Non-Linear Growth

A glimpse around the next corner; mind the curves.

July 17, 2009 • 10:44 am 3

The most undervalued discipline in venture capital

PSYCHOLOGY! But very few even recognize it as a discipline.

As the cliche goes, every night, the most valuable assets in my investments walk out the door; the people. And the group that is responsible for managing all those people, the management team; they are not just “executives”, they are people too. Those executives need to be nurtured and developed if they are to perform. And from my perspective, psychology and “mindset” play a key role in executive development.

So how does a VC help put the entrepreneur/executive in the right mindset? Well, it starts with the VC having the right mindset to begin with. So what is the “right” mindset? Carol Dweck, a Professor of Psychology at Stanford, wrote a book on two basic mindsets she has observed and analyzed over many years, creatively called “Mindset”. It is a simple, but remarkably powerful construct for understanding how people frame their worldview and their place in the world.

According to Dweck, there are two basic mindsets that people adopt; the fixed mindset or the growth mindset. In the fixed mindset, people see their abilities and those of others as based on fundamental talent. This inherent talent is perceived to be unchangeable; fixed. A fixed mindset person would think “I am talented at math”, “I am not a good artist”, “I am a naturally gifted athlete”. In contrast, people in the growth mindset believe that talent is “developed” through hard work and that everyone has the ability to improve. They are interested in the journey, and view the result as an outcome based on many factors, including effort. Both success and failure are considered opportunities to learn and improve.

In my opinion, a venture investor with a fixed mindset is doomed and potentially dangerous. Every failure is taken as a personal affront to their talent. Rather than learning from failure, those in the fixed mindset look to blame others; the market, the management team, the “irrational” competition. They view investments that are behind plan as failing them and therefore a waste of additional time and effort. If the Company is behind its sales target, the VP of Sales and Marketing must not be talented enough. Fire him. There is no consideration given to helping the CEO, and executive team develop their skills, because they can’t be developed, their talents are fixed. Success is even more dangerous for the fixed mindset VC, because success validates the belief in their raw talent. They don’t have to work hard, their inherent “deal-sense” will carry them. In fact, working hard might cause others to question their raw talent. Those who are inherently gifted don’ t need to work hard.

More importantly, a VC with a fixed mindset can’t help a management team get into a growth mindset. They don’t view the team as people to be developed, but rather as people to be judged and kept or terminated. They take credit for others successes and blame others for their falures. This risks putting the entire company in the fixed mindset, stifling team development, creativity and the risk taking that emerging companies thrive on.

If the fixed mindset is dangerous, the growth mindset is powerful and empowering. Every challenge  is an opportunity to learn or to help someone else learn. Success is seen as the result of hard work; effort is rewarded as well as results. There is no blame, no finger pointing, only accountability. The only way to fail is to not try.

I look for growth mindset entrepreneurs. If you are an entrepreneur, look for a growth mindset VC. And if you are in a fixed mindset, fret not. Read the book; you’ll learn something. And with some hard work, you can change your mindset!

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

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 3

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, , , , , , ,

May 4, 2009 • 10:56 pm 0

What it means to be non-linear

Some years ago, I promised myself I would start a blog, but only after I crossed the chasm of having been in the venture business for five+ years. After all, what could you possibly have to say that is of interest to anyone before you’ve seen a few great outcomes and a couple of disasters. Well, I’ve now been in the game for over six years and I’ve finally gotten off my duff to get this going.

I’ve learned a lot in my six years in the business. The first thing I’ve learned is that I have a lot more to learn. Failure is part of the system; you can not be a VC without encountering frequent failure. I’m pretty comfortable with that; the trick is to learn from your mistakes and learn fast. Nothing frustrates me more than hearing others attribute their investment failures to “external factors outside of my control” - an “irrational competitor”, a “tough market”, ”too much capital sloshing around in the space”. No, you made a bet and it didn’t work out; deal with it. If you attribute failure to factors beyond your control, you deprive yourself from an opportunity to learn. It turns out that one of the key personality traits that separates the great VCs from the pack is totally non-intuitive. Can you guess what it is? The answer later on.

The second thing I’ve learned is that things never work out quite as you plan them; even the successes. I’m a big believer in strategic planning. But I also believe that linear strategic planning (set a goal, create an execution plan and stick to it) is a recipe for disaster in emerging markets. What is required is “emergent” strategy, define the future you want to create, listen to the customers you wish to serve and meet their needs. Bill Taylor at Harvard Business School’s blog had a nice post on a related topic just the other day. In it he takes on the topic of whether MBAs or entrepreneurs are better suited to dealing with “tough times”. The results of the research are pretty interesting, although I don’t agree with the MBA vs. entrepreneur dimension along which the analysis is framed.

The difference in mindset, Sarasvathy concludes, boils down to a different take on the future. “Causal reasoning is based on the logic, To the extent that we can predict the future, we can control it,” she writes. That’s why MBAs and big companies spend so much time on focus groups, market research, and statistical models. “Effectual reasoning, however, is based on the logic, To the extent that we can control the future, we do not need to predict it.” How do you control the future? By inventing it yourself — marshaling scarce resources, understanding that surprises are to be expected rather than avoided, reacting to them fast.

I love that; defining the future, constantly re-inventing yourself, marshaling scarce resource, understanding that surprises are to be expected. If you break it down, whether your educational background includes an MBA or not has nothing to do with. It is all about a frame of mind, a way of thinking, an “emergent” view of building a great company. It is important to recognize that things don’t always, in fact rarely, go according to plan, but that not all is lost. Course corrections are just part of the game. People who think too much of themself tend to have a fixed mindset; “this is the way this will happen”; and when the plan doesn’t work, they can’t react fast enough.

Which brings me back to that personality trait that separates the great VCs (and entrepreneurs) from the rest. What is it? In my opinion; HUMILITY. Why? Because humility enables you to be introspective, to learn from your mistakes, and to know that things never go according to plan so you can make course corrections along the way. 

Introspection, learning and course corrections are all representative of the theme of this blog; non-linear. It is the way I view the world; everything is iterative; there are no straight lines to success. Success comes to those who are able to shape markets, to define the rules of the game, to respond when assumptions are dashed and to lay down the road ahead so to that others can follow.

Filed under: Lessons Learned, , ,

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