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Is The Daily Deal Backlash Overblown?

15 Sep

According to the business maxim, you can always tell who the leader is in a given market: it’s the one with all the arrows sticking out of its back.

While this axiom is applicable across the business landscape it is particularly relevant in the startup world given that most leaders in an emerging market end up taking as much incoming fire from me-too startups coming up from the rear as they do from incumbents threatened by the continued advance on their territory.

I raise this point because I’ve been surprised in recent weeks at the backlash in the media and across the venture landscape against daily deal sites, most notably Groupon and LivingSocial.

To be sure, the daily deals business has become ferociously competitive. There are now dozens of venture-backed businesses pursuing some configuration of the daily deal/social buying/demand aggregation business model. To this number add the emerging group of established web companies now brand extending into the deals business–Facebook, Yelp, Travelzoo, OpenTable, Amazon, and Google, to name but a few.

The birth of any new industry is rarely elegant, planned or pretty. With little argument, whenever one is dealing with the kind of torrid growth that both Groupon and LivingSocial have experienced one will find plenty of areas to criticize. However, I think some of this criticism is misguided. To call a marketplace with hundreds of competitors vying for consumer dollars emerging might be an oversimplification, but emerging it very much is. Let’s not forget that like the early days of social networking, the winning model in this space has not yet been fully realized. Constant iteration is underway, all being attempted at the breakneck pace one would expect in a marketplace still decidedly in its land grab phase. This means things are going to break — loudly and often. This is not altogether bad.

The daily deals space is the kind of web phenomenon we have seen before: Explosive growth, high user engagement, huge cash flow implications for the companies, lofty valuations, investors elbowing their way into funding rounds, and lots of media attention to fuel the frenzy.

In this environment, Groupon and LivingSocial have broken out as the market’s de-facto leaders and built robust businesses. Revenue growth has been nothing short of spectacular. In turn, the companies have responded by raising sizable funding rounds to further consolidate their positions and extend their reach into new markets. Investors and employees have every reason to be proud of these accomplishments. So far, so good.

This, however, is far from saying that their status as perennial leaders is a fait accompli or that they cannot be felled by either other participants or by their own strategic missteps. Indeed, it is still early days. This is perhaps why I find the latest hand-wringing over Groupon’s recent stumbles in the media somewhat disconcerting.

Massive customer churn is to be expected. Explosive growth, particularly as relates to web companies, raises the notion of the shiny new object theory. This notion should inform us that exponential growth and buzz brings huge consumer curiosity which, in turn, brings an influx of users that will try the product/service once and never return. Is this a reflection of a company that has provided a poor user experience? Or, is this simply the realization that 30-40% y/y revenue growth is likely unsustainable and that large swings in customer churn will be in evidence for a long time to come? I am in this latter school of thought.

The “churn” issue so often cited by critics is not simply a matter of consumers being fickle but one of SMBs and merchants as well. They are still trying to figure out how to work with deal sites and whether such marketing campaigns are right for their specific businesses. This will take time.

The Spaghetti Test. Additionally, daily deal sites are incented to build vast Rolodexes and cover wide areas of terrain to extend their brands. This means lots of offers are being written across broad categories of SMBs where the suitability of the daily deal model is still not thoroughly understood and where there is little historical frame of reference. While most managers are loath to admit it, the Spaghetti Test of  ‘throw it against the wall and see if it sticks’ inevitably drives a lot of iteration around determining which offers resonate and which do not. This results in a lot of mediocre offers that don’t perform well which can leave merchants and consumers with a poor experience.

Work to be done. Critics are right to point out that there is still a lot of work to be done in elevating the daily deals business to deliver on the full promise of its massive potential–both for consumers and for businesses. Merchants need better post-deal monitoring and CRM-like tools to help with yield management and provide better tracking and analysis. Merchants also want more control and flexibility over how offers are created, sold and redeemed so they can maximize profits while minimizing the impact on their organization when the “crush” of redemptions comes. [Fortunately, startups are already innovating around these themes to fill precisely these voids.]

Consumers, for their part, are demanding better offer targeting, more consistency in pricing and redemptions, and less intrusive appeals in order to fight against emerging deal fatigue now evident across the space. Personalization software needs to catch up so that users can better tag offers of interest and opt-out of those that are annoying or redundant (Cupcakes? Again?)  Also, Hyperlocal and Location-Based-Targeting need to demonstrate that they are more than just elegant theories.  Too many service-oriented SMBs (i.e. hair salons, etc) have gotten burned in money-losing offers for premium services to out-of-town customers with whom there is no opportunity to develop a long-term customer relationship. That kind of mismatch is being corrected but hyperlocal offer targeting has a ways to go.

Ultimately, the scale that Groupon and LivingSocial have achieved has likely put them beyond the reach of most competitors. The battles ahead, therefore, will be over how best to go vertical. The winners will be those most savvy at customer segmentation and in finding unique offerings positioned against specific themes and product categories. Predictably, there are numerous companies doing precisely that — tweaking group-buying mechanics and applying them to niche, premium markets and making a successful play in those areas. In another market in another time, this “go vertical” approach may have doomed a company to a market insufficiently large to support its efforts. However, as companies such as Gilt Groupe and One Kings Lane have demonstrated, the daily deals market is large enough that even pursuing a niche approach and a narrow customer segment can prove to be enormously lucrative.

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My 2010 Predictions: A Look Back

5 Dec

Around this time each year we in the tech/venture community turn our attention to the year ahead and pick trends and themes that will presumably shape the coming twelve months.

To my mind, no view forward is complete without a retrospective on the year drawing to a close and, with it, a re-examination of themes that were ostensibly to define the year. From that perspective, let’s take a quick look at the trends I identified in my Ten Tech Trends For 2010 post from January and assess how I fared.

1. Green Shoots But No Chef’s Salad. Given an abysmal 2009 by most accounts, that 2010 demonstrated greater activity across the tech landscape—from rising public and private company valuations to overall investment pace—was hardly cause for jubilation. That said, the pace of financings, the froth in early stage valuations, and the continued strength of the M&A market surprised many of even the most bullish of observers. Grade A-

2. Physical Media dies..a little more. On September 23, Blockbuster dropped the other shoe and finally, unceremoniously—and mercifully—declared bankruptcy, thereby joining the ranks of now-defunct juggernauts Tower Records and Virgin Megastore  and putting a very public face on the continued disintegration of physical media.  Grade A

3. Strongest IPO market in (almost) a decade. We began the year with some impressive tech names filing their S-1s, or threatening to do so, but few of the most closely watched companies ended up taking the public exit route in 2010. While the pace of IPOs in 2010 was a significant improvement over that of 2009, Facebook, Zynga, LinkedIn and Silver Spring Networks all remain privately held entities, albeit very successful and very well-funded ones. To be sure, the vigorous secondary market and the continued institutionalization of that market played a significant role in enabling these companies to be cavalier about the prospect of going public. With no shortage of capital available at often sky-high valuations to companies like Facebook and Twitter, a key pressure point for CEOs seriously considering a public exit—providing liquidity to early employees and investors—was largely mitigated. Grade B

4. Entrepreneurs Reign Supreme. Facebook, inarguably the most closely watched privately held technology company, is still helmed by its 26-year old founder despite its torrid growth and its having raised hundreds of millions in capital. Groupon, which this past week reportedly turned down a $6 Billion takeover offer from Google, is considered the fastest-growing technology company in history and will reportedly generate $2 Billion in revenue this year. It’s CEO, Andrew Mason, is all of 29. The story of the ‘return of the entrepreneur’ cannot be told properly without remarking on the revival in consumer internet and how there exists renewed investor comfort and appetite for young founding teams that really understand consumer web services and products. Grade B

5. Changing of the VC guard escalates. Despite a frothy early stage market and big (still private) successes like Zynga and Groupon becoming household names in 2010, fundraising for venture firms remained challenging. One explanation offered in my January post was the lack of distributions from many venture firms for the better part of a decade. The fundraising picture did not particularly improve in 2010, despite a strong M&A market and some decent venture-backed IPOs. While first-time managers have long faced headwinds in the LP community, in 2010 many branded legacy firms struggled to raise follow-on vehicles as well. In cases where established funds were successful in raising follow-on vehicles, many of those vehicles were considerably smaller than their predecessors.  

Venture funds that moved too slowly to adapt to changing market conditions, or who have not managed partner succession adroitly, or who missed the boat on fast-moving areas of investment will continue to struggle to maintain relevancy in 2011. Grade B+

6. Vertical Social Networks Catch Fire. My position that users would “continue to demand rich content, ubiquity and connectivity of social networking platforms” has certainly been supported by the marketplace. However, the predicted boomlet in vertical social networks did not come to pass in 2010, although usage across the category expanded dramatically. That said, there were a number of recent product launches and acquisitions by the large “horizontal” social networking companies that appear to support the notion of offering robust vertical solutions with custom applications idiosyncratic to those vertical markets. Grade C+

7. EnergyTech has its Moment. The clean-tech community rang in 2010 with high hopes that a big-name IPO coming from the space would spur a wave of exits in its wake and finally quiet naysayers that felt the sector was overheated and would not generate returns to overcome the significant investments made there over the past decade. Twelve months in, Silver Spring Networks remains privately held and there is some speculation that investment pace and enthusiasm has cooled in EnergyTech as of late. Grade C

8. Early Stage VC Returns To Form. In perhaps the biggest story of 2010, early stage venture investing—particularly around consumer web, cloud computing, digital media and web services—came back with a vengeance. The year also brought new terms to the venture lexicon such as “Micro-VC”, “super-angel” and “Angelgate.” Personal note: Thankfully the BIN 38 kerfluffle has blown over and I can make the wine bar my regular post-dinner nightcap spot again. I don’t have a problem with what happened there (or didn’t happen there, as many insist.) I just wished the people in attendance that night had chosen an iHOP. Grade A

9. Alternative Fund Models Gain Momentum. 2010 undeniably brought creativity back to the structuring of investment funds. The clearest winner was the Pledge Fund, which never really went away but, rather, benefited from renewed interest in seed stage investing. While the emergence of novel fund models was partly an answer to a tough venture fundraising environment, 2010 also brought new categories of funds that were derived for specific purposes—such as to purchase early employee and angel investor stakes in popular technology companies. Grade A

10. RIP the 2 & 20 Fee Model. Tough fundraising environment or not, the 2 & 20 model is alive and well and remains baked into the subscription agreements of a majority of venture firms. That said, few new venture funds were actually raised in 2010, raising the prospect that should 2011 be similarly difficult for fundraising this debate may re-ignite. Grade C+

In summation, I’ll give myself a B+ average. A few items were clear winners and there were no glaring missteps. Share your thoughts here. In next week’s column I will issue my Top Tech Predictions for 2011.

10 Tech Trends for ’10

4 Jan

As the calendar flips to a new year and decade, the temptation to opine on trends for the year ahead becomes almost a parlor game for those in the technology sphere. Predictions in this industry are inherently broad. Oftentimes, so many things must work in tandem for a prediction to play out in the time allotted that one must give prognosticators partial credit if even some notion of what was predicted reasonably pans out. With that caveat, I offer the following — not so much as predictions for the year ahead but as a collection of things I will be watching closely over the next twelve months.

1. Green shoots, but no Chef’s Salad. Saying 2010 will be a better year for technology companies and their investors than 2009 is hardly a bolt from the blue. Fortunately, there is now compelling evidence that the IT backlog is loosening up and businesses are investing again in their IT infrastructure which should provide a nice collateral uptick for devices, software, services, and support. In this new, frugal world, a disproportionate share of the spoils will go to companies offering scalable solutions, often in the cloud, that are cost-conscious, flexible for their customers, and customizable on the fly.

2. Physical Media dies..a little more. Been passing a lot of empty storefronts that were once a Blockbuster Video or Virgin Megastore? It will only be getting worse in 2010. Not a believer yet? Pick up a newspaper. No, wait, on second thought that’s not so easy any longer either. This also applies to new technologies replacing our old ways of consuming media. Amazon’s Kindle is a runaway hit and Apple’s Tablet is enjoying buzz not seen since the debut of the iPhone. These might prove to be the first real wave of consumer devices (after so many flops) to finally live up to the promise of shifting media consumption and media spend from the brick-and-mortar to digital world.

3. Strongest IPO market in (almost) a decade. The moribund exit environment appears to be improving, albeit not as quickly as most in the venture community would like. While M&A continues to dominate as the traditional exit path of least resistance, IPOs are becoming more numerous as well. Prepare to see 2-3 high-profile tech companies go public in 2010 which will have a positive effect on overall tech valuations and provide much-needed coattails to other public technology companies in waiting. Possible 2010 IPO candidates? Facebook, Zynga, LinkedInSilver Spring Networks and a handful of smaller cleantech and game companies. If only a few of those marquee names actually consummate public offerings, 2010 could be the biggest year for tech IPOs since the Google offering of 2004.

4. Entrepreneurs Rule Supreme. In a December 2007 post, I offered the notion that entrepreneurs were becoming increasingly relevant again. This came after several years of professional CEOs regularly being brought in by frustrated investors to replace ostensibly prodigal 20-something founders that investors felt were ill-suited for those ascetic post-bubble years. While ‘gray hairs’ and competence will never go out of fashion, the unique qualities of a compelling, charismatic founder who can envision and develop products that can change the world cannot easily be overstated. The Marc Benioffs, Mark Zuckerbergs and Sergey Brin/Larry Pages of the world are often the builders of companies that most directly shape our world and create the greatest value for investors. If Facebook ends 2010 as a multi-billion dollar market cap publicly traded company, helmed by its 24-year old founding CEO, it can only bode well for young, visionary entrepreneurs everywhere and for venture firms willing to take a chance on first-time CEOs with potentially game-changing ideas.

5. Changing of the VC guard escalates. Talk has swirled for years now about a winnowing of venture firms, to little effect. 2010 may change things. Now that ’99 and ’00 vintage funds have wound down (or will shortly) there is a bit of a case of the emperor’s new clothes. LPs can now see in the harsh glare of red ink on white paper how poor many investments in some storied venture firms fared over the past decade. The old saw that ‘no one ever lost money buying IBM’ was also a prevalent view among some LPs who, overly focused on brand,  generationally backed storied firms almost out of habit. This trend is on the wane as limited partners get more serious about sharpening their pencils and closely evaluating what firms they want to be investors in over the new decade. The ivy league venture firms ten years from now will not likely resemble those considered ivy league firms today. Limited partners that take a chance on younger venture firms doing riskier, earlier deals may well be rewarded when the ball drops on 2020.

6. Vertical Social Networks catch fire. Some argue that ICQ and Friendster begat Facebook and Twitter, and that Facebook and Twitter have sired companies like Athleon, Gowalla and Foursquare. Sure, Social Networking has gone wireless but it has also gone vertical, and usage is exploding. Users are demanding the rich content, ubiquity and connectivity of social networking platforms but they are also demanding richer tools more focused on their specific needs, like coaches who use Athleon to communicate with their team’s players, parents, and sponsors as well as using the platform’s suite of applications like playbooks, stats trackers, game film storage, and the like.

7. EnergyTech has its moment. Sure, biofuels and hybrid engines may be more intriguing (and capital intensive) but the “energytech” sphere of cleantech, such as the smart grid arena and Demand Response companies like eRadio, is where many of the first exits in the broad cleantech space are likely to come. Watch investment into the space increase substantially in 2010 with participation from unlikely sources.

8. Early stage VC returns to form. Building companies from the ground up is sexy again. Perhaps it was the bloom coming off the buyout rose in 2008, but many investors are realizing that clever financial engineering and interest rate arbitrage plays do not generally build great companies of lasting value. Limited partners who shunned early stage venture firms after the dot-com bubble are returning in force and looking to again be part of the creation of the next generation of great technology leaders. It’s hard to buy your way into that party after the fact; one needs to be there at the beginning to truly realize substantial returns. Just ask Ron Conway.

9. Alternative fund models gain momentum. I’ve spoken of Pledge Funds and Search funds and a variety of other venture/private equity hybrid structures that have gained prominence in recent years. The ’08 financial collapse has only raised their profile. As LPs pressure private equity and venture fund GPs on everything from clawbacks to management fees, more GPs are going off the reservation and debuting new funds with LP-friendly terms and structures. Some are a bit hyped, but many have some real merit and can address specific needs of certain LP groups.

10. RIP the 2 & 20 Fee Model. As a follow-up to #9 above, the traditional 2% management fee/20% carry structure that has supported the venture industry for decades is now under attack and is not likely to survive unscathed or unaltered. True, there have been previous attempts at LP mutinies that have come to naught, but this time LPs seem better organized and more aligned than ever before. They also now confront an industry somewhat chastened by a tough decade and willing to re-appraise prior assumptions about how to work with long term investors than was the case during the dot com haze when we rang in the year 2000. Oh, what a difference a decade makes.

Is the bloom off the User Generated Content rose?

21 Dec

Like many in the venture community much of my December date book centers around internal meetings and planning sessions for the coming new year. I’ve found that a number of these meetings ended with us having a fairly freewheeling discussion about User Generated Content (UGC), its implications for consumer internet companies in particular, and its place in the development of a number of companies we are specifically involved with. These internal discussions were punctuated somewhat by news items over the past week about the on-again, off-again talks between Yelp and Google. Today’s PEHub piece provided the latest dispatch in the saga.

While I wouldn’t want to speculate as to what issues would cause the Google/Yelp talks to snag, my own view is that a re-appraisal of UGC is underway among many early stage investors in consumer internet companies. UGC has proven to be far more complex and difficult to properly harness than many in the start-up community probably considered when initially drafting strategies for their companies that were highly dependent on UGC.

The ‘noise’ factor in UGC remains unabated. The somewhat Utopian vision — promoted by some when YouTube, UStream and others were in their infancy — that there would emerge a uniform way to manage, cleanse and tag UGC to control for noise never materialized. Our foray into Location-Based Services (LBS) a few years back, chronicled in a prior post about a GPS-enabled tour development and delivery platform company, was a good primer for us on the enormous potential and pitfalls of User Generated Content. LBS and UGC seemed a natural marriage to us then and is certainly a “hot” play now given the recent Gowalla and Foursquare funding announcements.

Weaving content into GPS waypoints and then embedding bits of information provided by users to those waypoints made a lot of sense. Our initial thinking was that licensed content — namely, content we’d get from tour book publishers — would provide the necessary backbone so that users would get a uniform, quality experience; over time, however, UGC was expected to dominate. In truth, that hasn’t occurred. The UGC contributions were almost unmanageable. The development team quickly learned that the amount of time required to cleanse it almost negated the benefits of incorporating it. The net result was that the UGC piece has been de-emphasized on the company’s product roadmap. Now, content available through the tour delivery platform will be primarily reliant upon licensed content. To be fair, the source of this content will go downmarket so that, over time, the company will become less dependent on the more expensive content from the travelogue publishers and more reliant upon small, local tour companies going after a more custom, hyperlocal experience.

Still too many competing interests/axes to grind. In addition to the usual spam, quality issues and overall noise with UGC, we were troubled by how common it was to find people using UGC to settle petty scores, rivalries or just to cause mischief.  In recent reporting on the Google/Yelp talks, there is a sobering itemization of the number of lawsuits filed against Yelp from irate merchants and others who feel they were unfairly maligned by anonymous posters on the site. Also a common problem was instances when, say, a restaurant would receive a scathing review only to uncover later through an investigation that the poster was the owner of a competitor restaurant across the street.

Conceptually, I have long been suspicious of sites that provide posters a forum to anonymously bash a restaurant, retail store or service provider without requiring anything from the poster in terms of supporting documentation. Ratings are fine and they have value, to be sure, but abuse has now become rampant on so many UGC-driven review and rating sites. Ask virtually any restaurant manager or small business owner about Yelp or a similar site and it seems they all have a story about an unfair review that they had no way of properly defusing, defending or responding to. One bad review can seriously damage a small business; however, a bad review that is also of questionable merit or is an out-and-out mischaracterization is altogether more disturbing.

Gaming the system. Almost as bad as unfairly maligning a business is the epidemic of hoaxes or “ghost” reviews, usually of the glowing variety, that so often pepper the ratings of certain businesses and skew rating scores to the point that they become meaningless. Stories have become legendary of business owners writing their own rave reviews and, in some cases, forcing their employees to offer their own effusive praise. Yelp and other rating/review sites insist that they are working diligently to address these issues and I have no reason to doubt their sincerity, but clearly this is a big problem.

To be sure, UGC is powerful and will ultimately drive a lot of successful consumer internet businesses going forward. That said, is it no longer the can’t-miss buzzword in an investor pitch. Consumers want unvarnished candid comments and feedback — whether they are restaurant reviews or travel tips — but even more than that they want to have confidence in that information and a consistent experience. With the exception of a few companies that have been able to selectively weave UGC into their business models and maintain that consistent, reliable product, most companies still fall far short of delivering that experience.

The Rise of the Pledge Fund

19 May

Angel investing has existed since the very beginning of what we consider the modern age of venture capital. Indeed, long before there ever was much of a venture capital community, loose groups of semi-retired execs assembled regularly to discuss interesting young technology companies to fund. Routinely, there would be a “passing of the hat,”  some cursory discussion of deal terms and, whammo, a seed investment would be made. Colorful stories of just such seat-of-the-pants financings of companies that later became tech industry juggernauts are now the stuff of venture capital legend.

Since the “institutionalization” of venture capital, beginning in the 1970s, angel investing has evolved quite dramatically. Sure, there will always be wealthy uncles and trusting friends willing to back energetic young entrepreneurs with intriguing business ideas, but finding strangers willing to do so out of their own pocket has become increasingly challenging. Indications are that it will become only more difficult as many “angels” have found themselves squeezed out of many opportunities and the prospect of backing companies in general increasingly fraught with risk and uncertainty.

To be sure, true angel investing is tough to do – and even tougher to do well.  For this reason, even many successful retired venture capitalists steer clear of angel deals. The reasons for this are many. For one thing, it is not often that an investment comes along that matches one’s direct domain expertise, skillset, and network of contacts. As such, many angels get into the dicey business of investing out of one’s comfort zone and away from a relevant knowledge base that can actually help the company. This is fine when things are going well, but when things hit rough patches many angels find themselves unable to really be of much assistance. This can be enormously frustrating for both the angel investor and the company experiencing troubles and needing sound guidance from its investors.

But this is just the tip of the iceberg when it comes to the challenges of being a good, successful angel investor. For every Andy Bechtolsheim or Ron Conway there are a thousand well-meaning angels who made their money in shopping centers or tanning salons only to lose a chunk of it backing technology or life sciences ventures where they had no expertise or understanding of what was really going on at the companies.

However, even with the risks, prospective angels understand that participating in early stage deals can bring staggering rewards for those fortunate enough to come in on the next Google, Skype or YouTube. And thank goodness for that, because angels provide a critical and increasingly valuable service to the venture and start-up community. As venture capital fund sizes have generally increased in recent years, many venture firms have moved upstream into more developed opportunities where more capital can be deployed and where the classic early stage risks can be somewhat mitigated. The result of this has been a dwindling universe of investors that still specialize in truly raw, early stage opportunities. 

For years, the options available to individual investors determined to participate in venture were not terribly attractive. Option one: Become a limited partner (LP) in a top-performing venture capital fund. Sounds good, but in truth many venture funds have increased their average fund sizes dramatically in recent years and, as a consequence, have focused almost exclusively on big institutional investors (endowments, pension funds, etc) to make up their LP base. In many cases, individual investors need not apply — unless, of course, you were in that particular VC firm’s last few funds and have an established relationship with the partnership. Secondly, the need for a venture capital firm to openly solicit funds outside a narrow group of previous limited partners is proportionate to an extent with how successful it has been historically. In short, the more successful and renown the firm the less it probably requires or wants your investment commitment (again, unless you are already a known quantity with that fund and there is a relationship already.)

Option two: Become an angel investor. For reasons cited earlier, this is tough. Even with a technical background and some operating or investing experience, how does a prospective angel begin to create deal flow? How will entrepreneurs of promising companies even find the angel or learn that he or she is interested in making early stage investments? Of course, the prospective angel can try to join a prominent angel fund to gain access to their deal flow, but such groups are often very exclusive, require one to go through a lengthy and competitive membership process that can take months, and are often closed to new members for years at a time.

Now, fortunately, something of a third option which can mitigate some of the inherent risks in angel investing has begun to emerge. Enter the Pledge Fund.

What is a Pledge Fund?

A Pledge Fund is essentially a non-committed venture capital fund, or a fundless VC firm if you will, that operates as a bit of a cross between a traditional venture firm and a loose confederation of individual angels making early stage investments together. The logic is fairly simple: take the best elements of both structures to create a model that enables individual parties to make angel investments in a standardized, formalized way that eliminates many of the traditional pitfalls of angel investing on one’s own.

How it works:

The Pledge Fund is typically run by experienced angels or former (or even current) VCs. These individuals constitute the “GPs”, as it were, of the fund. The GPs handle all of the admin functions of the fund much as one would expect at a traditional venture firm: outreach to the entrepreneurial community; sourcing, vetting and presenting deals to the Pledge Fund’s “investors” (often called “Members” — more on that later); handling term sheet negotiations; drafting documents; and handling post-investment support by means of sitting on company boards, etc.

This GP management layer, if you will, is critical because individual angels are just not set up to handle most of these functions. Even assuming an individual angel can find good deals (and that’s a big assumption), will that person even be able to properly evaluate it? Will he recognize the flaws? Can he properly size up the team and do thorough due diligence on the technology? on the market? Would he have access to broad groups of experts in various fields to help him vett the opportunity and the management team? Even after an investment is made, will the angel sit on the company’s board and, if so, can he really expect to make much of a contribution?

A good venture firm performs most, if not all, of these management, deal-making, and post-deal support functions. So, in a sense, a Pledge Fund does much the same thing on behalf of the angels. The key difference is that, unlike in a traditional venture fund, the Pledge Fund does not operate a blind pool of capital from which to invest in deals. The Pledge Fund can only source, vett, and scrub deals for its members. It is the members that ultimately determine what deals they participate in. Traditional venture capital firms, by contrast, typically offer their limited partners little to no say in what deals the fund invests in and in overall day-to-day firm operations.

On becoming a Member:

Most Pledge Funds have a straightforward process to gain admission to the organization. There are usually some questionnaires to complete and accreditation requirements to meet, but they are far less onerous than one would expect at many venture funds. Once admitted as a Member, the only commitment is a small annual management fee (usually to cover overhead and ancillary fund expenses) We’ve heard management fees in the $5k-$10k/year range. The thinking behind the fee is not so much to be a revenue generator as much as a way to cover basic costs and to weed out people who are not serious about actually making seed stage investments. The logic goes that if a prospective angel is considering $100k-250k in angel investments over the next couple years, paying $5-10k a year to see scrubbed and vetted deals should not present an issue; if it does, then the investor was probably not serious to begin with.

This management fee permits the Member to gain access to the Pledge Fund’s deal flow but does not commit him in any other way. Each month, the Pledge Fund’s deal review committee scrubs all that month’s deal submissions, meets with the most promising companies, conducts a preliminary due diligence process, and selects the top 3-5 deals. Those deals are then scrubbed again, executive summaries in the Pledge Fund’s standardized format are prepared, and the deals are submitted to the Members.

Members are then given a fairly narrow window (we’ve heard a few days, some as long as a week) to review the deal submissions and respond back to the Pledge Fund GPs about which deals, if any, they are most interested in. In short order, the Pledge Fund GPs can determine what syndicate, if any, they can pull together among their Members to make an investment.  If it can, then deeper diligence is commenced, the Pledge Fund’s attorneys are summoned to draft deal documents, and things move apace at that point.

Once an investment is made, another interesting twist occurs. In the past, angel deals sometimes suffered from a bit of a stigma within the venture community. Venture investors looking at an investment that was previously seeded by angels sometimes grew concerned that they might be inheriting unsophisticated investors on the board and/or otherwise involved with the company that could potentially cause problems down the road. Stories of neophyte “friends and family” investors throwing up roadblocks or being obstructionist when a professional investor got involved are fairly common in the venture community. For this reason, some venture investors are leery of angel deals unless the angel group is already well-known and respected within the venture community.

To get around this problem most Pledge Funds structure the investment by creating a separate limited partnership entity to make the investment into that specific company. The Pledge Fund’s Members are then LPs in that new entity that, in turn, makes the actual investment. The impact of this is two-fold: (1) for the purposes of the Capitalization Table, there will not be a list of every Tom, Dick and Harry angel investor and their individual investments; there will only be a listing of the Pledge Fund’s name and the name/number of the LP — i.e. Acme Pledge Partners, Fund I, etc. That keeps the Cap Table pretty clean; (2) If a board seat is part of the investment terms, then a member of the Pledge Fund’s GP group will take that board seat. Since the Pledge Fund’s GP group is often made up of former VCs or well-known angels, there is less concern from professional investors that the member representing the angels will be unsophisticated and/or obstructionist.

Obviously, it’s still early days for this new form of Pledge Fund and it will be some time yet before we can opine on whether this model will become commonplace in the venture community. That said, we have seen versions of this in the past and always found it intriguing for the reasons cited here. It appears that, at least in this current iteration, this modern Pledge Fund approach is presenting a well-constructed and well-reasoned model for those individuals interested in early stage investing while mitigating many of the classic pitfalls long associated with the practice.

[Updated Note: In light of the response to this post, readers interested in learning more about Pledge Funds and/or interested in being put in touch with funds pursuing this strategy are asked to contact me directly at jtower(at)citroncapital(dot)com for more information.]

Microsoft to acquire Yahoo for $44.6B

1 Feb

The truly pedantic among us will notice that the above headline is loaded with pre-supposition. I intentionally did not write “MSFT offers…” or “MSFT intends..” for the simple reason that this is one of those rare deals that must happen — for both parties. Google continues to grow market share and that growth continues to come directly at the expense of YHOO and MSFT. Furthermore, for Jerry Yang to spurn such an offer (at a 62% premium to the slumping YHOO stock, mind you) would all but guarantee a storming of the Bastille by irate shareholders. Put simply, Yahoo is out of options and must take the Microsoft offer. Yang’s much bally-hooed return last summer as CEO has been less than stellar and the turnaround he put in place has, for all intents and purposes, been a flop. The company is floundering, the stock closed yesterday at a four-year low, and the tech giant’s very own raison d’etre is now clearly being called into question in the shadow of the Google juggernaut.

There will be endless navel gazing in the coming days and weeks on the merits, long-term prospects, and challenges of this acquisition. So, here’s my rundown, in no particular order, of the implications and imperatives of the Microsoft-Yahoo combination:

1. This is good for M&A, (with some caveats): The $44.6B MSFT offer is by far the largest in the Redmond-based company’s 30+year history and dwarfs last year’s $6B aQuantive acquisition. If history is any gauge, this will likely usher in a boomlet in search-related M&A. Watch for a flurry of relatively small acquisitions as Google and others snap up small search players as they wage war in the burgeoning areas of persistant search, vertical search, social search and the old-fashioned ‘my algorithm can beat up your algorithm’ variety.

Furthermore, the psychological effect of such a large acquisition will do much towards loosening the purse-strings at several major tech players — particularly those sitting on mountains of cash — and providing political cover to pay up for accretive, high-profile deals.

The negative aspects of this deal for the purposes of M&A is, of course, obvious. Yahoo was a famed member of the GYM (Google-Yahoo-Microsoft) Contingent – a trinity of tech buyers responsible for a lot of exits of venture-backed companies in recent years — particularly important given the sluggish IPO window.  That ready buyer will now be out of the market — hunkered down managing the tremendous merger integration complexities of a Microsoft acquisition.

2. Google continues to lap the field. The naysayers will certainly dredge up the old ‘Barbarians at the Gate’ quote about how putting together two sick puppies will only result in one really big, sick dog–not the show pony everyone hoped for. There are plenty of examples of that in technology M&A annals, to be sure. That said, MSFT has been trying to buy Yahoo for years. As recently as a year ago, Ballmer & Co. made the overture to then-CEO Terry Semel, only to be rebuffed. The situation for both MSFT and YHOO in search has only deteriorated further. Ballmer now realizes, rightfully so, that if MSFT has any real hope of catching up with Google, the time for that is now! According to current search pageview data, the combined MicroHoo would barely account for half of Google’s share. If Google continues to grow at its current rate — and there is everything to suggest that it will — then any more delay and Google would effectively be unstoppable.

3. With YHOO, MSFT continues its needed transformation. Yes, YHOO needs this deal, but so, too, does MSFT…badly. (MSN China anyone?). Cynics will say it has grown a bit lazy and self-satisfied as it has earned mountains of cash from its operating system near-monopoly and premium desktop applications lo these many years. However, as Office has come under increasing attack from Google, Sun and others offering Web-based apps, MSFT is having to pivot quickly to adjust to a rapidly approaching world where operating systems and desktop applications are becoming commoditized and, dare I say it, increasingly redundant. The cloud computing revolution underway only underscores that threat to Microsoft. The Redmond-based giant has been accused of being many things, but one thing it is decidedly not is stupid. MSFT can execute better than almost anyone. Ballmer and Co. see the writing on the wall and have determined that if their core businesses are going to become marginalized and cannibalized in the coming years, they would prefer to be one the ones to do it themselves. 

4. This is good for Google, too. Honest. Forget that GOOG stock fell out of bed this morning. Much of that had to do with a retrenchment beginning last night following earnings that disappointed Wall Street analysts. The MSFT/YHOO deal, even under the best of circumstances, will take at least a year of back-and-forth negotiations, personnel re-assignments and merger integration planning. The consequence for Google will be a huge management distraction for two of its largest chief rivals in the tech world. The world is still Google’s oyster…and now there is no one else at the table with them while they gorge themselves; at least not for the next year or so.

5. No other bidders. Despite the fun drama this would create for all of us who enjoy watching these events unfold, I am not holding out much hope that a Rupert Murdoch will swoop in with a bigger offer to top Microsoft’s. Moreoever, the sheer size of this deal and the creakiness of the debt markets makes a financial buyer-driven deal a relative non-starter. So, don’t expect to see any PE guys throwing their hats in the ring. Furthermore, thoughts that Google might want to play spoiler or muckracker with its own offer for YHOO are likely to be wishful thinking. Infectious Greed’s Paul Kedrosky and others make some good points on this, but I am not persuaded. Hell, Google can’t even sort out what to do about Doubleclick, and don’t get me started on the anti-trust issues a GOOG/YHOO combination would raise. Nope, Microsoft will play this one alone. It’s a very generous offer, it needs to be given the time and consideration it deserves, and — at the end of the day — it needs to get consummated.

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