether or not we are happy or sad. Do I have enough money..I want more chocolate cake...if I just had a bigger house....etc...because none of these things individually brings peace to the soul we find ourselves hopping from one hope-filled attachment to another.

Now the difference between any of the human-exchange mediums described above and the fashion industry is: a designer clothing brand can change its feel sufficiently to accommodate the endless human journey of self-expression ( cloth is a medium capable of a very wide range)...a piece of software, in general, can not change enough to help here. As a result....social software gigs seem to pop up and then slide down (they sell the same dress year after year).

If I step back from these platforms and am honest with myself...I believe they are promising me some upside...a differently perceived future me...I can be a YouTube star. As a result, my mind is stuck in a YouTube/Facebook/Myspace/Twitter future. It is this very thing that many human philosophers and at least one eastern religion say is the source of human unhappiness. Not being in the present. I am still looking for the social networking site that puts me in the Now..this will be a big thing.









Tuesday, May 12

The Thousand Yard Stare

I work at an asset management firm. The investment assets we manage are diverse and the skills required among our managers are diverse. Many times the managers will sit and talk shop about what they see, what they might be sensing around the market, their projects or something like this. These are illuminating conversations.

Many times I may be asked about this portfolio company or that portfolio company, its performance and the inevitable, "What do you think it is worth?" Since so many of our positions are in software, I am regularly quoting some multiple of revenue. This conversation generally results in a facial expression trying to conceal the listener's disbelief (i can feel the "thousand yard stare"). The suggested value appears to have no rational connection to earnings or cash flow of the subject company. The listener then politely leaves the room trying to spare my feelings from what he is really thinking.

When a software company is acquired by another software company...the rationale is generally in one of two camps: (a) the acquirer is trying to grow something they already own, or (b) the acquirer is trying to preserve something they already own. When the buyer is trying to grow something they already own...they are generally doing more speculating than not - they believe the product set is previously incomplete and that the addition of something else will finally be the thing that causes things [sales] to really take off (I am not sure I have ever seen this work). When the buyer is trying to preserve something they already own...my belief is that they are doing less speculating than in case (a). They have seen the acquisition target have a negative impact on the thing they already own and are worried about about its further negative influence on this thing (which they value so much). So what is the thing they already own that they value so much?

Investors in software early-stage software companies incur a lot of risk to get to a place of comfort and confidence. The possibility of operating leverage resulting from scalability in license sales influences this confidence. BUT...the end is not scalability of license sales per se but rather scalability of the maintenance stream (that license sales produce) and the recurring cash flow stream it produces.

The maintenance stream is really "the gift that keeps on giving." It is a pool of "insurance payments" that customers make for years after their initial product purchase. It guarantees them the right to all future advances of the software product. As customers become increasingly dependent on a particular software product the reliability of this "annuity" increases. It becomes extremely valuable to shareholders of software companies as a funding source for future product development and even more "annuity". It is when this annuity stream is put at risk that acquiring companies seem to go into action. The greater the risk to the existing annuity stream...the more they are willing to pay for the target company.

So...lets say you are a $20 million/year software products company. You are growing at a nice rate and you currently make $1 million per year in operating profit. Life could be worse. You get a knock on the front door and XYZ software giant wants to buy you. Nobody at XYZ software giant is going to tell you how scared they are about their annuity stream...they are going to say something like you are a meaningful complement to their solution set and that this is a build-vs-buy evaluation. If this is in fact true and you belief it is true...this will likely be a short negotiation and you should probably take the second offer they make. You will close the deal at 1.5x revenues.

However..let's say that XYZ software giant is calling because they see you as a threat to the maintenance stream on their "time travel" software. You go to their annual report, look deep in the footnotes and you see that maintenance revenue from "time travel" software was $600 million last year. You deduce that your product set is creating risk around this annuity stream and four years out could cause great problems for it. As a result...you have significant negotiating leverage. They are not focused on your annuity stream and speculating about what it could be. They are focused on their annuity stream and what it "is". They are taking some of the insurance payments made to them by their customers and, in turn, taking out insurance of their own by acquiring you. They are buying an extension of their own annuity stream It is the nature of the beast.

By way of example lets say that XYZ software giant estimated you had permanently impaired 1% of their annuity stream and that by next year this was going to reach 2%. Without considering any escalation thereafter XYZ anticipates that your existence would kill off $12 million maintenance per annum of say $7.2 million after-earnings. If ZYX trades at 10x earnings...then it might be worth $72 million (10 x $7.2) to stop the risk of greater damage occurring. So in this setting with this perspective layered on top...your little $20 million software product company might be worth 3.6x revenue ($72 million/$20 million).

And this is the story of how a fair number of software companies trade at something that bears absolutely no planetary resemblance to the rest of the world.

Monday, March 2

For all their faults...

I have been living in the venture capital world for what seems like too long.  Many successful companies evolve to include investor syndicates consisting of 3, 4, and sometimes 5 different venture groups.  Many times the perspective and priorities across the syndicate vary greatly.  It can cause huge headaches for management teams simply trying to do their jobs.   These management teams sometimes are not exactly sure who is the boss. They are left guessing and a "gap" is created between the company and its investors. 

Despite the resulting lunacy, the measurable dysfunction manages to plod along approximating (over time) something resembling rational thinking.  I say this in comparison to one particular form of alternative: one where there is a mix of professional investors and non-professional investors.

I have lived in this dynamic believing that non-professionals can come along via the experience gained along side those whom invest for a living.  This is nothing less than a near-fatal belief. Many times the absence of experience causes all humans to cling to emotional behavior. Absent a recognizable pattern of data the emotion takes root and chaos begins to surface. One experienced investor can not overcome the emotional activity of the inexperienced lot.  I have lived this too many times to know otherwise. It really only takes one person screaming "the sky is falling" to create doubt despite substantial empirical facts to the contrary.

We live in a period currently where "the sky is falling" is very difficult to quash. Here is an example: We have an investment in a small company that has over the past four calendar years grown license revenue 400%, wiped out competition, is winning the sector and is producing significant operating margins (this is a software company).  Is the sky falling....? YES.  Just ask the non-professional investors. As a professional investor I am absolutely delighted by the progress.  We are winning a turf war and dominating a sector.  Until the market emerges into the thick of "early majority" this is about as much as one can ask for. Nonetheless, chaos reigns supreme.  It is exhausting.

So why the panic? The answer is that the non-professional investors in the deal are not familiar with the attributes of a successful enterprise software endeavor. They don't really know what to look at. There is no recognizable handle upon which the can firmly place their fingers, tighten and derive confidence. Unchecked panic is a California brushfire headed toward the planned community anxious to leap on rooftops and jump from house to house.  Don't believe me...just contact the local branch of your go-to venture firm and ask if they have any "similar" experience. It is nuts.

So what is the lesson here: To the professional investor - as capable as we make think reason alone may be, it is not always an adequate translation mechanism to overcome many categories of those who don't do this for a living.  To management teams - chose wisely whom you elect to pull into the syndicate....the price of some money can not necessarily be computed in an Excel spreadsheet.

Yes...this may all sound like hubris but this is the exact reason so many firms invest only in control positions so perhaps it is a popular form of hubris.