Non-Linear Growth

A glimpse around the next corner; mind the curves.

June 27, 2009 • 10:02 am 2

The future is in services

Last week, I attended GigaOm’s Structure ’09 Conference: Put Cloud Computing to Work. It was worthwhile to attend and I intend to return next year. It was exciting to see how the services business model is being rapidly adopted by the technology-delivery value-chain.

In a talk titled The Cloud in Context, Russ Daniels, VP and CTO of Cloud Services Strategy at HP put it most succinctly, describing HP’s vision as:

“Everything is a Service”.

Full video of Daniels’ talk here. While the “everything is a service” mantra is almost certainly overreaching, it drives home an undeniable point; the action is in services. To make it fully, I think you have to start with the view from the customer’s perspective. What the customer wants is functionality that helps them achieve a business objective delivered at a total cost of ownership that is less than the value they can extract from the functionality. Issues of security and control aside for a moment, the customer is mercenary about this and will adopt the delivery method that gives them the functionality they want with the best ROI. Said another way, customers are becoming delivery-model agnostic.

It is no wonder then that the operating model through which value is delivered to customers (whether enterprise, smb or consumer) is turning away from products and toward services. It is well documented that in many cases, the services model has an ROI advantage over the product model. At a macro level, I tend to frame the transformation technology markets are undergoing as one where products are turning into services.

Products turning into services

Consider the transformation taking place in each of the following areas:

Value Proposition Product Delivery Model Services Delivery Model
Application level functionality Shrink-wrapped Software Software as a Service
Data storage Hardware Storage as a Service
Computing power/Processing Web Servers Computing as a Service

In each case, the value proposition – once delivered to the customer in the form of a one-time sale/license product – can now be accessed by the customer through a CapEx light service. Customers are dropping the CapEx and OpEx associated with managing IT infrastructure for pure OpEx in the form of services.

An Investors View

While technology plays a key role in enabling the trend toward services, the trend itself is not fundamentally about technology. Rather, the opportunity offered by the cloud is a more efficient operating model; the service operating model. This creates a new layer to the technology value chain; the services layer. Any time a new layer is added to a value chain, new investment opportunities are created and pre-existing layers of the value chain are at risk. From a venture investor’s point of view, this forces a rethinking of investment approaches.

An ecosystem play

The new investment opportunities in the cloud go way beyond the traditional IaaS, PaaS, and SaaS layers of the stack, although there are opportunities within each of those categories. Each of these layers will require its own support ecosystem to achieve its full potential. These are often referred to as enablers. Enablers are interesting investment opportunities, because they enable the investor to play the momentum of a category. For example, an investment in a SaaS enabler that provides billing, operating support and other capabilities to SaaS developers is a play on the success of SaaS as a category as opposed to any one SaaS operator. If the category you “enable” fails, like the mobile virtual network operator category, your enabler will fail, like the mobile virtual network enablers failed. But if the category you are enabling is successful, the rising tide is likely to lift your boat too, so long as you have a valuable service.

Existing value chain is threatened

The emergence of the service layer is facilitated by massive improvements in networking, computing, storage and software, including virtualization. What is ironic is that the emergence of the services layer threatens the very same product vendors that have facilitated its development. In the product oriented technology value chain, product vendors (software, storage, computing) sold to end users; enterprises, small businesses and consumers. In a services oriented value chain, these same product vendors sell to the service providers (IaaS, PaaS, and SaaS). For an investor there are two implications. The first is that those product companies just lost access to the end customer, replaced by the relationship between the service provider and the customer. The second implication is less obvious, but more threatening. The services business is a business of economies of scale. It requires a significant up-front investment in service delivery infrastructure, but has very low margin costs for each new customer added. The result is that sub-scale service operators can’t compete; and the big get bigger. This tends to restult in a concentrated service provider market, consolidating buying power, which squeezes margins of  the suppliers to the service providers. Those of us who have roots in the services sectors understand this phenomenon quite well. We have a saying at Meritage about the communications equipment space that I’ve grown fond of; “there are too many vendors and not enough customers”. This is one of the many reasons we don’t invest in communications equipment, but we love the communications services landscape.

The point is, if I were a product company focused on selling software, storage, or computing, I’d be frightened right now because my sales model is going to change dramatically over the coming ten years and not in my favor. The “On the Shoulders of Giants” panel at Structure really drove this message home. The panel, moderated by Jonathan Heiliger of Facebook, included ops leaders from Microsoft, MySpace, Google, Yahoo! And LinkedIn. These guys push their vendors hard. Heck, Google designs its own hardware and considers it a competitive advantage. Product vendors can expect more of the same treatment with the emergence of big cloud services operators like Amazon, Salesforce.com and others.

It is no wonder then that every major product vendor, from SAP to EMC is stuck in a seemingly bipolar tug of war between their legacy product businesses and their emerging attempts to run services platforms. Unfortunately, the key success factors for running a product-oriented company don’t translate well into a services environment.

Implications for Venture Capital

Participants in the technology supply chain aren’t the only ones struggling with the implications of the cloud’s emergence. The venture community is as well. It turns out that investing in services businesses demands a different skillset and philosophy than investing in product companies.

Because most services businesses go to market with a recurring revenue business model, the economics of the business are much harder to evaluate and the profitability is back-end loaded. In a prior post, I wrote about The economics of on-demand services, which includes an evaluation of unit factors like ARPU, churn, service delivery costs, etc. This is sufficiently more complicated than the economics of hardware; sell a unit, collect the revenue and lock in your gross margin on the sale.

The net result is that services businesses can be quite capital intensive, even if the market responds well to the service. It is more capital efficient than was the case when you had to build your own network to deliver a service (think cable), but still more capital intensive than product investing. As a result, investing in services is not for the faint of heart. Early indicators of success that are so prevalent in the product world are harder to come identify, except with an expert eye. It takes a tremendous amount of patience and in some cases stubborn conviction to be successful in services investing.

The opportunity for investors in the cloud is real, but only for those with an appropriate long-term company building philosophy and a level of comfort with the services business model.

Filed under: Cloud, Conferences, Themes, Venture Capital, , , , , , ,

June 23, 2009 • 9:29 pm 0

Success has a thousand fathers, failure none

I just finished reading Jim Collins’ latest book; a short one titled How the Mighty Fall and Why Some Companies Never Give In. I’m a big fan of Collins’ writings, including his prior works, Built to Last and Good to Great. Both of the prior works focused on the light side of business; assessing the factors that contribute to a company’s success. As Collins’ points out, in How the Mighty Fall, he’s turned to the dark side; analyzing failure.

Analyzing failure is unfortunately prone to post-hoc analysis and revisionist history. As a result, Collins takes an empirical and analytical approach to the process. The companies Collins analyzes are necessarily large, public companies. Despite this, there are many key takeways from the book that are applicable to emerging growth companies; two of which I wanted to capture.

Takeaway 1: Pride Cometh Before the Fall

There is a great synergy between How the Mighty Fall and Collins’ prior works, in that failure is to some degree the mirror image of success. In Good to Great, Collins’ concludes that a single personality trait separates leaders of good companies from leaders of great companies; humility. It is no surprise then that the first “marker” of the impending decline of a great company is the replacement of “humility” with “hubris”. If your Company is growing and looks as if it will be successful, the right response is utter paranoia; of competition, of a shift in your market, of anything that can take your business off track. But most of all, you must be paranoid that hubris sets in and your team starts believing its own press. It is a surefire sign; perhaps the first sign; that your company is at risk.

Takeaway 2: The Fatal Wounds are Self-Inflicted

Decline can be reversed if caught early. Hubris can be re-replaced with the humility required for an organization to question assumptions, to come to grip with the harsh reality and with the persevering drive necessary to harness great market opportunities. But if caught, “hubris” leads to a series of bad decisions that are disconnected with the core mission of the organization. It is like an airline crash; rarely caused by a cataclysmic damage, but rather by a series of bad decisions (none of which is fatal in isolation) that compound on one another. This quote from Collins on the back cover of Why the Mighty Fall pretty much sums it up.

“Whether you prevail or fail, endure or die, depends more on what you do to yourself than on what the world does to you.”

There is no shortage of ways to fail. But to summarize Collins’ findings, the things companies do to themselves that cause them to fail include pursing growth that is undisciplined or that can’t be digested by the organization, increasing the risk profile of the business by pursuing non-core ventures, incessant restructuring and choosing to blame outside factors for failures rather than looking in the mirror. The nature of these items is noteworthy; as Collins points out, it is not complacency that kills most companies, but rather, doing too much. The good news is that the process of decline is not irreversible. So if you see hubris seeping into your emerging growth business and see your organization making decisions that are inconsistent with the organizations core, abiding values, return to your roots, look internally, assess the situation without panic and make sure you have the right people in the right seats to work your way out of it, slowly, methodically, surely. There will be no magic bullets.

Success has 1,000 fathers and failure none. But we can learn a lot from the mistakes of others. Better to learn that way than to learn by repeating others’ mistakes and wasting a lot of capital in the process.

Filed under: Books, , , ,

June 4, 2009 • 12:15 pm 2

Tearing apart the assumptions

The trials and tribulations of traditional media are well documented. For a humorous look at the issues, take a look at this parody video created by Terry Kawaja at GCA Savvian; it will make you laugh or cry, depending on what you do professionally. Despite the humor, it got me thinking about some pretty serious stuff; in particular a conversation I had with a senior strategy executive at a major newsprint operator a little over twelve months ago.

This executive – who is no longer with the company – worked on the digital side of the business and was conducting outreach to venture investors who had made digital media investments. His goal was to understand how venture investors would construct a frame for the problems faced by the newspaper industry. In the process of learning about the frame, he hoped to find a roadmap to solutions to the problems plaguing the sector.

Rather than give a rapid-fire answer, I began probing him with questions; I was trying to suss out the assumptions that a newspaper operator makes in running the business. It took about twenty minutes of back and forth to get to the core assumption: that the creation of content and the distribution and monetization of content are inextricably linked. If you think about it, this assumption pervades much of media. Newspapers, for example, created content and distributed it through a single local distribution channel; the print form of the paper. In the world of even 20 years ago, this was a fairly valid assumption. The logical consequence of this assumption is that newspaper operators built vertically integrated businesses, including writers, editorial, print production, distribution, and advertising sales. Success was dependent upon controlling all of these aspects of the business.

So what happens when an external force (like the Internet) tears apart a core assumption, completely invalidating it in the process? It depends on the implications of the assumption being invalidated. In this case, the Internet ripped apart the need for content creation to be vertically integrated with content distribution and monetization. Quality content wanted to be distributed and monetized through any means possible. Get the content to the user wherever they are. Whether that consumer is within the footprint of your local delivery boy or not was irrelevant.  Syndicate massively, break the content apart if you have to, turn over the monetization to those better suited to monetizing content this way. Likewise, the distribution side of the newspaper business should have wanted to bring the best content to the consumer, no matter who created it. Think personalization, verticalization, etc.

But what did you see newspapers do; well, they replicated their vertically integrated approach on the Internet; create a website, leverage the “strong” brand presence of the newspaper and off you go. Surprise, surprise, it didn’t work; because the assumption the strategy was built upon - a tight linkage between content creation, distribution and monetization – was slowly, but surely being torn apart.

So what is the lesson? Well, every venture investment is based on a set of assumptions. Given the pace of innovation and change in the technology, services and media landscape, and the five to seven years it takes to build a truly great company, every company is likely to face some external forces that invalidate core assumptions during the company building process. If the core assumptions don’t change, you are probably on to a hot-spot in the market where your value proposition is well aligned with a major, enduring problem. Run fast and hard. If a core assumption does change, watch out, question your assumptions, understand the implications and adjust fast. If you wait too long, you’ll make the same class of mistakes traditional media has made in coping with the Internet and as a consequence, your business may suffer the same fate.

Consequently, this is one of the reasons I look for entrepreneurs who are able to come to grips with the cold, hard truth and make adjustments. This in turn requires both humility and a high level of self awareness that enables deep introspection.

Filed under: Lessons Learned, Media

June 2, 2009 • 11:48 am 4

The economics of on-demand services

A post by Ben Kepes over at CloudAve got me thinking about the economics of on-demand services, so I thought I’d do a quick blog. On-demand services businesses come in all shapes and sizes. This is particularly true today with the emergence of SaaS, where the vendor diversity is staggering. Despite the diversity of services – ranging from traditional communications services (think voice, video and data) to highly verticalized SaaS applications (think point of sale applications for yoga studios) – the fundamental economic building blocks of these businesses are, for the most part, the same.

You wouldn’t know it though based on the business plans I review and the discussions I have with entrepreneurs. Generally speaking, the CEOs of traditional communications services businesses that I speak with have a much more mature understanding of the core economics of services businesses than most SaaS executives. I attribute this to the fact that most SaaS executives I see come out of the software space, not the “services” space. And in the services business, there are fundamental economic concepts that simply put, don’t exist in the software business. So if you are a SaaS, PaaS or any on-demand executive whose business plan gets far enough down the Meritage Funds pipeline to have a hard-core conversation about the business’ economic characteristics, here are the things I will want to talk about.

Customer Acquisition Costs: It all starts with acquiring a customer. What are the marketing channels you will use, online, direct, traditional, sales channels, etc.? In each of these channels, what is the fully-loaded cost for you to close and implement a new customer? Do you have hard implementation costs; equipment, installation, setup? If the answer is that you expect customers to find you, go back to the drawing board. You will spend money to acquire customers, particularly if you hope to scale in any meaningful way.

ARPU: ARPU (average revenue per unit) tells me a ton about your business; the first thing being what you think the appropriate unit of measure is for your go to market strategy. So what is a unit? In a communications model, it is typically a “subscriber”. In a SaaS model it might be a seat or in an enterprise or smb model it might be the enterprise as a whole or the smb. Point being, it really depends on the level at which you are selling and where the purchasing decision is made at your customer.  ARPU tells me how much revenue you can generate per month out of a customer as you define it.

Price Degradation: With ARPU in mind, I also want to know about how you expect the price of your service to degrade over time. My experience is that prices for services tend to go down, not up, because as a service moves into a mass market phase from an early adopter phase, the value proposition is naturally diluted. The benefits that accrue to the mass market for adopting your service are less than those that accrue to the early adopters. If this were not the case, the mass market would be early adopters. If you believe that the value and therefore the price of your service goes up over time, be prepared to justify it. Some opportunities have natural monopoly characteristics where the addition of each customer adds value for all the prior customers. If this is the case with your business articulate clearly why this is the case.

Up-sell: Offsetting the natural price degradation in services, tell me about other services that you intend to offer in the future that will provide you with some ARPU lift. Service segmentation is critical, because this enables you to optimize the revenue you generate from your customer base. Be sure to not give functionality away in your base service that you may be able to charge a large percentage of your customer base for later.

Variable Costs: I want to know about all of the variable costs of your business on a monthly basis. These typically include commissions, infrastructure and other service delivery costs, customer support costs, billing expenses. The common thread being that each of these scales up with the number of customers you serve.

Churn: When you sign a customer, how long to you expect to keep them? What does the churn pattern look like; does most of your churn take place in months 1-3 or before the customer ever gets fully implemented? Once the customer is past the initial adoption phase, what percentage of your customers do you lose every month?

With these building blocks, I can make some key observations about your business and its potential to generate big profits. First, with ARPU, price degradation, and up-sell on the revenue side and your variable costs, I can determine your customer level contribution margin, the amount of monthly net cash you generate from a customer unit. If your customer level contribution margin is negative, no level of customer volume can save you. Some refer to this as profitless prosperity; you can sign customers, but never make a profit.

The second observation I can make is related, but less obvious; I can determine the lifetime value of your customer. By running the contribution margin through your churn calculations, I can estimate the lifetime contribution margin of a customer. This number must more than offset your customer acquisition costs if your business is to be profitable in the long-term.

From here, the questions all become about scale; how many customers can you sign, over what period of time and how many are required to cover the fixed costs of running your business.

Don’t worry, I won’t push you on these economics in a first meeting, unless your business plan is so clear that we can jump right into the economics. But rest assured, we’ll get into them eventually. If your business can’t prove out on these metrics, I probably won’t invest and you probably won’t want to spend the next five to seven years of your life trying to build a business that can never get to the finish line. Some may argue that these metrics apply only to enterprise, smb and related segments and that they don’t apply to consumer web 2.0. Unfortunately in the end, I think eBay’s experience with Skype and the poor track record of monetizing web 2.0 and social media are on my side of the argument in the long-term.

Filed under: Economics, Lessons Learned, , , , , , ,

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