Non-Linear Growth

A glimpse around the next corner; mind the curves.

November 10, 2009 • 2:22 pm 1

Managing your Board; Give ‘em a job!

In a post last week, I addressed the notion that everyone needs someone to report to. After all, you can’t report to yourself.  The reporting relationship between a CEO and a Board is critical for a Company’s success. That relationship must be based on trust, candor, and transparency.

While that hierarchical reporting relationship is necessary and constructive, it is far from sufficient for a company to succeed in a dynamic, ever-changing emerging growth environment. My view has always been that venture investors (and Boards more generally) need to get “on the same side of the table” with entrepreneurs and work with entrepreneurs (shoulder to shoulder) to create value. The burden of making this work is clearly on Board members, but there is much a CEO can do as well. As my Partner Jack Tankersley is fond of saying,

The CEO has to give each Board member a job.

It is my experience that Boards are often left unmanaged by CEOs and that an unmanaged Board is a dangerous Board. When smart people (the kind you typically find on venture-backed boards) are left unmanaged, they manufacture activity, because they don’t know what else to do. They create their own “job definition” whether it is aligned with the needs of the company or not. The risk for a CEO is that an unmanaged board can run roughshod over an entrepreneur. What is a CEO to do?

First, a CEO must view his/her Board as a set of tools to utilize. This starts with understanding the skills, capabilities, and relationships your Board has. Identify the strengths and weaknesses of each board member and figure out how to use their strengths to the Company’s advantage.

With an understanding of those resources in mind, a CEO can then give each Board member a job. In other words, define the Board members job and make it a job that they are both likely to enjoy and succeed at on your behalf. Here are a couple of examples:

  • A Board member with a deep Rolodex with potential strategic partners can be assigned to work with the Company’s business development team to generate new biz dev activity.
  • A Board member with a penchant for strategy and planning can be given the responsibility to help the Company prepare for an annual strategic planning exercise.
  • A Board member with a skill in shaping discussion might be assigned to facilitating Board level discussion.

Think about it this way; would you hire an employee without telling them what their job responsibilities are? Of course not! So apply the same management discipline you apply to your employees to your Board. The effects can be really constructive. By assigning tasks, Board members become accountable to the Company. They are forced to work with and for the CEO to help accomplish a task, ensuring alignment. This also sets boundaries for each Board member. By signaling what you want to them to work on, you also signal what you don’t want them to work on.

So if you are a CEO having a difficult time managing your Board, take this simple advice: Give each Board member a job. Your Board will be much more productive as a result, your Board members will be happier because they will know how to contribute, and your Company will be better off.

Filed under: Boards, Lessons Learned, Venture Capital, ,

November 10, 2009 • 12:48 am 2

The math of SaaS revenue growth

A conversation with the CEO of a SaaS company today reminded me of the importance of the rule of 78s. What is this “rule”, you ask. If you run a recurring revenue business, it is the most important number you have never heard of.

Back to my conversation with the CEO. We were talking about the use of proceeds for the financing she is trying to raise. In her case, the business is break-even, but has the opportunity to grow into some oncoming market demand. So I asked a classic VC question; “Assuming you close the financing in Q4, 2009, what will your 2010 revenues be?” Simple question right?

Lets say that this company ended 2009 with $3 million in run-rate revenue and that the Company has two sales reps. Each sales rep. has a quota of $10,000 of incremental monthly recurring revenue (“MRR”) bookings per month. Sales reps. historically produce at 75% of quota in this company, so the incremental new bookings per month, per rep is $7,500. At its current level of sales and marketing resource and productivity, this business can expect to generate $1.17 million more in revenue in 2010 than it generated in ’09. To get there, just multiple the $15k per month of incremental revenue the two sales reps. will generate by 78. Why 78? Because 78 is the ”sum of the digits” for revenue producing months in a year. Incremental revenue added in January will produce revenue for 12 months; incremental revenue added in February will produce revenue for 11 months; …; incremental revenue added in December will produce revenue for 1 month. The sum of digits for 12 is: 12 + 11 + 10 + … + 2 + 1 = 78. So the baseline revenue projection for 2010 should be about $4.17 million.

Now lets talk about the enhanced growth opportunity. The Company wants to hire two additional sales reps. who can be expected to produce at the same $7,500 of MRR as the two existing reps. For purposes of the example it will take a quarter to recruit and hire the two new reps and another quarter for them to build a sales pipeline given the sales cycle. Conservatively, these two new reps. won’t begin generating MRR bookings until June. Lets say there is a one-month install cycle so that June bookings convert to revenue in July. So what kind of incremental growth will these reps. generate in 2010? We don’t get to use the rule of 78 this time; no, because these reps. will produce for only six months during 2010, we use the sum of digits of 6, which is 21. That is a lot less than 78; that six month delay between making the decision to hire two new reps and getting them on board and productive really hurts. In 2010, the two new reps. will generate only $315k of incremental revenue. The business can be expected to generate $4.485 million of revenue in 2010; not meaningfully more than the base scenario without additional investment.

While this looks like meager growth, it doesn’t tell the whole story. Remember, this business came into the year with a $3 million run-rate. Without hiring the two new reps, the business should end 2010 with a run-rate of $5.16 million. By hiring the two new reps. that can be increased to $6.24 million, even though the two new reps. are productive for only six months. That incremental run-rate of over $1 million makes a huge difference and sure makes hiring the two new reps. look a whole lot more attractive than the meager incremental revenue they will generate in 2010.

Here are the key takeaways:

1) Get the Base Right: Recurring-revenue businesses are great because they are highly predictable. Applying the rule of 78s and with a little understanding of your sales resources and their productivity, you should be able to estimate your baseline next year revenue with a high degree of confidence.

2) Scaling Takes Time: The most common mistake I see recurring-revenue entrepreneurs make it to underestimate the time it takes for increased sales and marketing resource to impact the top-line. Hiring new sales people today probably won’t move the needle on your next twelve month revenue. More likely, an investment in sales and marketing won’t have meaningful impact until the following fiscal year.

3) Run-Rate Matters: You will see the impact of an investment in sales and marketing in run-rate much faster than in top-line GAAP revenues. If you are asked about what your revenues will be next year, answer the question directly, but also include a description of the difference in the run-rate you expect to end the year with under the no-growth and growth scenarios. The run-rate difference will impress much more than the top-line difference.

By the way, the CEO of the SaaS company I was speaking with got this analysis dead-right. Well done!

Filed under: Economics, Lessons Learned, SaaS, Uncategorized, Venture Capital, ,

November 6, 2009 • 1:38 pm 4

You Can’t Report to Yourself

Everyone needs someone to report to; even VCs.

This may sound strange coming from a VC. Some entrepreneurs who choose to raise venture capital have great disdain for the necessary evil of reporting to their investors. That disdain is appropriate to the extent investors are asking for mundane information that creates a reporting burden and does not add information necessary for critical board decision-making. But entrepreneurs that cross the line and don’t like to report because, well, they don’t want to report to anyone, are making a great mistake. There is no excuse for not wanting to stand and be counted; no excuse for not wanting to answer difficult questions; no excuse for not wanting your thinking challenged. I once interacted with an entrepreneur who chose another investor over us because, “we understood the business too well”. Apparently this entrepreneur thought my understanding of his business would be a “burden”.

VCs have someone to report to; Limited Partners and Advisory Boards. Yesterday, my Partners and I reported on our progress here at Meritage Funds to our “bosses”, our Limited Partners and Advisory Board, at our Annual Meeting. In a series of sessions, we stood and were counted; we answered difficult questions; our thinking was challenged. In presenting our progress, we strive for transparency and to give a balanced view to our Limited Partners. We talked about the elephant in the room - the difficult macro-economic environment and the difficult fundraising landscape for venture capital funds. We shared our enthusiasm for the opportunity to invest the capital we have raised in our Fund III and the excitement over the opportunities we are currently evaluating. We talked about our failures and the lessons learned. We talked about the challenging spots in our portfolio as well as the upside opportunities. And most importantly, we told our bosses what we were doing to capture the opportunities we’ve created and what we are doing to minimize the risks we see. The picture we drew was not all rosy and bright, nor dark and depressing; it was balanced. In addition to the annual in person meeting, we send written quarterly reports, have quarterly Advisory Board meetings, and a semi-annual conference call that all Limited Partners are free to attend.

We don’t report to our Limited Partners and Advisory Board because we have to, although we do. We do it because it is a good and valuable discipline. If we could convince our investors to gather quarterly, we would be thrilled. The process provides us with the opportunity to record and contend with the facts; to deal with harsh reality; to account for decisions we have made in the past, and to explain and justify what we are going to do next. For us, this is a valuable exercise; one we cherish. The feedback we receive is invaluable and helps to shape and reframe our thinking in constructive and positive ways.

Many entrepreneurs share this view. Such entrepeneurs use their Boards of Directors as sounding boards. They report with transparency and share not only what they have accomplished, but also where they have failed. These entrepreneurs cherish the opportunity to stand and be counted. I like this kind of entrepreneur. They understand that you need someone to report to; and that you can’t report to yourself.

Filed under: Boards, Lessons Learned, Venture Capital, , ,

September 16, 2009 • 11:55 am 2

Why VCs Need to Create Value

VentureBeat’s Entrepreneur Corner has a must read post today on the recent history of the Venture Capital business model. Every entrepreneur should read this, particularly those looking to raise venture capital and in the enviable position of being able to select the right investor for their company.

The author, Steve Blank, walks the reader through four distinct exit market cycles and discusses venture capital behaviour and philosophy in the context of those market cycles. The title of the article is a bit misleading as it posits whether or not you can trust VCs under 40. I’ll return to that later; suffice to say for now that it is one of those titles intended to stir controversy, but not fundamentally of value. 

The first cycle Blank covers is the 80s and 90s, where exit markets, particularly the public equity market required five quarters of profitability. As Blank states, the implications for venture investors during that period of time were clear:

What this meant for entrepreneurs and VCs was simple and profound – and is entirely underappreciated today: VCs worked with entrepreneurs to build profitable and scalable businesses. In this time, a successful business was one that had paying customers quarter after quarter, not one that was flipped or hyped to the market despite a lack of earnings or revenue.

Venture Capitalists on the board brought a firm their expertise to build long-term sustainable companies. They taught companies about customers, markets and profits.

Blank then goes into detail on two subsequent phases. The “IPO Bubble” (August 1995-March 2000) and the “Rise of Mergers and Acquisitions” (March 2003 – 2008). In each phase he articulates the warping effect of these markets on VC behaviour. In both phases, he makes the basic point that VCs were building companies to be sold prematurely to a greater fool; either into an overvalued IPO market or to a frothy strategic acquirer. The notion that stable revenues and profits were a key part of the formula for a successful exit was still missing. One might refer to this as “momentum” investing.

Back to the Future

And finally, Blank makes the case that 2009 will be a back to the future period where VCs will have to return to the fundamentals of building real value in their portfolio companies in order to generate meaningful returns for their investors. I think Blank is dead on here.

But I’m here to say that some of us never left the approach of working with entrepreneurs to create fundamentally valuable operating companies. My Partners and I at Meritagebelieve that venture capitalists have to work with entrepreneurs to create fundamental value. This core belief is the very reason for our unusual - and I believe innovative – organizational design. Four of my Partners are in a special category we call Operating Partners. Each is a successful, serial entrepreneur. Each has started companies, raised venture capital, dealt with venture capital boards of directors, and despite those boards, had successful exits. They are full-time, long-term employees of our firm and members of the General Partner. The shortest tenured has been here for five years; they are not like EIRs or Venture Partners. We won’t make an investment unless one of them represents us on the Board of Directors of that company and when they do, they invest their personal capital in the Company along side the fund. They stay with that Company for the life of the investment; cradle to grave. Each is limited to no more than four boards at a time so that have the time and focus to truly assist the entrepreneur. Our whole system is about creating value over a five to eight year investment horizon, not about momentum investing. Momentum comes and goes, trends ebb and flow, markets change. But fundamental value endures.

Does this mean that the traditional VC skill-set is no longer required? Not in my opinion; it takes a myriad of skills, and resources to help a company. The classic VC skillset is alive and well. But not all VCs are created equal. And here is where I’ll diverge from Blank. I don’t think the value of a VC has anything to do with the age of the venture capitalist you select. When I look at an entrepreneur, I don’t evaluate them by age, I evaluate them by experience, wisdom and judgement. I know many 55-year-old entrepreneurs who don’t have these characteristics and a lot of 30 something entrepreneurs that do. I’ll back the wise 30-year-old entrepreneur 7 days a week and twice on Sunday. Likewise, the value of a VC has everything to do with philosophy, wisdom and judgement; and alignment with the nature of your investment opportunity.

Evaluating a VC

What I encourage entrepreneurs to do is to evaluate the VCs philosophy. Are they a momentum investor or are they a fundamental investor trying to build a real operating company? Are they interested more in the theme of your investment than in the fundamental value-creating engine of your company? Do they get caught up momentum buzzwords like web 2.0, eyeballs, mobile, etc., or are they more interested in the needs of your target customers, the vertical market you are attacking and the sustainability of your competitive advantage. Answers to these questions will shed insight on how the VC attempts to create value for their investors.

Momentum investing is inherently neither bad nor good; the same for fundamental investing. But these approaches do work differently in different exit markets. In my personal opinion, we’re in a market cycle that will disproportionately reward fundamental investors and not momentum investors. In fact, fundamental investing works great in any market. Momentum investing often outperforms in strong markets and underperforms in weak ones.

In the long-term, I believe that the fundamental approach is a better fit with entrepreneurs trying to build fundamental operating company value. It is not right for everyone; is it right for you?

Filed under: Lessons Learned, Venture Capital, , ,

August 5, 2009 • 11:24 am 1

Cognitive Dissonance: Are you a technology or a service?

One of the trends I’ve observed over the past several years is that more and more technology entrepreneurs are starting service-delivery business.  By services businesses, I’m referring to the category of businesses that some venture investors refer to as technology-enabled services (“TES”). We at Meritage prefer the term network-enabled services (“NES”), which we think more accurately demonstrates the fundamental innovation in the business model, which is that there is a high-level of connectivity between the service delivery platform and the customer. Services is a big tent, so to ground it, put your mind on business models like SaaS, cloud computing, and even search.

Many casually refer to these businesses as “technology companies”, by which most intend Wikipedia’s definition of “information technology”, not the generic definition of “technology“. After all, these businesses create technology to build their service, right? Salesforce.com is a technology company; Yahoo! is a technology company; Akamai is a technology company …; AT&T is a technology company. Whoa! Hold it right there; rightous indignation time; I can hear it already.

AT&T is not a technology company! They don’t know the first thing about technology! AT&T is a communications services business.

So what is the difference? Why do we think of Salesforce.com as a technology company and AT&T as a service provider.

Cognitive Dissonance

Objectively, either all the companies in the list above are technology companies or none of them are. AT&T uses every bit as much technology to run its business as does Salesforce.com. And while some of that technology is different, much more of it is fundamentally the same. More importantly, the technology serves the same singular purpose; it powers the service.

So which is it? Are they all technology companies or are none of them technology companies?

Brace yourself; here comes the controversial statement. If you are a services business, you cannot be technology company. Salesforce.com is not a technology company; Akamai is not a technology company. They are service companies.

To Create of Consume

I’ll return to where I started this post; with the observation that I see many technology entrepreneurs moving into services businesses. Often times, such entrepreneurs bring with them a technology creator mindset, not a technology consumer mindset. And as a result, they are susceptible to a number of mistakes. The most common of these is when the entrepreneur convinces themselves that their proprietary technology is going to make there service provider successful. Here are three examples:

  • Wireless service provider that has invented a new technology for mesh wireless networking, enabling quality of service management for voice over wireless applications.
  • Tech-enabled service provider for eBay resellers that has invented a new web server technology that will make the technology infrastructure highly scalable.
  • SaaS developer who built its own platform for managing its application in the cloud.

What is the problem with these businesses? They are acting like creators of technology, not consumers of technology.

The rationale is that by creating a proprietary technology, the service provider can gain a competitive advantage over its service provider competitors. It is an alluring and dangerous trap. But fundamentally, there is no way the wireless service provider above can keep up with the R&D budgets of Motorolla, Qualcomm, Cisco and the like and create a best of breed mesh QoS technology in the confines of a single wireless service provider. The tech-enabled service provider can’t possibly out-compete the web server technologies on the market in the long-term.

Embedding a proprietary technology business inside a service provider decreases execution focus and greatly increases execution risk. Creating this kind of technology requires a different skill-set, different processes, and a broad market in which to distribute the product. The economics of spreading the costs of creating and maintaining a technology company like this over one, captive service provider don’t work. From an investors perspective, the Company will consume more capital than is required, trying to capture/maintain a lead in a core technology that creates only the illusion of competitive advantage for the service provider. It is hard enough to build a successful service provider. Why would you want to complicate it by having to simultaneously execute the creation and maintenance of a core technology you could purchase from a third-party vendor. And what if the science upon which the new technology is predicated upon doesn’t pan out. Then what?

Rather than invent and maintain truly proprietary core technologies, I encourage all of my service provider investments to be rational and ruthless consumers of technology, not creators of technology. Find best of breed wherever you can, configure it in a way that suits the needs of your particular service and drive your vendors, who have the R&D budgets and skills, to innovate on your behalf. It is much more capital efficient and the execution risk is significantly lower.

What I am not saying

Does this mean services businesses should not be inventive? I’m not saying that at all. In fact, the successful services businesses are highly inventive, but not at a core technology level; rather at a business process level. One of my portfolio companies, Pipeline Trading has developed some amazing algorithms around large block and algorithmic trading of equity securities. This invention is unique to Pipeline and highly proprietary. But it is not a “technology” in the information technology sense of the term, it is a business process. Sure these innovations are expressed through technology; lots of software to be precise. But that doesn’t make the innovation a technology innovation; quite the contrary. Any quality engineer who is given the advantage of understanding the business process expressed by the algorithms could easily write the software. The innovation is not the software itself, it is the algorithm; and that algorithm has fundamentally nothing to do with information technology. It turns out that the competitive advantage is also in the algorithm, not in the software that expresses it.

But, but but…

But what if we really have created an incredible technology (in the information technology sense of the term) in the process of building our service provider? What if I really do have the best cloud-enablement platform in the world. Great, you just hit the jackpot, because you’ve discovered and solved a problem that every other service provider like you will also experience. But don’t keep that innovation captive to your own little service provider; free it. Spin the business off; create a hardware, software or new service provider around the technology; open source it. In fact, this is exactly what the SaaS operator with the cloud-enablement platform did. Kudos; right call!

The highest and best use of a new technology innovation is to sell/license it to anyone and everyone who could benefit from accessing it. That includes the service providers with which you compete. If it is amazing and valuable new technology, you should be able to sell the technology to your competitors and a lot more customers. If you can’t monetize it directly, ask yourself again why you believe the technology innovation will be a source of advantage for your captive service provider?

Final thought

Where does this leave us? Well, if you are a technology entrepreneur coming into a services business, I’d suggest you first change your mindset from one of being a technology creator to a technology consumer. Whenever possible, focus on innovating at the business process level, not the core technology level. Avoid technology “research” projects and focus resources on expressing your innovative business process with software. And finally, if you are absolutely forced to solve a tough core technology problem and create a truly proprietary technology in the process, look for ways to free it from the shackles of your captive service provider. In the end, the technology will have a better chance to flourish and your service provider will be unburdened from the costs, and challenges of having to execute on two fronts simultaneously.

Don’t confuse the services business with a technology business. You can’t; and shouldn’t try to be both.

Filed under: Economics, Lessons Learned, Risk, Venture Capital, , , , , ,

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