Archive | March, 2010

Online Reputations Are Dead. Long Live Reputations?

30 Mar

Some months ago I went on a bit of a rant in a post ostensibly about User Generated Content (UGC) against online sites that were, in my view, providing a dangerous outlet for irresponsible and unsubstantiated charges against businesses and professionals by anonymous posters. This subject has taken on renewed interest in the wake of the launch of new online services that will allow people to post comments on others’ personal reputations, as opposed to just feedback on businesses and professionals.

TechCrunch’s Michael Arrington has just done me one better with a thoughtful piece on the evolving nature of online reputations and how, according to Mike, we all need to just lighten up and embrace our indiscretions. While I applaud Mike for his somewhat Zen-line perspective on how to navigate a world increasingly open to mischief when it comes to reputations — one’s own and other people’s – I question some of his prescriptions.

To take liberties with an old cliché, in the future there will be two types of people – those whose reputations have been trashed online and those whose reputations are about to be. In truth, the notion that all of our online reputations will eventually be tarnished is not that extreme when one considers the avalanche of online data about every person remotely connected to the digital world and the freedom with which others can, legitimately or mischievously, add their own narrative – anonymously, of course.

Arrington would argue that the sheer volume of data that will be attached to our online reputations ultimately dilutes the value of online reputations in general. Thus, to fret about negative feedback from customers, or ex-employees, or bad dates, or old roommates, is unnecessary and unproductive. Data will level the playing field, so goes the logic. The bad stuff will be counterbalanced with the good — assuming others will come to your aid online — and the result of all your feedback will average out along with everyone else’s. The net of this will be that online reputations will become more and more meaningless, so why worry?

Interesting point. Where I would differ is that this “free market” or laissez-faire approach, predicated on data self-cleaning the good with the bad, will take a good long time and presupposes that fair-minded, well-meaning people will be equally vocal as people complaining or wishing to do us harm. As any restaurateur knows, this is hardly the case. Gripers always make the most noise and trump satisfied patrons. Happy customers usually just pay the check, push in their chairs, and go about their business; they will rarely take the time to sing your praises online — and certainly not as fervently as those who felt ill-treated and have an ax to grind.

Conceptually, I like the notion that the sheer volume of online information about us all (coming soon to a website near you!) will somewhat self-inoculate. I can’t be all that bad, the logic goes, because look at all the other people accused of being a lousy friend, noisy next door neighbor, inattentive date, sloppy kisser, or bad tipper. Moreover, I appreciate the Zen-like perspective of accepting our flaws — the idea being that the bad stuff we’ve done is going to come out anyway so why not just embrace it, neutralize it, and move on? Sounds very New Age and I’m sure it would have saved countless political careers over the past decade that have come to ruin over allegations that might have had a more muted impact had the offenders shrugged them off instead of resisting mountains of evidence. As the saying goes, it is rarely the act; it is more often the cover-up.

The Case for Why Thin is In

24 Mar

A pair of thought-provoking posts in recent days has taken opposite sides of the issue of whether start-ups should run “lean” — as a strategy, not simply a function of a tough fundraising environment — or continue to invest heavily in the business before key milestones and points of validation are achieved.

It helps that both posts (here and here) are well-researched and come from respected voices in the venture community, notably Union Square Ventures’ Fred Wilson and former entrepreneur and recent addition to the VC community, Ben Horowitz of Andreesen Horowitz. Not surprisingly, I found much to agree with in both pieces, but I’m more persuaded by Fred Wilson’s arguments that ‘Thin is in’ – both as a path to market leadership and as a strategy to retain sufficient equity in the company to fuel growth later on in the company’s evolution when capital is cheaper and more productive.

Ben Horowitz’ “Case For The Fat Startup” points out convincingly that some entrepreneurs may be overplaying their hand in VC meetings about how lean they can run, as if running lean is the panacea for all that ails the startup community. Many who have been around the start-up community long enough remember the “Get Big Fast” mantra of a decade ago and how rampant spending by companies whose business models were far from well-sorted led to a lot of carnage that took years to unwind. The scar tissue is still very much there. To this day, many limited partners remain leery of returning to the venture capital asset class because of the concern that few truly learned the lessons of the tech bust years. 

For this and for a variety of other reasons, it behooves a start-up team to demonstrate to investors its ability and its willingness to be very capital efficient — particularly during the early days when key market validation points have yet to be achieved. Venture investors, particularly in the current environment, have little appetite for investing capital just so a new team can throw things at the wall and see what sticks.  Angel investors may be a little more willing to accept that kind of super early stage risk, but even angels are now demonstrating less willingness to back companies at the concept stage.

That said, running “lean” needs to be seen more as a tactic, not as a long-term strategy. As the corporate world learned with the Reengineering fad of the early 1990s (yet another recessionary period), a company cannot cut its way to growth. At some point, companies need to fuel growth to solidify market position, acquire smaller companies with specific assets, add talent, and to do a host of other things critical to achieve market leadership and to remain a market leader. This typically takes capital. Lots of it.

My perspective comes from the software and services world, so much of what I say next would not reasonably apply to very capital-intensive businesses in the clean tech or hardware manufacturing realm where large capital infusions early on would be a requirement. With that caveat, I maintain that most early stage companies founded upon software/services-based business models should eschew raising and spending large amounts of capital until most early stage risk factors have been controlled for, or at least well-understood. For many first-time entrepreneurs, this is hardly a choice as few would reasonably be able to raise large amounts of capital without those factors being addressed, but it is still important to point this out. Messrs Horowitz and Andreesen were able to raise large amounts of capital due in no small part to their successful pedigree. This is clearly the exception and not the rule. That said, there are still examples of companies today viewed by venture investors as extremely attractive and those same investors will try aggressively to fund — even over-fund — those companies just in order to participate in the deal.

The pressure for certain “hot” companies to take more money and deploy that capital is very intense. While this might be seen by some entrepreneurs chastened by the current fundraising environment, quite cynically, as a “nice problem to have” it is still a problem, in my view. There are very few success stories involving companies that burned through tremendous sums of cash while they were still working out their business models, service offerings, and the like. Instead, the reverse is much more common — Pets.com, Webvan, Kozmo.com, to name but a few. Once a company is supporting hundreds of staff and millions in monthly burn, it becomes extremely difficult to remain nimble and to quickly adapt to fast-evolving markets. Even if a company, once it realizes it needs to downsize and adapt, is successful in reducing staff and the attendant burn of those resources, often the shock to the system that such a right-sizing has on the organization is too much to overcome. Morale can plummet and the “blood in the water” image of the company in the talent pool can jeopardize its ability to secure key partnerships or to hire again once better times return.

A final reason as to why most young companies should hold off on executing large financings and ramping up spend in the early days is due to valuation and equity dilution issues. Staying lean typically means less dilution because a company that has yet to sort through key early stage risk factors will simply not command the valuation it will likely command some months later when those issues are clearer for investors. As such, raising large sums when there still exists significant early stage risk will bring with it signficant dilution. From my experience, it is much better to secure large amounts of capital at a later “inflection” point when that capital is seen as fueling specific growth initiatives and not to extend runway while the company still deliberates on whether its business is viable.

In summary, there are clear reasons and opportunities for start-ups to fuel their growth with cash, but those exceptions are, to my mind, swamped by the more compelling reasons for young companies to sort out product/market fit and other points of validation before raising and deploying large amounts of capital. One of the ironies of the tech bust was that the overspending during the frothy years — particularly around communications – radically lowered the cost of launching a business, building a product, and getting that product into the marketplace. Companies that have pitched me in recent years often have a product, customers, revenue, and are sometimes at cash flow breakeven — all before raising a dime of institutional capital. A decade ago it might have cost $10mm to get a company to that point; today, often a company has done that with $300,000 from a few friends and family angels.

The Market Penetration Trap

16 Mar

There is no shortage of pitfalls in a typical VC pitch where an entrepreneur’s new business opportunity can unravel in the eyes of a venture investor.  However, if I were to pick one area where management teams often tend to get caught in their own underwear it is when the subject of market penetration is first raised.

As any primer on raising venture capital will attest, targeting a sufficiently large market is a necessary but not sufficient requirement for most venture funds. Big markets provide the requisite upside a venture investor needs to feel comfortable that the new enterprise can carve out a sustainable business and defend that market position. Experienced investors know that many successful companies course-correct a number of times before they find the right market position, product and strategy for long-term success. As such, big markets are somewhat more forgiving; companies can muddle their way through, make mistakes in the early days, and still have a hope of building a significant business. Small markets rarely allow for that.

What big markets also offer investors is the potential for (relatively) bigger exits. As has become obvious across the venture landscape in recent years, the average fund sizes at many venture firms has increased, and larger fund sizes typically bring requirements for larger exits to effectively “move the needle” for that fund. Roughly speaking, billion dollar funds are going to need billion dollar exits. While this is not a hard and fast rule (and many of my friends at billion dollar funds would argue that they still want to see early stage deals with lower capital requirements and possibly smaller exit windows) the hurdle for a small deal at a big firm is pretty high. My suggestion is that if you are pitching a firm whose most recent fund is $500mm or larger and your company’s financial projections are for a business with a revenue profile in Year 5 of $50mm or less, you’re probably wasting everyone’s time. The partner you present to may love the business and its product or service but it will likely get nowhere at the Monday partner meeting when that partner presents your deal to his or her other partners. It would be best to focus on smaller funds or, even better, focus on a larger market opportunity.

Assuming you get over the ‘big enough market’ threshold as discussed above, here is one key piece of advice to entrepreneurs pitching professional venture investors: steer clear of statements such as “We just need (low single digit) percent of the market to build a really big business here folks!” These statements are fraught with peril and VCs will often visibly recoil when they hear a presenting company trot out such a naive comment. The reason for this resistance is that there is rarely support given by the entrepreneurs about how they arrived at that number or how the product or service can reasonably scale to that level.

The other trap that comments such as these set for a presenting management team is that it often makes the entrepreneurs appear to be focused on attaining low market penetration. That’s not an appealing goal for most VCs. The entrepreneurs make the mistake of thinking that by trotting out a number such as 6% the venture investors will consider the goal modest and, thus, achievable. Unfortunately, what the VC hears is that the founding team intends to work tirelessly (with the VC’s capital) to build the business and if everything goes according to plan (it never does), they will have 6% of the market in five years. No self-respecting venture investor is likely to be interested in a business that will have 6% penetration after five years of effort. If the team executes well and if after five years the company has only 6% market penetration, then something has gone terribly wrong.

What I advise start-ups to do when confronting the market size/market penetration question is to first define the market well and define what part of that market is truly addressable. This is commonly referred to as the TAM (total addressable market) number.  If this is well-reasoned then it demonstrates to the investors that you have thought long and hard about your customer set, how to reach them, and why they are right for your product/service. Next, I would recommend that you emphasize that your goal is market leadership and that market leadership may not have a fixed percentage so early in the game. Markets can be fundamentally different – consolidated markets versus fragmented markets, new markets versus mature ones, and so on. What is considered success in those markets can vary widely depending on market structure and the behavior of market participants. Where the low market penetration percentage figures become important is to demonstrate that the business can achieve profitability fairly quickly. A business that requires, say,  20-30% market penetration to attain profitability is a tough sell. That hurdle demonstrates that you are probably in too small of a market segment, are not terribly capital efficient, or likely both. The best combination would be a big market, a large TAM number, a product or service that can scale quickly and cheaply, and a fast path to profitability with minimal market penetration and low capital requirements. Oh well, we can dream, can’t we?

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