Venture Capital - late vs. early stage

An interesting article in the San Jose Mercury News by Mark Boslet discusses the higher valuations of venture capital deals – “Venture capital funding, valuations rise.” (links to PDF file of the article on the Saints Capital website).

Some thoughts on the article to consider:

1. The investors that compose the continuum of private equity, ranging from LBOs to traditional venture capital to angel networks, are growing individually, and as a result, are creeping into each other’s territory. Look at the investment parameters of many “Private Equity” companies and you’ll see a growing number targeting later-stage companies (not the traditional LBO/MBO private equity model of 10 years ago), creating competition for the market. The article states that “too much money [is] chasing too few late-stage deals.” The result is the increased valuations.

2. Angel networks are becoming more and more sophisticated - what used to be the territory of the traditional VC companies. “Angels” used to mean people like your Uncle Bill who did well in the market before retiring and could afford to throw $10K your way. Now angel groups are targeting investments up to the $2 mln range (and higher in some cases). Even organizations like the Angel Capital Association now exist that did not 5 years ago.

The article also states that early-stage companies are forced to suffer. I disagree to some extent.

Firstly, good companies with good ideas, good products, and good managers will get funded. The market works. There may be fewer investments and funding events at the early stage, but perhaps that is better to better information availability about markets, products, and strategies.

Secondly, the wave of VC capital that was thrown at Web 1.0 companies was often spent on outrageous marketing campaigns (i.e. $1 mln for Super Bowl ads) to build brand recognition.

Take a moment to consider where we are with Web 2.0 and marketing:

• Long-tail marketing
• Viral Marketing
• Blogging
• User-generated content
• Google Ads

I don’t have any hard statistics to back this, but I suspect that marketing costs for start-ups are relatively lower as measured by capital than they were 7 years ago. With decreased capital costs for marketing, a significant chunk of the demand for early-stage VC capital infusion diminishes. Start-ups can focus resources on technology and product development and launch their products to market by effectively utilizing a Web 2.0 marketing strategy.

Definition: Entrepreneurship

Over the past month at a couple of local events, I’ve heard speakers offer two different definitions of Entrepreneurship:

1. “Leveraging resources to get things done” &
2. “Prudent risk-taking.”

The first definition was offered by Christopher Keene of Active Grid Software at a SVASE lunch event last month that I’ve referenced in previous posts.

The second was provided today by Sean Murphy of SKMurphy, Inc. at a Technology Venture Corporation (TVC) event in Menlo Park. (If you are an entrepreneur, I absolutely suggest that you check out TVC and their FREE services!)

What is striking about these definitions of entrepreneurship?

Both definitions are verbs. In grammar school, we are all taught the basic definition of noun to be “a person, place, or thing.” But entrepreneurship as defined by Christopher Keene and Sean Murphy is an action.

This leads to a more philosophical discussion of entrepreneurship and what it is – a state of mind, an ever-evolving process of innovation, initiating new results, proactively acting on a business idea. Any of these definitions are arguably valid, and perhaps one of the reasons that entrepreneurship is such a challenging course of action is the subjectivity that plays into defining it.

Sales Incentive Programs

I am currently working with Altos Research, a real-time real estate information service based in Mountain View, CA, in a part-time role. Currently, the sales force consists of the CEO, me, and well, that’s it. My role with Altos is to develop the overall sales strategy and long term organization.

We were discussing the longer term issue of sales territories as the company grows, deliberating over much revenue per sales rep should be the base of a territory, and then looking at how to compensate salespeople. Altos is a service with low customer attrition/turnover – probably less than 5% of the customers that sign up as paying customers cancel their service subscription, with an equal percentage that will likely upgrade their service plans, thus increasing the revenue per customer. A 95%+ retention rate! One of the reasons for this low attrition rate is the incredible level of personal attention and service that we have been able to provide to each customer. A key objective in the long term strategy is to replicate this high level of service as the company grows.

Our discussion turned to a philosophical conversation on how much to focus a bonus/commission structure for future sales representatives on new customer acquisition vs. growing a given territory base.

The key factor to remember with sales people is this – whatever compensation program that you establish for your salespeople is exactly what you will get. If your compensation program rewards new customer acquisition, then you’ll get new customers. But if you do not have a dedicated customer support team – and most start-ups rely on their sales reps to double as customer service reps - you’ll also have to deal with a higher attrition rate as your overall level of customer service will decline.

Salespeople are inherently selfish people, and I mean that in a good way. They often view themselves as the free agents in your company that are seeking to maximize their personal return – that’s why they work on commission/bonus and that’s why they are willing to take lower base salaries as a percentage of compensation than anyone else in a company. So, if your sales programs are focused more on new customer acquisition, then you absolute number of new customers will certainly increase. But at what cost? There will be a trade-off that will be evident in a higher churn rate. If your market has a finite number of potential customers, a high churn will impact the long-term growth of your company. Unless to you able to expand into new markets, you’re sales reps will eventually reach the end of their call list, and going back to prior customers that have dropped your service in the past may be a far more challenging sale.

Finally, it is important to take a look at you customer acquisition costs versus customer retention costs. If your acquisition costs are high relative to your retention costs, and your service is one that provides the ability to constantly upsell and upgrade your current customers, a sales program that drives this behavior in your sales force is probably a better option.

Innovation, Google & Employee Retention

[Author's note: A new article on this blog regarding Google employee retention is also available.)

A recent Wall Street Journal article - "Start-Ups Make Inroads
With Google's Work Force" has many people in the technology and business community clamoring with regard to Google’s innovation and employee retention challenges.

Google has long been a source of personal interest, stretching back to 2000 when I was first introduced to the website by a business school professor. What most intrigues me about Google is its culture of innovation and development. I organized a tour of Google for an executive MBA cohort from Kyiv-Mohila Business School in 2005 and obtained brief exposure to its corporate life.

In reading the WSJ article, I began to think about Google’s innovation strategy from an economic point of view, and found the following “Equilibrium Innovation” model in a textbook sitting on shelf (stick with it - it's not as complicated as it looks!):



Where:

CoI = Cost of Innovation
PVI = Present Value of Innovation
L_R&D = Amount of Resources devoted to R&D
g = Innovations/year
B = Amount of resources needed to create an innovation

(Source: Van Den Berg, Hendrick. “Economic Growth and Development,” c. 2001, McGraw-Hill. Page 216.)

PVI is a function of the monopoly profit (π), discount rate (r), and L_R&D/B.

CoI is a function of the price of resources (w) and the amount of resources needed to produce an innovation (B).

This graphical model shows that as more resources are dedicated to R&D, the “Cost of Innovation” increases and the Present Value of Innovation decreases. In economic terms, the CoI curve is the “marginal cost curve” and the PVI curve is the “marginal benefit curve.”

So how does this relate to Google and its innovation strategy?

An article printed in the July 10, 2006 edition of BusinessWeek , considers the success rate of Google’s innovations – citing that the success rate of new products at Google is below planned corporate levels.

According to their 2006 annual report, Google anticipates “that research and development expenses will increase in dollar amount and may increase as a percentage of revenues in 2007 . . . because we expect to hire more research and development personnel and build the infrastructure required to support the development of new, and improve existing, products and services.”

In order to maintain the innovation growth rates of previous years, say from 2002 – 2004, Google is looking at a HUGE expenditure if it considers this investment in R&D in a per employee basis. Employee counts at Google have risen tremendously in the past 3-4 years, from approximately 1500 employees in 2003, to 3000 in 2004, to 7000 in 2005, to 11,000 in 2006.

Going back to our model and considering the R&D and infrastructure costs on a per employee basis, this equates to a potentially substantial rise in the Cost of Innovation (CoI), especially as labor markets remain competitive during the current period of economic growth – leading to a higher price of resources (w) and the increasing amount of resources necessary to create an innovation (B). As CoI shifts upwards, the number of innovations will ultimately decrease.

Regarding PVI, increases in B will contribute to a lower PVI. Additionally, as innovation occurs more rapidly, the monopoly profit that Google will receive for their innovation will decrease because new innovations will overtake the usefulness of current innovations (Joseph Schumpeter and “creative destruction”). These factors will shift the PVI curve downward, further decreasing the number of innovations produced.

If we couple two factors:

1. The effects of shifts in CoI and PVI due to higher overall innovation costs; and
2. The appearance of Google’s “shotgun” approach to innovation

the net result is slower innovation and development within the company.

If Google has had a penchant for hiring those unique individuals that want to innovate, incubate, and develop new ideas but their internal structure inhibits employees from doing so, this may explain the reported move of employees to new companies and start-ups.

Breeding Partnerships

Last week, I traveled to Canada (including Winnipeg, Regina, and Saskatoon) with a representative from the Ministry of Agriculture of Kazakhstan to continue work on a current project we are undertaking. The representative is the director of an agricultural research facility in Astana, and the goal of the trip to parts north was to discover possible partnerships that may exist between Canadian agricultural organizations and universities, and those in Kazakhstan.

Working on projects such as this, it is always amazing to me what can be accomplished in a single meeting between two interested parties with legitimate stakeholder opportunities in a newly developing project. In this case, Canada is a global leader in grain development, processing, and milling technologies (among many other agricultural sectors).

One example is a meeting with held yesterday at the Western Canadian Farm Show in Regina, Saskatchewan. We met with a representative from the University of Saskatchewan that is responsible for developing international partnerships and liaisons. After discussing the goal of the project in Kazakhstan and the desire to establish connections with their research institutes, we were able to verbally agree to sign a “Letter of Intent” to begin working together that will be signed in the upcoming weeks. For the University, this is an opportunity to transfer know-how and technology to an important international market, and for the Kazakh counterparts, this is an opportunity to expedite the development of their agricultural research facility in Astana.

The meeting was established through significant planning and research from our end on behalf of the ministry to uncover possible linkages between the two parties and countries – planning that began with a simple cold call to the director of the Grains Research Laboratory at the Canadian Grain Commission (CGC) in Fall 2006. Many phone calls, emails, and rescheduled trips later, we were able to procure this and other highly successful meetings during the course of the week.

Not knowing much about grain and grain production in Canada, I relied heavily on the idea of “Investigative Selling” – asking many questions to uncover the possibility of partnership development and understanding the mutual benefit on both sides. This is a topic on which I will write further, but with this successful trip just concluded, I wanted to share this positive experience to those seeking partnerships from organizations and companies that may not appear to be a good match or may seem impractical because of geographic constraints.

Most importantly, it emphasizes the importance of treating partnership development as you would sales development. Without clearly presenting the benefit to the target organization, the chances for moving the relationship forward can be diminished. Fortunately, I was able to find the right person at the CGC who was willing to be proactive and consider the seemingly odd proposal of considering a partnership with a research facility in Kazakhstan.

And finally - if you've never visited Saskatoon in the summer - you are in for a very pleasant surprise. Wonderful city with great people and surprising restaurants. We were in Saskatoon on the first day of summer and finally saw the day creep into night at 11:00 PM, and morning arrive well before 5:00 AM.