Brace for Impact

Those of us who have been in Silicon Valley for few years now have been through bombastic highs and lows which seem, frankly, far from the lows of this blogger’s humble beginnings. Yet despite our roots in paranoia there’s been a certain feeling of invincibility in the face of difficult odds which typifies the Silicon Valley entrepreneur. That’s worth remembering as business cycle gravity takes hold and we head into an era of far slower growth and possibly contraction. It’s also worth looking a hard look at the tactics which will increase survivability in tough times, even as the balance of power has tipped heavily from entrepreneur to investor in the span of two weeks.

The Only Thing We Have to Fear is Fear Itself

Sensibly, some investors have been quietly coaching their investees on strategies to come out of the economic black hole. It;s understandable, as this downturn is different than most since mortgage equity withdrawal is no longer fueling domestic consumption. Sequoia Capital’s downturn strategy presentation to its funded entrepreneurs has leaked out and added to dread. Oh and the first slide doesn’t help:

Sequoia Capital on startups and the economic downturn

View SlideShare presentation or Upload your own. (tags: depression recession)

Startup angel investor/advisor Dave McClure “smacked-down” doomsayers, calling on them to persevere like the fictional desert-dweller Muad’dib. In Dave’s words:

the companies and people i bet on HAVE to be both optimistic & opportunistic, if only because THE ODDS AGAINST STARTUPS SUCK ***ALL*** THE TIME, not just in downturns.  you damn well *better* have a positive attitude, or you’re just never going to get out of bed in the morning.

The messenger is overpowering the message a bit here, but he’s essentially correct. Ramen-profitable businesses are best poised for long term success and high cash-burn businesses aren’t, irrespective of the general economic climate. Besides, a number of macroeconomic factors are in our favor here. To see why, let’s take a stroll down ancient history. The last time panic set in here was in in 2000-2003, where highly leveraged debt crushed a number of startups who tanked when the interest payments began to far outpace revenues. We’re talking 9:1 debt/equity ratios here in some cases – not pretty.

The Force is With You, Young Jedi

Nothing like this exists in the post-Web 1.0 world, where capital requirements for startups are a fraction of the massive costs incurred laying down fiber optic cable to found the original web. How many Web 2.0 startups burn through 300 million in a few months? None, and that’s the point. Web 2.0 startups have a far quicker time to utility and require far less capital and hence are imbued with a lower burn rate right out of the gate because of lower financing costs. The best visual I’ve seen of the differences between Web 1.0 and 2.0 startups was in Amy Shuen’s book, which I’ve semi-plagiarized below..

Visual Representation of Web 1.0 v Web 2.0 Profitability Over Time (x axis)

The most successful founders I’ve met are far more MacGwyver or Luke Skywalker than Jack Welch, and the evaporating time to revenue driving Web 2.0 startups make it easier than ever to be a entrepreneurial Jedi. It’s never been easy, but has never been easier than now.

Tactical Maneuvers

This blog tends to focus on ideas and possibilities, mostly because that’s what I enjoy reading and speaking about. However, bracing for a slowdown tends to make such talk seem a bit trite. So while others have made lists of things you can do right now to depression-proof your startup, it might be worth adding a brief list of things I’m observing from the fault lines. Here’s what entrepreneurs I know personally are doing now to weather the economic storm:

1. They’re Communicating. Our CEO assembled the team to address the economic crisis as the full brunt of reality hit Wall Street. The message? We’re a software as a service company, and positioned for success when potential clients are looking to outsource to lower burn rate. He asked us to filter out the noise and focus on executing. Have you done the same? If you haven’t, let me assure you your team isn’t focused on executing right now – they’re focused on what they will do if they lose their jobs. Speaking of which..

2. They’re Dumping Mr. Milquetoast. This one is uncomfortable to speak about, and I’m not suggesting that layoffs is to be taken lightly. Having said that, a highly motivated, smart teammate is worth many average ones. We’re likely to see a few more announcements like the one made by Loic LeMeur in the new few weeks. Which leads me to the next point..

3. They’re Investing in the Core Team. This is always a good thing to do, regardless of the macroeconomic circumstances. Calancais dropped this nugget of common sense in his post:  “Invest in training and education of your top people, because they are the ones who will lead your company through this mess.” Besides, there’s inherent risk mitigation in a slowdown anyway – the top people you train are less likely in a recession or depression to jump ship, giving you a longer investment horizon.

3. They’re Finding a Revenue Stream and Hanging on For Dear Life. The expression “cash is king” is truer now than ever. A few startups I’m familiar with have changed strategic direction in a matter of a day or two to  generate cash flows. No joke. Every startup I’m familiar with is also making a list of their top 10 customers (by cash flow of course), and is calling on them all the time to make sure they won’t leave. Bonus points for developing new revenue streams from clients who are already reliable about paying you.

4. They’re Forgetting Seed Capital. Seed and early stage capital are the first to dry up going into a down cycle. Every time. There are two reasons why. The first is that investors who are currently long on a few startups are going to try to nurse those startups that much more to mitigate their risk. That is, they’ll spend a whole lot more time with their current portfolio and forget acquiring new startups. The sceond reason has to do with business cycles and value investing. Simply put, if you think spending will rise in the macro economy, it makes sense to invest early in promising startups to get in on the growth for a bargain price. That dynamic works in reverse going into a downturn. For more reading, hit up Fred Wilson’s “Startup Depression” post. In short, bootstrap if you can, or fund your new venture out of current services you’re providing. Now would be a great time to turn your consulting project into a product.

5. They’re Taking Root. It might be tempting to pull out of the domestic market and try to jump into China, but hold on before you do. The Chinese haven’t focused on building up domestic consumer markets fast enough to head off the U.S. slowdown – which they should have seen coming when American consumers began cannibalizing home equity to support unsustainable consumption. Driving growth through an addiction to US Dollars will now start to stress newly minted graduates who will have a tougher time finding work when the Dollars stop flowing (it was already tough for many of them, by the way). Paul Denlinger has more analysis here. For good measure, I’ll mention the Euro region isn’t going to fare much better.

6. They’re Renegotiating Everything. Try to negotiate with your credit line suppliers to give yourself some extra breathing room (it’s unlikely, but worth trying). Renegotiate with your every supplier provider and insist they reduce prices or you’ll leave them. More often than not, it will work – remember #3 on this list?

7. They’re Preparing to Feed off the Dying. An item that caught my eye from Jason’s “10 Things to Do Right Now” is this little quip:

Make a list of every Web 2.0 startup to raise an A or B round and cross 80% of them off the list, because they will not make it to their next round of funding or profitability.

Every single startup CEO or GM I’ve spoken with has told me he or she is targeting the “walking dead” amongst their competitors and are preparing to strike at their customer list.

8. They’re Connecting with Others. Here’s some additional reading material to get your business geared up for the coming downturn. If you can contribute, get involved in the discussion!

The Startup Depression

VC Fred Wilson’s Thoughts

What Startups Can Learn from Sequoia

15 Ways to Cut Your Home Budget by Mukund

The Economist Magazine’s background on the downturn

The Measurable Impact Web

Like many of you reading this blog, I too have the attention span of your average hummingbird.  The funny part my ADD-ness has become more acute over the last year or two, and I’ve discovered an odd side effect to it. Rather than sit in a zen state just thinking for an extended period of time, I tend to think in a packet-like state. That is, I tend to process information, then come back to it later and pick up where I left off last whenever I have a spare moment. This happens over and over again until I have completed “processing”, which is usually where I begin blogging. Like Susan Wu at CRV, I’m pretty bad about opening up my thought process and I usually blog about fully baked thinking, but I’m going to step out of my comfort zone here.

I Confess…

So, I’ve been mulling a confession for the past 2-3 months. Here it is: like Fred Wilson, I’ve grown restless with Web 2.0 startups. Now, Fred is a smart fellow with a high signal to noise ratio, but he’s bored for a different reason than I. He basically wants to change the world and feels Web 2.0 is not world changing. you can’t blame him, considering Supernova and TED have been all about energy and microfinance of late. I’m with you Fredster, but I’m bored because I believe the web is world changing but I’m not seeing jaw dropping innovation (or revenue for that matter). But this isn’t about Fred – his posts tend to spawn more than a few copycat blog posts anyway. Nor is this about me. It’s about what’s next in connecting us all.

Exhibit A

Case in point (and one of two catalysts for this post): Yammer wins the TechCrunch 50 competition. Now, we’ve been using Yammer internally for our company with some success, but frankly Yammer is more evolutionary than revolutionary. Most of us are still using Twitter and email primarily and no adoption methodology is in place. This isn’t a hate fest on Yammer, by the way, which is a good product with a real business model (where for art thou Twitter??). But the Yammer nod seems a bit of smarmy protest vote for the oft-errorprone microblog default Twitter, who’s been giving us the big fail whale far less of late. Also, Twhirl, the social software front end client, now supports any laconi.ca installation. In plain English, this  means that any company can set up their own microblog and allow employees to send messages in one interface to the public Twitter and the private company microblog (Loic LeMeur, you are one uber-smart Frenchman). Let’s put this in big-picture-principle perspective: will Yammer earn even a footnote in a historian’s texts 100 years from now?

Exhibit B

I mentioned there were two catalysts for this post. The second was my chat with James, biz development dude for BigWorld games, who has developed a platform for massive multiplayer online games (MMOs) development. They’re doing some cool things with gaming performance which I won’t delve into here, but one of the things I will mention is they’ve extended the mashups idea into the virtual worlds space. Consider a gaming character interacting with an e-commerce site within a virtual world (sort of a virtual mall)..

Interacting with the Web in a Virtual Environment

Now consider a mashup with micro finance site Kiva, allowing small business owners in Bangladesh give investors in New York a virtual tour of their operation. Last stop: an in-world Kiva website where would-be investors can sign up. Another application: video gamers can get involved with each other via the web within a virtual world – and voila, instant e-commerce among players. Remember the old wild west days of Yahoo storefronts selling everything from lawn gnomes to dog biscuits? Lifting the poor out of poverty is going to be easier with virtual items – there’s virtually zero capital costs other than time involved, which the poorest unemployed have plenty of.

Where We Need to Go From Here

We need to start talking about measurable impact.

Not some hypothetical “ideas are currency” talk, but real quantifiable results. Once we do, we’ll start seeing Web 2.0 copycats merge just like the American automobile industry went from about 10 players to 3 from 1910 to 1940, since the network effect requires will natrually shrink the number of platforms out there. One great example of putting social tools to work to product measurable impact is Carticipate, which is pragmatic and location-aware way to combat high gas prices. Nothing sexy, fun, or lofty here. Just people reducing gas costs and carbon emissions to boot. Impact: less traffic, less money thrown at ExxonMobile,  and more money socked away for Christmas gifts.

If you’re not sure where to begin, here’s a few questions to get started:

• “How can social interactions lift the poor out of poverty? The Chinese have been turning World of Warcraft items into real dollars for years now. How do others in poverty enter the market without introducing so much competition that incomes collapse (ie supply far outweighs demand)?”
• “How can microblog-accelerated serendipity create revenue-driving partnerships between entrepreneurs in 3rd world regions with otherwise poor connectivity?” (related thought by Marc Hustved here).
• “How can we create a revenue stream from creating synergy between traditionally unrelated markets?” An example: Wall Street discovered a while back that engineers’ heat diffusion equations are surprisingly good formulas for stock option pricing. That’s what created the options trading market we have today.

That’s just for starters. Yes, I’m working on one of the above. No, I’m not dropping any hints here, but I might leak some of it if you and I strike up an interesting chat here.

How Not to Inhibit Mitosis: A Spore Case Study

I started to blog about things I’ve learned from the recent fiasco with Electronic Arts’ release of Spore, only to find the post started to look less like a timeline of events and learnings and more like a case study. So I figured I might as well try my hand at writing one…

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From Cheers to Jeers

As Tim reached over to pick up his ringing mobile phone, a quick glance at the caller ID info was all he needed to see. He had seen the reviews of Mark’s new production, and he knew exactly where to begin the conversation. “So, just how bad is it Mark?”, he spoke as he picked up the call. “I feel like I’m on one of those free-fall amusement park rides” replied Mark, not missing a beat.  “I mean, what the heck is wrong with these fickle gamers – they better damn well understand we’re a business!”

Mark and Tim had been close friends since they bunked together in college, and often bounced ideas off one another. Now Mark needed someone to talk to as customers reacted overwhelmingly negative to his newest game release. As senior producer of the much anticipated game Spore, he was responsible for distribution of the most talked-about project in the gaming market all year. Mark worked for game publisher Electronic Arts (“EA”), who placed high hopes to extend a rebound from lackluster Q4 2008 results, after reporting a 400 million increase in sales in Q1 2009. There was still the nagging issue of a net loss for Q1 2009, but EA expected as high as an 80% margin on Spore, in an industry where 30% margins are more the norm.

Spore was also poised to capitalize off the two hottest trends in the market. Gameplay involved the creation of an alien species, which a player must guide through stages of evolution and social development – from single cell organism to complex society. Some called Spore a “god simulation”. The game concept lends itself to user generated content, which was accepted as a “must have” feature for any successful release. Spore also capitalized off the concept of Internet play, which had been the driver behind more than 50% of EA’s Q1 revenue increase. Players would be free to create a species and upload their creations to share with friends. Will Wright, the creator of Spore felt that the nexus of rich user-generated worlds which were sharable on the internet would lead to the next big hit. Most industry observers lauded the direction he’d taken.

High Expectations

Mark and his team carefully tied a limited release to the July 14th E3 show in Los Angeles; one of the big showcase events the industry. While Mark figured he would have to compete for attention share with other game titles debuting at the show, he knew no one has the kind of buzz Spore had going in. The Spore trailer debut at the show was welcomed with thunderous applause and only heightened the feeling that he was on to something big.

Mark and lead designer Will also carefully devised a timed release of the game to better forecast how well received the game would be. The game came in two parts: the first was a creature creator, where players could construct the look of their aliens, and the second is the game itself, where players could interact with the creatures of their own design. The first part of the game was thus a barometer for the second (and main) release of the game. The results were over 1 million new player creations by mid June, and the top selling game for the month, more than doubling the number of games shipped by anyone else.

The Piracy Tradeoff

“I still don’t understand why the game release has gone sour, Mark..”. Mark let out an audible sigh and then began to speak in hushed tones. “We knew buyers would distribute copies to their friends, Tim”, said Mark, “so we had to put something in place which would prevent gamers from sharing their game copies with their friends. We originally had the game connect to our systems every ten days to perform a validity check. A game copy deemed illegal would alert us as well as shut down the game.”

“Hold on Mark”, Tim interrupted. “What about people who don’t have internet access?”

“Well, we had to nix the plan after we realized it would report back too many false positives. We figured it would also spike our customer service calls with angry customers if game players weren’t connected to the Internet. Instead we opted to have the game install a maximum of three times, after which the game would not install anymore.”

The Release Date Crash

Mark knew something was wrong as he began to read the numerous reviews on the morning of Spore’s launch. To his surprise, the reviews mostly talked about the anti-copy measures taken as opposed to the actual game content. It appeared as though many game players were in full revolt, and were either refusing to buy the game, or were actively trying to return the game title for a refund. One game critic website in particular caught Mark’s attention:

“No matter what people think about the actual game play, the story now centers around the DRM scheme EA built into the title, and a grassroots movement has begun to tell gamers just how bad the DRM sucks.

The method? Bombing the comments on Amazon.com. Right now the game has 222 customer reviews, with 194 of them giving the game one star (out of a possible 5).”

Mark quickly navigated over to internet retailer Amazon’s Spore webpage, where he found an overwhelmingly negative rating on the game, followed by scores of buyers and would-be buyers complaining about the anti-piracy measures. Mark knew carpet-bombing Amazon would be particularly nasty way of protesting the anti-piracy measures, since casual gamers who aren’t aware of the “protest” may not bother to read the content of the reviews and only assume the game isn’t very good. A quick call to his team confirmed his worst fears: early revenues were not shaping up as expected.

Mark turned back to the Amazon website Spore page and began to read through the reviews to try to understand the uprising. Two feedback posts in particular seemed to sum up the mood:

“I upgrade my computer often, and still play some old favorite games. I wouldn’t be able to do this with Spore unless I stop upgrading to newer computers. This is more of a resell to paying customers package.”

“This basically means that you are actually RENTING the game, instead of owning it. The game WILL stop to function in the future. That’s inevitable, because even if EA keeps the activation servers going, there IS going to be a time when EA will simply cease to exist because of financial issues or federal laws (like most businesses eventually do). “

Turning it Around

Mark was becoming increasingly irritated the more he thought about it. “We never intended for this to get in the way of legitimate buyers, Tim. All we want is to make sure is that everyone pays for what they use. What’s worse still is that copies of the game are out on the Internet anyway. What a catastrophe.”

Mark picks up a drink and takes a sip, beginning to speak again after an uncomfortable pause: “I expected complaining to come from would-be pirates, but this is just irritating.. it’s affecting our bottom line. It’s not unreasonable to want to install the game after buying a new computer, I guess, but gamers will just have to compromise.”

Tim cleared his throat and replied “Well, maybe that’s the point Mark. Customers hate to be told what they can and can’t do with things they buy. You’ll need to find a better way, because it looks like they’re not just voting with their wallets anymore.”

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The Day Our Economy Changed

One of the fundamental principles in  market economy is the risk-reward tradeoff – investors are free to take greater risks and win big or lose their shirts if the big payoff doesn’t happen. Today that axiom has been thrown to the wind in the U.S. mortgage markets with the nationalization er, I mean “conservatorship” of the nation’s largest mortgage backing institutions, placing effectively 6 billion of the nation’s 12 billion total real estate-backed holdings either in direct or indirect government holding.

Here’s a good discussion form CNBC which sums up the situation nicely:

You might be wondering why a blogger about startups, cleantech, and China is writing about the socialization of the mortgage market. The reason is this move will affect not only the value of the dollar (and hence the valuation of startup businesses to would be foreign investors), but also will contract the amount of credit available to new business owners.

As it stands, the current administration and White House have decided that bailing out homeowners assuming irresponsible levels of debt is unwise. I mostly concur, but I’m flummoxed that the congress and president don’t hold the inverse to be true. This nationalization move will bail out lenders assuming irresponsible levels of lending. The sham cover story to the American people will be something to the effect of “stabilizing Fannie Mae and Freddie Mac will cost taxpayers less because it will dampen the damage to our economy”. Rubbish, I say; the move will achieve the exact opposite effect. To see why, simply follow the process through to its conclusion. Nationalization of Freddie and Fannie will have to be followed specifically by a write off and pairing down of all outstanding debt held by both organizations (we wouldn’t want taxpayers to assume even higher risk). So we’ll rehabilitate the mortgage giants by shrinking the total amount of mortgages outstanding. That in turn will drop the valuations of current homeowners, who will be hard pressed to sell without deep discounting when the easy mortgage money is gone. That’s why commentators are calling this socialism for the rich: the only net effect of this is a direct transfer of funds to Fannie and Freddie supported by borrowing by the taxpayer.

I have a funny feeling I know where the borrowing will come from, at least in part. I suspect the Federal Reserve print out dollars as fast as possible to pump liquidity into an already over-stimulated credit market. Those dollars will eventually have to deflate in value accordingly, and houses will become even more expensive relative to the dollar. When houses sit on the market unsold, the discounting begins. And voila, we have both a devalued dollar and a devalued housing market – we’ll go from a sub-prime mortgage system to a sub-prime financial system.

We created this problem by pumping too much easy money into our economy to hold up an unsustainable growth rate, but markets of course correct themselves in time (this isn’t a downturn as much as it is a return to where we should have been). Unfortunately the current congress and president seem content to patch up the situation and pass the stink bomb to the next congress and president. We’re headed for a mortgage market contraction either way – the only difference here is that taxpayers assume the cost of investment risk, instead of the investors by bailing out Fannie and Freddie. All of this makes investment in start ups and innovators less attractive (and more expensive for entrepreneurs) if real estate is now a zero-risk proposition, and angel investors burned on asset holdings pull back.

Well, It’s a good thing Web 2.0 economics provides a pretty quick path to ramen profitability.

Update: Quint Cobb has a good play-by-play primer on the secondary mortgage market and why the cost of mortgages is about to go up for everyone, as well as some good investment principles to follow in the wake of everything that’s happening now.

Startup Camp Starts Up

It started as an idea blogged by two guys and turned into an awesome event at Palo Alto based Vysr, where nearly two dozen aspiring entrepreneurs showed up to share ideas, learn, and teach. Startup folks from as far as Australia unconferenced with bloggers, media folks, and angel investors and angel groups about a variety of topics, such as scaling on a dime, finding angel investors, and pitching a deal. We even had the pleasure of meeting a fifteen year old entrepreneur behind Teens in Tech. The most oft-recurring themes of course were bootstrapping (discussion lead by Mukund Mohan), and angel funding (discussion lead by MR Rangaswami of Sand Hill Partners, Guda of Vysr, and Mark Balabanian of Koders). Between participating in a few sessions, I managed to snap a few photos, which can be found here.

Since the majority of sessions and the preponderance of collective interest were focused around angel funding (post-seed), I put together a 14-point list of learnings for entrepreneurs looking to pitch angel investors:

1. Relationships are a discussion starter. Get to know people with personal relationships to angels, and approach angels through those people. M.R. notes he’s never funded anyone outside his network in 11 years of investing.

2. Mind the basics. M.R. and Mark look for a clear value proposition which stands out.

3. Lose the Hockey Stick. The market size looking big is unimportant, as everyone who pitches investors has a habit of putting up impressive looking “hockey stick” graphs of how the total market is set to explode. Everyone can project a big market – what those kinds of graphs do is make your audience cynical. Savvy pitchmeisters specifically talk about total addressable market rather than total market size, which is received as more realistic.

4. Parallelism. Make sure your personal resume supports what you’re looking to do – investors are investing more in people than in ideas, and they want to know you’re not new at what you want to do.

5. Chemistry. The personality and chemistry is important. An investor’s involvement doesn’t end at funding, and they will be looking for people they can comfortably work with over the next 3-4 years time. Investors will sometimes provide a helpful “kick in the rear” and are keen on people who respond positively and decisively to it.

6. Demonstrate incremental success. They will also look into whether the person makes his commitments over a 3-4 month cycle -about as long as it takes to fund a deal. Even a stray comment can be construed as a milestone. Many a pitch has been blown off by a ballyhooed “we’re about to close a deal with Facebook, etc” pitch which never came to pass. If you’re working on meeting a milestone, alert investors to it only after it’s a sure thing, which make it appear you’re executing effectively.

7. Develop your story slowly. This may sound inscrutable but MR and Mark advise sandbagging to some degree. Giddy entrepreneurs usually make the mistake of showing all their cards as quickly as possible. A more effective strategy is to develop the story during the close process to maintain investor interest in your idea. It’s also important to maintain consistency. If the investor feels like they are being pitched a plan to be followed with a backup plan, then they will get cold feet.

8. Quit your job. Investors will be skittish about funding a startup in which none of the founders are working it full time. Said differently, they are looking for entrepreneurs willing to dive into their ideas without reservations.

9. Teamwork beats heroes. All else being equal, a founding team with well segmented duties will be more attractive to a single founder. While single founders do get funded, an angel will likely inquire why an idea is likely to be fruitful if a founder can’t convince others to join him or her.

10. Keep it real. Investors wade through many pitches and will mentally discount hyperbole with nary a thought. Do not pitch divine inspiration or perfection -be open about weaknesses you’ve identified and have a plan to deal with them.

11. Align interest with involvement. Pitching an angel based solely on the numbers is hubris; there are simply too many unknowns. Make sure to pitch to investors who are interested in your market. For instance, if you’re starting up a social network for soccer fans, then find angels who are soccer fans.

12. Advisory boards. Advisory boards are effective leverage: you pay people in stock and benefit from influencers who will talk about your idea to everyone they know. Adding an adviser is also a great way to mitigate risk of disinterest – advisers who do not want to be involved are usually removed quietly, while board members can not be removed to easily. Mark specifically notes that an adviser who is proficient in marketing wizardry is particularly important, since founding teams are usually weak at promotional savvy.

13. You Have No Secrets. Every angel or VC talks to every single other angel and VC. There’s no secrecy here so you have to pitch the idea intelligently and make sure that you retain value.

14. Put Everything on Paper. Many an internal founder power struggle has doomed a startup to failure. Since clairvoyance isn ot part of the business plan, preparedness has to be. Investors will feel more comfortable with a founding team defining their core competencies and their ownership stakes on paper, along with vesting schedules to each founder providing incentives towards continuity. That last thing an investor wants to see if half the team bail with full vesting in hand shortly after funding.

Thanks again to everyone who came and made the event a success. I look forward to the next such event; we’re hoping to put another one together sometime after the summer. Please drop me a line or comment below if you’re game!

General and contact info on Startupcamp:

Wiki: http://barcamp.org/StartupLegalandFinanceBootcamp

Twitter stream: www.twitter.com/startupcamp

Email: startupcamppaloalto@gmail.com

Will the Real Venture Capitalists Please Stand Up?

One of the big inflection points (out of many) in any startup’s trajectory is of course series A funding. In speaking to a friend of late who is looking to get into the wacky world of startups, I’ve discovered there’s a perception gap regarding the role of VCs. The perception is that they seed-fund great ideas which someday become the next Google and so on. Some do, but in general this is about as grounded in reality as Santa Claus or the tooth fairy..

It’s worth looking at the heavy lifting in funding, and Don Dodge has done a lovely job of summarizing the data:

“The Center for Venture Research at UNH today released their annual Angel Capital report for 2007. Angels invested $26 Billion in 57,120 companies, up slightly from last year. The report says there are 258,200 active angel investors in the USA. By comparison, Venture Capitalists invested to $29.4B in 3,813 companies in 2007.”

So let’s see, deal ratio is near 20 to 1 with about 50-50 on total cash. So Angel Investors are the ones doing the biggest risk taking (as most people in silli valley know intuititvely). Said another way, VCs are outsourcing early stage investing to Angels. This is of course beyond the tactical scope of the barcamp style conference in Palo Alto on April 26th, 2008 called StartupLegalandFinancecamp (or “StartupCamp” for short). Still, any meaningful discussion of getting funded in 2008 will have a backdrop of credit crunch and real estate bubble burst. As individual investors, angels are invested in land and other credit- fueled investments (heck, everything in our economy seems to be credit-fueled). Many of them may have gotten pummeled on those investments – any angel who was invested in Bear Sterns may recoil at funding anything with those fresh wounds.

There’s another side to this. Sramana Mitra obviously feels this may reign in bloated valuations and gut check-writing. I’m inclined to agree (economics 101 here: misallocation of resources = FAIL). The concern of course is an over-correction. I figure most of what’s going on is a mixed blessing of sorts. According to Valley-watcher Tom Foremski, Jeff Nolan (a former venture capitalist now at Newsgator) says money moved away from VC funds and into hedge funds, but that’s reversing with the large institutional investors will be rebalancing their portfolios and pouring more money will come into VC funds. This might lead to the odd effect of increasing series-A funding while decreasing the amount of seed money spread around. Ever drive down a street with stoplights where the timing is of greens and reds is off, forcing you to stop at every intersection?

A few things seem certain. I’ll bet a significant amount of startup capital is going overseas, since the Euro, Yen, and Reminbi provide capital preservation over the free-falling Dollar. I’ll also bet that we’ll see a number of hot ventures jump out of this recession, just like the last. Recessions seem to do that.

The basics never change too. Investors will keep looking for a sustainable revenue model and a smart exit strategy, and entrepreneurs need to partner with investors for more than just their money. As Paul Kedrosky writes, “Today I had lunch with a smart, seasoned entrepreneur who told me about a 4-inch deal binder he had been forced to create for angel diligence. As I said to him: Run. Hide. Any angel who wants that much security in an early-stage deal is to be avoided like a banker.” Exactly Paul.

Update: Jeff Nolan of Newsgator has an editorial up on incrementalism he’s seeing in the funding market where he discusses how startups’ seed capital now is far below the minimal economically feasible VC threshold.

Bloggers Raising Money: Smart or Shortsighted?

There’s a wave of blog fundings going on, and with any new infusing of capital comes an infusion of discussion, rants, and general grab-assing. Here’s a quick summary plus the take of one guy (me) who was in the eye of the storm during the previous silicon valley funding bubble.

In 2006, a few blogging-as-a-business setups were out hunting for growth capital, but we were looking at a mere trickle of funding. That all changed in 2007: GigaOm took in a cool million, Xconomy and BlogHer funded at $3.5 million, and both Sugar and The Huffington Post hooked up $10 million a piece. Quick math – that’s almost $30 million there, and presumably since VCs are usually looking to cash in a 10x payout, that would place their expectations at $300 million.  For comparison’s sake, the venerable NY Times is sitting at about a 2.8 billion market cap.

Mike Arrington’s contention is that the blogosphere is more like a grade school playground where fist fights break out all the time, and he contends that blogs need to grow up. Oh, and the blogosphere is an ecosystem dependent on small and mid size players, and that the big blog funding will suck up all the talent, screwing up the ecosystem. Hence the “A list” should consolidate and take on the likes of Cnet. “Phooey” says Robert Scoble – no great accomplishment ever started with a mission statement stating “crush the other guy” (btw: note to Robert – we did in fact race to the moon to beat the Soviets, hence the term “space race”).

It makes sense to have content creators rise to the top, while ranters throwing stones in response to long forgotten insults sideline themselves, for sure. Here’s a pragmatic question though: who’s going to unite the dream team Mike? Did you have a specific blog in mind? Hmm. Anyway, who would subrogate their ego and become a cog in the 250? Unless there is a dearth of money and eyeballs, most of these bloggers will want to roll their own. It’s just like any other growth industry – a shakeout usually happens when the market potential comes close to “ripe”. Read between the lines, intrepid reader.

As for the blog ecosystem, the hope is that we’ll benefit from the infusion of new bloggers to link early and link often to counter the “giant sucking sound” as the brightest get bought up by the machine. I believe this will happen since blog adoption is likely to keep growing fast, but of course time will tell. The other point seems to be that most of these blogs will not live up to VC-optimistic revenue expectations, but come on – we know that’s by design. VCs are often lucky to have 1 in 10 investments become wildly successful and plan accordingly. Eventually rolling up many of the successful blogs into one or two big mega networks is eventually the endgame and VC involvement makes things pricey for the roller-upper. That’s the real rant.

Social Media Adoption – The BONG framework

A recruiter friend of mine getting into the social network and social media scene asked me what’s driving the uptake. There are a number of terrific blogs out there cheerleading the social media movement which have looked into this, and of note particularly is Marshall Kirkpatrick’s thoughtful post on common objections to social media adoption. Like Marshall, I’m not convinced persuading anyone to join the party is a fruitful exercise.

However, I do think watching out for conditions which may lead someone to adopt social media tools and spurring on adoption is helpful. I’m taking a queue here from Sun Tzu’s classic treatise – creating conditions for victory is imposible, but taking advantage of conditions for victory which present themselves leads to success. Watch out for these needs if you want an opportunity to introduce someone to social media tools, and carpe diem.

I’d argue people join social media to do one of four things:

Belong to a Group – Maybe your friends all joined myspace, so you did also. Maybe you joined Twitter to connect with people with the same interests, or perhaps because it gave you a direct line to speak asynchronously with people whose work you’ve come to value. Prime example: Facebook

Office chat/gossip participation – I’m talking about the watercooler chat effect taken online. We’re particularly primed for this kind of adoption considering all the M&A activity during the past few years, which creates coworking situations between distant geographic locations. Another driver is the rise of telecommuters. Prime example: Twitter.

Nature’s Call – This is my polite term for saying that a number of people sign on to social networks to find potential romantic parters. To put it more colloquially, people log on to get laid. It sounds funny, but I know at least two guys who signed on to Myspace and Facebook for that express reason. Prime example: Myspace.

Get a Job or Sale – Basically networking to advance one’s career objectives; to network with influencers to get hired, get a starup partner, or get a contract executed. Prime example: Linked in.

So there you have it.. the “Bong” framework. I can’t think of any drivers falling outside the four basic buckets outlined above. Can you?

Twitterpitch?

The subject line here could also be titled “What I, a sales/biz dev guy, think about Twitter’s market position”, but I’m going with a punchier title. I’m totally addicted to twitter, but I feel like there’s something missing here – what’s missing goes beyond the obvious scale issue everyone else is talking about.

Twitter has been a bit of a whipping boy lately on the social software circuit. Some choice samples:

Mike Arrington: “Twitter downtime on the upswing”

DA Howlett: “.. while Twitter has great utility, it could be so much more”

Jeremiah Owyang: “The cracks are starting to show”

Allen Stern: “Is Twiter F’ed?”

There’s even an open letter out there to twitter from Shel Israel. With all due respect to him, claims that tweeters are mostly talking about twitter and the chatter is not positive is quite overstated. That said, the trend is decidedly from twitterpraise to twittergripe.

But let’s put this in context – Twitter hasn’t had much competition since the Goog bought out Jaiku and basically put them in cryostasis. That’s changing, and fast. SAP is on the move. The Automattic team will likely capitalize off the wordpress community to build adoption of their Twitter-like tool. Other vendors are likely to follow as well.

Michael Porter’s five forces model is an instructive if aging benchmark to identify areas where any organization is competitively vulnerable. I would submit the following “back-of-the-envelope” analysis is instructive despite being MBA-ish:

Threat of Supplier Influence – Low. Twitter is on an OSS/RoR stack.

Intra-industry Rivals – Low. Rivals are fairly marginalized right now.

Threat of New Competitors -High. There’s quite a bit of interest in casual awareness of activity, which seems to be a key pillar of the social graph. I expect a whole lot of activity jumping in during 2008.

Threat of Substitutes – High. We’re already seeing a number of social graph players flirt with casual presence applications mixed with other core competencies. I expect more to follow with features like conversation threading.

Buyer Propensity to Switch – Medium. My take from geeks leaving Facebook in droves is that social graph users are fickle lot (I know I am). However it’s easier to port yourself than to port everyone you speak with, so I’ll call this an orange level threat.

What falls out of this analysis is that Twitter’s challenge ahead will be differentiating itself using something other than “We were first”. There’s more than just a business model or monetization model to consider. I’d be interested what your own napkin-analysis of Twitter is based on Porter’s Five Forces, and your takeaways from it.

Startup Camp?

One of the coolest things about working at Socialtext is the openness leadership has with the company as a whole. One example of this in action is the company face to face meeting, where our CEO drove a conversation about venture capital, appropriate goals for a VC backed startup, the implications for stock and stock option ownership. As I watched the room during the discussion, it struck me that this sort of continuing education is valuable in developing future leadership in an entrepreneurial society.

Enter Ross Mayfield’s blog post I read (and he composed) while present in the company face to face about what he calls “Stockcamp”. Since stock ownership is a key driver in silly valley, an unconference for startup stockholders would be a great idea. Extending it to include future startup leaders would be neat also, as there would be some neat synergy in getting together entrepreneurs and people who would work for them in hallway chatter. Three distinct topic areas off the top of my head (and typical questions) are:

Stock and Stock Options

What are the tax implications of stock option ownership?
When is the best time to exercise vested options?
What kinds of stock grants are typical for positions like mine?
What are the implications for foreign workers vesting options?
What are additional grants?

Funding

What’s the difference between angels and venture capital?
What should you look for in an angel?
What should you look for in a VC?
What funding rounds do companies usually go through, and why?
How do I mitigate friction between different investors?
What’s a term sheet and what does one look like?
VCs fund people they’ve worked with before – how do I break in?
What motivates angel and VC behavior?

Operations

How do I structure the organization?
What are common mistakes entrepreneurs make?
What kinds of partners should I look for?
What kinds of people should I hire?
How do I attract the right kinds of people?
How do I find and negotiate the best office space lease terms?
How can I leverage community to build product awareness?

There’s a startup camp happening in March in the UK already focused on entrepreneurs only which is a great idea. I’d like to see it extended to include a wider audience here in silicon valley. Would you join a StartupCamp? Are there any key areas of interest I missed? Please join the conversation below..