I was well paid though. I received a base wage rate plus a piece-rate, where I was paid an additional amount for each binder bin that I completed. The piece-rate was set based on meticulous analysis of the manufacturing process which determined how many units I should be able to produce per hour. The full-time factory workers, who were lovingly referred to as “factory rats”, were paid under the same scheme. This scheme was intended to motivate higher output on the manufacturing line.

A couple of weeks into my first summer, I figured out that I could improve my output of binder bins, and therefore my compensation, with a couple of tweaks in the process.  During lunch, I shared with some of the factory rats what I had discovered. Their response was not what I expected. Essentially, I was told:

You don’t get it. If you improve the process, management will modify the piece-rate component of our comp scheme. We’ll have to make more units to get the same total compensation. You’ll only be here for the summer, but we’ll have to live with that change forever. Don’t do it. Don’t ruin it for us.

The factory rats didn’t want to help the Company figure out how to produce more, because they didn’t believe they would receive more compensation for identifying ways to produce more. This was my first experience with what compensation experts call “if-then” rewards. I have been skeptical of “if-then” compensation schemes ever since. If this kind of pay for performance scheme doesn’t work for a mundane repetitive task, imagine what happens when you apply “if-then” rewards to knowledge work.

Established management philosophy treats all employees like the factory rats – with carrots and sticks. That philosophy says “I can cause you to do more of what I want you to do if I pay you when you do it” and “If you don’t do what I want, I will withhold rewards or worse punish you”. This is tantamount to giving a mouse a piece of food for pushing the blue button and shocking it if you push the red one.  The only problem is we’re not mice (or rats for that matter). WE’RE HUMAN and that makes us complicated. Carrots and sticks don’t work.

The first book I read on this topic (many years ago now) was Edwards Deming’s The New Economics. Yes, that Deming, the American-borne manufacturing process guru who helped to usher in Japanese domination of manufacturing process. It turns out that Deming was also a management psychologist who was well ahead of his time. Deming believed that we should abolish performance reviews in the workplace and grades in school. He felt that those types of subjective measurements of performance wiped out the employee’s/student’s intrinsic motivation. The employee’s goal becomes to please management, rather than to do good work. The student’s motivation becomes to get a good grade, as opposed to learn. It turns out that we complicated humans like to do good work and we enjoy learning; we are intrinsically motivated beings; external rewards and punishments get in the way.

Many years later, I’m encouraged that there is finally a new management regime beginning to take hold. It is best summarized in my most recent reading on this topic. Written by Daniel Pink, Drive: The Surprising Truth About What Motivates Us gives a good overview of the roots of our antiquated management/compensation philosophy and the science (much of which has been around for many years) that shows how flawed it is. Pink also offers insight into what we can do to change. To sum it up; pay people what they are worth, give them autonomy in their work, provide them the opportunity to master their craft and create a sense of purpose in the workplace. It is not that hard.

My own experiences, my personal reaction to comp. schemes I’ve had imposed on me in the past and years of reading on this topic (Here are my favorites) make me contrary on compensation. I’m done with carrots and sticks. How about you?

Note: For a good summary of Drive, check out this RSA Animate sketch narrated by Pink.

Leo couldn’t do anything right. He couldn’t read. He couldn’t write. He was a sloppy eater…

Leo’s father, playing the classic fatherly role, was very concerned. He couldn’t figure out what was wrong with Leo. He feared that “Leo would never bloom” and raised his concerns with Leo’s mother. Leo’s mother was not phased, saying to Leo’s father:

Leo is a late bloomer.

Being the dutiful father, Leo’s father continued to watch Leo for “signs of blooming”. Seeing none, he asked Leo’s mother:

Are you sure Leo is a bloomer?

To which Leo’s mother responded succinctly:

Patience.

Leo’s father eventually gave up and stopped watching Leo for signs of blooming.

An Example

Like any child, Leo was on a one-way path toward adulthood and beyond. No going sideways, no turning back; one way. Company building doesn’t work that way, success is not in the future for every early stage business. Some fail, some go on to greatness. But regardless of the outcome, as a category, recurring-revenue businesses are late bloomers. Why? Unfortunately, the recurring-revenue model, with all its advantages, has its drawbacks; the biggest being that early in their development, the income statement profile of these businesses rarely reflects the value that has been created.

Product companies have a distinct advantage in this area; sell something and record it as revenue and profit in the period sold. All the value of the relationship with the customer is reflected on the income statement in the period in which the product is sold. Quite the contrary, in recurring revenue businesses; very little of the value is reflected on the income statement in the period the service is sold. Here is an example.

Suppose you sell storage equipment. You sell a tape back-up system to a small business and charge $1,000 for the equipment. You make a 40% gross profit margin on the product. In the period you sold the back-up system, you record $1,000 of revenue and $400 of gross profit on the income statement. Now suppose you change business models and decide to sell storage as a service. You sell under a three-year contract and charge the customer $50 per month; you make a 50% gross margin on your services. In the first month of billing, you book $50 if revenue and incremental gross profit of $25. In the first year, the storage service provider would book $600 in revenue and $300 in gross margin. Comparing these two business models on the basis of income statement performance only, the recurring revenue service company’s income statement looks less attractive than the product companies  for first 12-18 months.

This issue leads to what I’ve referrred to as the Valley of Death in fundraising for SaaS and other recurring-revenue businesses.

Apples, Oranges and Late Bloomers

The trouble with the example above is that it compares apples and oranges. You really can’t compare the income statement performance of a product company to that of a recurring-revenue services business. We need another measurement that puts these business models on equal footing. I have a strong preference for one metric, the lifetime value of a customer. In the product example above, the lifetime value of the customer is $400, presuming the customer never buys another piece of storage equipment from you. The entire value of the customer relationship is recognized on the income statement in the period in which the product is sold. The lifetime value of the “contract” in the service example is $600, the gross profit the company will earn over the three-year contract term. Contract value is an important measure, but only if the contract can’t be cancelled by the customer. More important is the lifetime value of the customer, which requires a more complicated set of calculations including customer acquisition costs, churn, etc. On this basis, ignoring time value of money considerations, I often find that recurring revenue services businesses capture more value per customer than product companies. The example highlights the point.

Customer lifetime value provides an alternative way to measure value that has been created. It is a concept that barely exists in product businesses. However, it is critical to recurring revenue businesses, precisely because – from an income statement perspective – recurring revenue businesses are late bloomers. If you are a recurring-revenue business operator you must measure customer lifetime value and the aggregate value of the all of the customer you have aggregated. If you don’t, can’t or won’t measure it, you are seriously short-changing the value of your enterprise.

Patience, Patience, Patience

Eventually, as they mature and scale, services business show great income statement profiles. Sticky, profitable, long-term contracts with customers lead to that. But because the economics are back-end loaded, it takes a while, and a great deal of patience. Leo’s mother understood that Leo would eventually bloom; she was patient. As the story goes, one day – somewhat miraculously in the eyes of Leo’s father - Leo bloomed. When he did, he turned into one heck of a tiger.

If your recurring-revenue business has a strong product in a big market segment and great customer lifetime economics, it too will bloom. But until it does, best to measure the value of the customers you have acquired so that you know you are creating value before your income statement shows it.

You set the price and I’ll set the terms.

From what I am told, Bill understood the interaction between pricing and structure better than most. The essence of the quote is that pricing and structure are inextricably linked; you cannot fully understand the valuation of the deal without fully understanding each of its elements.

Often, I find that entrepreneurs overemphasize pricing (the pre-money valuation) and under-value structure. This is understandable. The pre-money is “a number”. Being a number, it is easy to understand, requires little interpretation and is easy to communication.

Yeah, we got the venture guys to pay-up with a $(fill in the blank) pre-money.

The pre-money valuation of a deal lends itself to soundbite marketing and entrepreneurial chest-thumping. By driving pricing up, the entrepreneur can bring a big number back to his/her existing investors and Board, thereby validating what the entrepreneur has accomplished. This is all well and good; I’m all for entrepreneurs doing their fiduciary duty and battling to maximize pricing on the behalf of their existing investors. But a focus on pricing completely ignores the other half of the valuation equation, structure.

Unfortunately, in my experience, entrepreneurs over-value a high pre-money price and undervalue structure. Take the example of a $10 million last institutional growth capital round. Lets say the Company is choosing between a convertible preferred structure priced at a $20 million pre-money and a participating preferred structure with a $30 million pre-money. The chart below shows the payout to the new investor from this structure (the bottom axis is exit value, the left axis is $ returns to new investors. I’ve posted the full spreadsheet here.

This is an overly simplistic example, but I think it shows the interplay between structure and pricing very well. Notice that the returns for both structures diverge at the $10 million mark; this is the level at which the liquidating preferences of both structures are paid back. The difference is that the standard convertible preferred structure does not begin participating again until it is advantageous to convert and that happens only when the post-money valuation of the round is exceeded ($30 million). The participating instrument however begins to participate immediately after the liquidation preference is paid back. Although the participating instrument owns less of the company, it returns more than the standard convertible preferred structure all the way up to the $90 million exit value, where the structures are equal. The participation feature acts as a return accelerant at lower levels of exit valuation.

Why is this important? For me, the goal of pricing and structuring a new investment is to get a fair deal that maximizes the alignment between new investors, existing investors and management. By “fair”, I mean that it provides my limited partners with an expected return on capital invested that is commensurate with the risk of the investment. Getting to the right risk-adjusted return is a matter of both pricing and terms. When entrepreneurs try to push the pre-money valuation higher, investors have no choice but to respond with structural return “kickers” like participation features. In the scheme of things, a participating feature is a mild structural advantage for new investors; I’ve seen much worse (multiple liquidating preferences, performance based ownership ratchets, etc.) But even a participation feature can create a disconnect between the interests of existing investors/management and new investors. In this case, the participation feature may lower the new investor’s exit threshold, creating an incentive to sell earlier than they would otherwise. Caps and catch-ups can help to remedy this, but add another layer of complexity. And in my experience, complexity is rightly to be avoided because it often results in unintended consequences.

The point is that entrepreneurs should understand that valuation is matter of both pricing and terms. You cannot understand one without the other. The goal of alignment will always favor a simpler structure at a fair price. Unfortunately, in practice, things are never quite that straightforward.

Everything is a service

For several years I’ve been spouting off about the notion that “everything is turning into a service”. I outlined some detailed thoughts on this trend in a post titled “The future is in services” last June. As I look several years out, I see several big value chains threatened by this trend, creating opportunities for upstarts. For example, I think there will continue to be pockets of attractive investments in SaaS. But where I see big opportunity is in cloud based services and platforms that enable the cloud to become a true utility to the enterprise, small business and even consumers. Transforming computing from a product into a service is a non-trivial shift that will take many years, but the march is on and the direction of the trend is undeniable. Computing, storage, etc. will all primarily be purchased as a service in the not too distant future.

Platforms

For me, 2010 will be the year of the platform. The notion of open platforms that enable third-party developers to innovate on top of the platform by consuming API is alluring to me. I’ve already put my money where my mouth is on this one as several of my investments have ”platform” as a core component of their product and go-to-market strategy. Communications is an areas that has largely been untouched by the platform trend. It seems to me that the time is ripe for the network to begin opening up. I’ve written about this in the past on my firm’s blog; you can find that post here. The post is a bit dated, but I think you will get the point. Location services is another area where I think there are platform plays emerging.

Payments

I have an inkling that innovation is finally coming to payments. There have been some big exits in recent months, including BillMeLater and Revolution Money. Neither is particularly reflective of the type of innovation I think is coming in payment, but both show the size/scale of businesses that can be built given the massive size of the payments sector. With PayPal opening up its platform to third-party developers, there is going to be a rash of new payment application development in the coming years. As an investor in IP Commerce, I have a special perch from which to watch this trend. I’m staggered by the diversity of payment applications being developed on top of the IP Commerce platform. Several have already caught my eye as potential new investments and I believe more will do the same in 2010. I’m also tracking some big last cash markets, which I think are finally opening up to electronic payment providers.

Mobile

Mobile is an area I have tracked closely for several years now. And while some would argue that the market has disappointed, I would counter that we are still in only the early innings of a very long game. I continue to believe firmly in the mobile web, or the web optimized for the display needs and the unique capabilities/properties of mobile phones. I’m less enthusiastic about applications being developed for the iPhone/Android/RIM and other operating systems; or at least less enthusiastic about investing in companies that create those apps. There is just too much OS fragmentation for application developers to manage effectively and it is difficult to make any particular app stand out in the crowd.. As 4G networks begin to roll out, more bandwidth may obviate the need for a downloadable app. In some ways, apps remind me of PointCast; remember that? I’ll continue to track this trend closely, but as it stands, my money is on the web, not the apps in the long-run. Regardless, I’m more interested in the infrastructure and plumbing in mobile than the consumer-facing application side. The fact is that the mobile use case is fundamentally different from the web and it enables usage paradigms that are not relevant on the tethered web. As a result, the capabilities of the plumbing for mobile need to cater to what is unique about the mobile experience, creating an opportunity for new players to stake out a dominant and differentiated position.

I’m likely to make two new investments in 2010. I am more likely to prioritize my review of investments that synch with the themes outlined in this post. I’m also more likely to make investments in these areas than other areas I’m not tracking as closely. Having said that, I think it is critical to marry a thematic (and therefore planful) approach to identifying great investments with an opportunistic approach. So I don’t rule out making investments in other areas in 2010. I know there will be several entrepreneurs with whom I interact who light a spark causing me to dig deep into areas not outlined in this post. Frankly, I look forward to having that spark lit; it is a great part of the process of discovery that the VC business requires.

In no particular order:

1. Be Accessible

I believe it is a VCs responsibility to be a resource to the entrepreneurial community. A VC must be accessible by the community in order to deliver on that responsibility. This is not entirely altruistic; by being accessible, we develop a network of relationships and put ourselves into the flow of ideas that is the lifeblood of innovation and value creation. I endeavor to be more accessible to entrepreneurs this year than ever before. I’ll start by reaffirming how you can best reach me; here. If you have other suggestions regarding how I can be more accessible, I’d like to hear from you.

2. Be Present

We live in a world with a massive amount of stimulus and more ways to communicate than ever before. But so long as we are operating in the physical world, with synchronous face to face or telephonic interactions, it is imperative to be in the moment. Anything less is disrespectful to the person(s) you are interacting with. So turn off the cell phone for that board meeting, put your computer on sleep mode when you are on the phone. Sit up, lean forward and engage.  Deeply. Richly; as if the current conversation you are having is the most important one in your world. This shouldn’t be hard, because the current conversation you are having IS the most important one in your world; right now.

3. Be Scarce

Time. It is our most precious and fleeting resource. Once squandered, it cannot be gained back. I’m committed to using my time wisely this year. Doing so takes a  level of selfishness. If I do not make time for you, it is because I have decided it is not worth my time. If it is not worth my time, it is also not worth your time and so by the transitive property, I am saving you time by not spending time with you.

3. Plan and React

I’m a big believer in the idea that you can’t find what you don’t yet know you are looking for. This applies to finding great investments as much as anything else in life. I come into the year with a clear sense for the areas in which I’d like to find the two new investments I’d like to make (blog post brewing). I’m also committed to being flexible enough to understand that I must listen to the market, learn, adapt and react. As a result, what I am looking for may necessarily change as the events of the year unfold. And so in 2010, I’m committed to striking a balance between the discipline of proactive, planned sourcing and reacting to the market as it reveals itself.

4. Be Patient and Empathize

I believe that great businesses are not built overnight. The process takes years of laborious effort, smarts and a dash of luck. I admire entrepreneurs who have the stamina and perseverance to run the gauntlet and exit the process with a success. In 2010, I aspire to matching the stamina of the entrepreneurs I back, to be patient in the face of adversity and to remember that this is a people business. Empathy is the grease that makes the whole process run smoothly.

5. Be Urgent

Yes, building a business takes patience. However, I have no patience for a lack of a sense of urgency. There is never a better time to take the next step toward the success of the business than right now. Like the Seuss book “Oh the places you’ll go”, if you are…

headed, I fear, toward a most useless place. The Waiting Place.. for people just waiting.

we’ll need to talk in 2010.

6. Expect a herculean effort

Success comes first and foremost to those that work hard for it. There is no replacement for effort; it is table stakes and therefore must be expected. This goes for entrepreneurs and VCs. Sometimes success comes to those that don’t work hard, but that is not replicable. In 2010, I don’t expect to be lucky; I do expect to work my tail off. I’m likely to expect the same of you if we have the good fortune to work together.

7. Expect realistic results; and work to create break-out growth

Results are a lagging indicator of success; they trail effort. Goals that are unrealistic are worthless. I aspire to expecting results that are realistic and achievable. I am also not satisfied with the expected and so I aspire to help my companies create break-out growth that blows the expectations away.  I expect the entrepreneurs with whom I work to meet the expectations and to work to wildly exceed them.

8. Engage in the play-by-play

When it comes to working with portfolio companies, I aspire to being shoulder to shoulder with the entrepreneurs I’ve backed. Yes, I want to be a coach, but I also want to be a resource using my time, energy, effort and resources to assist the entrepreneur in achieving his/her goals. If you want to improve the outcome for your team, you can’t sit back and watch the scoreboard. The only way to make an impact is to get on the field. In 2010, I aspire to engage deeply in the issues and opportunities faced by my portfolio companies and to make time to understand  the evolution of the business, play-by-play.

9. Be humble and accountable

For some reason, VCs have been put on a pedestal. This is largely because of the association of VCs with successful companies. Of course, this ignores the unsuccessful companies that VCs back; apparently, those don’t count. I aspire to never forget that it is the entrepreneurs that create the value. I intend to give credit where credit is due, never accept credit for the accomplishments of others and accept responsibility for my failures. I expect the same of the CEOs I back.

10. Never lose sight of the scoreboard

Ultimately, there is only one way to keep score in the VC business; generating returns for our investors. Never lose sight of this fact. As a result, I aspire to treating the capital I am trusted with as sacred.

I aspire to live up to each and every one of these affirmations, but I also understand that my efforts will sometimes fall short. When (not if) I do fall short, please feel free to call me out on it. You will be doing me a favor.

The catalysts that create make or break moments vary. Sometimes the catalyst is external; perhaps the market meeting your product, an acquisition by one of your potential partner’s competitors. Sometimes the catalyst is internal; a great new product release, a partner deliverable. We all know what these moments look like; we’ve all described a moment in time as “make or break”.

The notion of “making” a business in a singular moment is alluring. But entrepreneurs rarely think about the execution risks they will face after they’ve “made the business”; and the fact that there are likely to be future “make or break” moments where they will also have to avoid breaking. For me, ”make or break” is a fallacy. You can absolutely break a business in a singular moment, but rarely can you make a business that way. The only way to truly “make” a business is to exit it, in which case, future execution risk and future “make or break” moments become irrelevant.

Perhaps we should rename ”make or break”. Lets call it a “don’t break” moment. ”Don’t break” moments comes with the recognition that by not breaking, you create opportunity to execute well in the future so that you can see future “make or break” moments where you must also “not break”. If you make it through the gauntlet of multiple “don’t break” moments, you might just have the opportunity to exit the business for a monumental value at some point in the future.

How would you rename the “make or break” moment?

Planning is for big companies.

Our space moves too fast to plan; if we define a strategy we’ll just have to change it in a couple of months.

We’re small, nimble and well-coordinated so we don’t need to plan.

Everyone in my company already knows what they should be working on.

Sorry to be Scroogy, but to those rationalizations I say hogwash! Go ask five of your employees to define the single most important thing the company needs to accomplish next year. Better yet, go ask your executive team; they should know, right? If you get more than one flavor of answer, you need a strategic plan.

Lets be honest, when you cut to the chase, the real reason entrepreneurs and VC’s object to planning is that it takes time, effort and concerted thought. Planning also implies goal setting and goal-setting implies there are objectives you can measure results against, and that implies accountability. Time, effort, concerted thought and accountability; who wants that hassle?

Planning doesn’t have to be complicated or burdensome. For me, planning is like creating a mental map.

Where am I, where am I going and how to I get there?

The process starts with an honest assessment of where you are. Unfortunately, in our reality-bound world, you don’t get to navigate from where you want to be; you can only navigate from where you are. When you are climbing a mountain, you don’t get to start 100 feet from the summit (that is unless you’ve driven to the top of Mt. Evans, in which case you are cheating in my opinion). Planning forces you to come to grips with where you are on a strategy map.

Planning also forces you to define your destination. If you can’t define where you are going, you are wandering aimlessly in the woods.  The rationalization that your space moves too fast to define the destination is not acceptable. At minimum, you should be able to create a directionally correct picture of the future that you are striving to create (ie. Our destination is to the west). The destination you articulate should be worthwhile and aspirational, yet realistic. Don’t worry if the destination changes in a future planning session; that is natural in an emerging market space. But the notion that the destination may change is a lame excuse for not planning at all.

Finally, planning forces you to create an execution path that closes the gap between where you are and where you want to be. If you can’t define the execution focus that will help you to close the gap between where you are and where you want to be, how can you expect your employees know how to close the gap? Tactically focused, execution oriented people you find in most companies need to know how to get from point A to point B in oder to be effective. It is your job to give them the map and show them how their job fits in.

Planning 101: Keep it simple

Planning doesn’t have to be complicated. To really boil it down, we can dispense with the “soft fuzzy stuff”; mission, vision, strategic intent, etc; although I’m a believer that those pieces of strategy have merit. For an emerging growth company, planning should be about two categories of issues:

1. The things that you can accomplish that will make you wildly successful and;
2. The things that you can do to yourself or that can happen to you that will kill your business if you do not prevent them from happening.

My Partners and I at Meritage call these the “Critical Issues”. There should be no more than five to seven of them. If you have ten or more critical issues, you probably don’t have the time, knowledge, resources or capital to execute your plan. Embedded in the critical issues is where you are, and where you need to go (point A and point B on a map). With those points in mind, the next step is to determine the route you are going to take.

For our companies, we like a set of three to five initiatives lined up against each of the critical issues. The initiatives provide tactical guidance regarding what you can to get from point A to B. Initiatives must be within your control; saying that your market must grow 50% next year is not an initiative. Initiatives must also not be prescriptive. “Sell better” is not an initiative, whereas “implement sales training program” clearly is.

Finally, now that you’ve defined the initiatives you are going to execute against, we have our companies establish measurements that define their success against the initiatives. Measurements must be, well, measurable. In other words, use numbers and dates; 10 enterprise customers by year-end, 8.5+ on customer satisfaction survey, version x.x of the product released by June 30, 2009 and on budget. Again, keep it simple; three to five measurements per critical issue is sufficient in our experience.

Putting critical issues, initiatives and measurements into a three column table gets your entire strategy map on one piece of paper. That is remarkable because it provides a simple communication tool to use with employees, Boards and shareholders. Some of our companies use the three columns as the first page of their Board reports and add a red-yellow-green light next to each critical issue to reflect the CEO’s overall assessment of progress against the critical issues. This format makes for an effective visual representative of progress.

This may sound old school, but its my experience that management teams that are honest about where they are, who know where they are going and are able to outline the key steps to get there perform better than management teams that can’t commit these things to paper. If you don’t have the vision to anticipate where you should be by the end of next year, shorten the time-frame; do quarterly or semi-annual planning.

Choosing not plan at all is a massive failure of leadership. So get your management team in a room and hash it out; you will all be better off for it and so will your company’s performance.

This trend is not the exclusive domain of established players. It seems two out of three new investment pitches I hear have a “platform” element to them. This caused me to send the following tweet last week:

Your desire to be a platform does not make you one. Only the ecosystem around you can make you a platform.

Clearly, this topic deserves many more than 140 characters; hence this blog post. So what is a platform? Most people, particularly technologists, default to a technology definition of platform. In layman’s terms, a technology platform is infrastructure (hardware and/or software) upon which other technologies and applications can be built. This is intuitive and easy to understand. An operating system is a technology platform. And in the web-world, all of the services above fit the “technology platform” definition, because they all allow application developers to develop applications on top of something.

 The much more interesting definition from my perspective is a business definition. I favor the definition forwarded by David Evans and his co-author Richard Schmalensee in the Catalyst Code, in which they define an “Economic Catalyst” (a synonym for platform in my world) as:

An entity that has (a) two or more groups of customers; (b) who need each other in some way; but (c) who can’t capture the value from their mutual attraction on their own; and (d) rely on the catalyst to facilitate value-creating reactions between them.

I won’t steal thunder from the book - if you are interested in this trend at all, you should read it and its prequel “Invisible Engines” - but what the business definition drives home is that there is much more to being a platform than building a technology and hoping an application developer builds something on top of it. You can’t just be a technology platform; you have to make an ecosystem around the technology. In addition, the platform must serve both each of your customer groups well and must be a means to an end; that end being “a value-creating interaction” between those two customer groups.

Most of the platform examples I cited above talk about only one customer group, the application developer. That is natural in some ways as the release of these platform technologies is marketed to application developers. But this is only half of the story. We talk way too infrequently about why are these application developers build something on Facebook, Twitter, the iPhone, etc. This is important, because it is notoriously difficult to charge application developers to build on top of a platform. As I’m writing this, I can’t think of any good examples of big businesses built by charging application developers for access to a technology platform; perhaps with a little more thought I could gin a few up. Microsoft doesn’t charge application developers to develop on top of its OS. Microsoft makes its money charging software licenses to businesses and consumers who choose a Microsoft OS because of the large community of applications that are available on it. Facebook, PayPal, etc.; they don’t charge the application developer; at least not in a scalable way. You can’t just aggregate a bunch of application developers and make money.

We need to redefine success for platforms. A successful platform isn’t the platform with most application developers. The money is made by creating a value creating exchange with the customer on the other side. Therefore, a successful platform is one that facilitaties the most value-creating interractions for the two or more customer groups it serves. On that measure, all of the platforms I’ve mentioned (besides Microsoft’s OS business) are nascent. No-one has figured out a truly scalable way to create value exchanging interactions on these platforms; at least not in a way that serves the application developers well. A piece in GigaOm about the long-tail of iPhone application developers is illuminating. Om calls it “extra-long”, which means there are a very small number of applications making all the money and the rest are left fighting over scraps. Most of the examples I’ve cited have a consumer on the other side of the platform. The easiest business model for monetizing application to consumer interactions is advertising, whether on the web or “in-app”. Twitter is heading in that direction now, although they are rapidly bringing back functionality that has historically been the domain of the application developer community as they roll out their monetization strategy. You can be sure that those two trends are linked. We’ll see how the advertising model serves application developers on all of these platforms; my guess is not very well.

When a consumer is on one side of the platform, it is easier to become a platform when you have an installed base of users. Facebook had a massive user base before it opened up its platform. The same goes for Twitter, the iPhone, etc. It is much harder; some might say impossible; to start a consumer facing platform. Consumer facing platform strategies emerge from large installed bases of consumers; it may not be possible to start one explicitely, although Google is trying with Wave.

If you are an application developer on a consumer-facing platform, be sure the platform you build upon has a clear business model for helping you monetize the relationship you develop with the consumer. If not, be wary; what you do may eventually be consumed back into the platform. You may be left with no strategy for monetizing the user base you help to create.

For startups with no installed base on either side of their nascent platform, getting an ecosystem started is a bit trickier. For most, the only way to be successful is if the attraction between the two customer groups is soooo strong that the ecosystem ”makes itself” around your technology platform. Some refer to this as the chicken and egg challenge of platforms. It is not mission impossible to crack the chicken and egg, but it is a challenge. This may be easier in B2B platforms than in B2C or C2C platforms. Perhaps more to come on that in future posts.

For now, on to another type of fowl; TURKEY!

Getting the VC to ask the right question at the right time is all about the logical structure and layout of the pitch; what you say when. What follows is a generic logical flow that I think optimizes an entrepreneur’s chance of getting the VC to play straight-man.

• Tell ‘em what you are going to tell ‘em: Pretty simple, really. Tell the VC the three to five conclusions they will take away from the visit if they are paying attention. End this with an introduction to your team. Keep the team description short, just high-level backgrounds and skill sets.
• The market: Articulate the market that you have specifically assembled this team to attack. This is not the addressable market for your particular solution (we’ll get to that later), but rather the umbrella market under which you are operating. How big is it? How fast is it growing? Is it dominated by giants or fragmented? Is it profitable, efficient, etc. Provide whatever information is necessary get the VC thinking about what the problem might be with this market; the unserved or underserved need. You want the VC to start trying to figure out the problem you are solving in that market, before you tell them what you do.
• The problem: What is the problem, the pain point you have identified. Why does the problem exist? How big is the problem? What pain does it cause. Can you quantify the $ value associated with solving the problem? Is this a problem that has been around for a long time or is it a new/emerging problem. I’m not looking for a solution yet; we’ll get to that later. By this point, you want the VC asking: “What is the solution to this problem?”
• The solution: Don’t tell me about your solution yet. What I want to hear about are the requirements to solve the problem. What technology needs to be developed? What added layer of the value-chain needs to be inserted? I want to hear you say things like: “What is required to solve this problem is …” Is cracking this problem non-trivial? Why has it not been solved yet? What is new (technology, etc.) that finally enables this intractable problem to be solved. What are the rewards that accrue to the player that leads the market in solving this problem? By this point, you want the VC asking: “Tell me how your products align with the requirements of a world-beating solution.”
• Your solution: Introduce me to your specific “version” of the solution. Show me how it aligns with the generic requirements that you outlined. What is unique and proprietary about how you have approached the problem and architected the solution? Why will others have difficulty replicating what you have done?
• The economics: Tell me how you get paid and why customers are willing to pay that amount. Use the economics of your business to show the size of the addressable market for your solution. You can flash your financial projections, but don’t dwell on them.
• Team: Return to the team and show how the team you have assembled is perfectly suited to executing against the opportunity you have articulated.
• Tell ‘em what you told ‘em: Revisit the three to five key takeaways you want the VC to walk away from the visit with.

What I have found is that pitches that follow this logical flow make for engaging discussions with lots of participation from the VC. Remember, the goal is not to “prevent” the VC from asking questions; that is unavoidable. The goal is to get the VC to ask the right questions at the right time. Getting a VC to play straight-man to your pitch doesn’t guarantee they will invest; but it will make for more effective and productive meetings and will increase your chances of raising money.

Talk to me when you have “momentum”; or

I need to see some “traction” first.

With more and more VCs looking to make later stage investments, entrepreneurs are receiving this feedback more than ever. You can understand why an entrepreneur might find this feedback frustrating. If they had massive traction, they probably wouldn’t need VC money, or if they did, the deal should be priced at a much higher valuation. That said, the real issue with this feedback is that it triggers a conversation about the definition of momentum. Entrepreneurs complain (rightly so I might add) that the VC definition of momentum comes in the following forms: 1) VC defines momentum by saying; ”I know it when I see it”, 2) VC gives a milestone as a proxy for momentum that if achieved means that the entrepreneur will no longer need capital, or 3) VC gives a milestone but moves the goalposts once the milestone is achieved. Fundamentally, these are all non-answers and don’t serve the entrepreneur particularly well.

I’ve tried to take a different approach. I’m not smart enough to define momentum for every business, so I don’t bother trying. In-stead, I try to work with the entrepreneur to describe the value creation engine of the business; the mechanics through which value is created. With those mechanics defined, investors will get excited about just about any business for which the process of igniting that valuation creation engine is both replicable and scalable.  I lay it out as follows.

Identify the value creation engine for your business

Generically speaking, the value creation engine links the time, energy and capital you invest in the business to the measure of output that you think will be used to value the business at exit. The measure of output you choose depends on the type of business you are building. If your business is about aggregating eyeballs and monetizing them, then you will likely be valued based on unique visitors, users, user engagement, and the “potential” monetization of the audience. For more mundane businesses, your value creation engine may be revenue generation and eventually your ability to generate profits. If you can’t articulate the linkage between time, energy and capital and the value creating output of measure for your business, then you haven’t figured out your value creating engine. For example, wouldn’t it be great to say:

Based on experience thus far, a new account rep. will begin producing between $5k and $10 of incremental monthly recurring revenue within six months of their data of hire.

Make the value creation process replicable

Understanding your value creating engine implies that there is both a process in place to create value and a causal relationship between time, energy and capital and the desired measurable outcome. If there is causation, then the process for creating value is likely replicable; if I do X, then Y. If I do X again, then Y again.

When something is replicable, a measure of control is implied. For my part, I like businesses where the company is in control of X; more sales people, more marketing, more channels, etc. Businesses that rely on “viral” effects where the company has little control over the creation or velocity of the viral process are more difficult for me to get my head wrapped around. If I can’t control X, why should I believe X will continue to turn into Y?

Show that the process is scalable

Some value creation processes have rapidly diminishing productivity curves. The more input you give the process, the less productive the process is in generating output per unit of input. What I’m looking for is a value creation process where I can add a significant amount of additional time, effort and capital as raw material without diminishing the returns on investment; that is scalable. If I add five more sales people, I generate 5 times more leads, which turn into five times more sales, etc. You don’t have to prove this, but you should be able to make a compelling argument for why the process is scalable. A really big market with lots of customer prospects really helps. I’m more likely to believe your valuation creation engine scales in a big market than in a small one.

Entrepreneurs should not be deluded into thinking that there is some magic threshold number that once crossed will enable you to raise huge sums of money. Businesses that have a replicable and scalable value creation process make for attractive investments because additional capital is fuel on a fire that is already lit. In a market where investors are more risk averse than ever, these businesses are the ones most likely to capture the attention and imagination of investors.