Software

Changing the Game

December 15, 2006 on 6:21 am | In |

There was a time in Silicon Valley when starting a company meant building something that you wanted to have, then other people came asking to buy one and you were in business. Companies in those days absorbed little venture capital and had the quaint notion that prior to going public it was a good idea to actually be profitable. As an example look at Apple Computer, which was financed in part by legendary VC Arthur Rock who invested -- get this -- $37,500 in the company. Apple was six years old before the company even had a budget, simply because there was no way prior to then that Apple could even think of ways to spend all the cash they were generating.

Those were the days.

Then the 1990s brought the dot-com era where this system was thrown on its head. Start-ups took gobs of venture money, a lot of it simply used to figure out what it was they really intended to do when they grew up. IPOs no longer required profitability. In fact profitability was seen as a bad idea all around, since it implied that some money wasn't being used to: a) finance rapid growth or b) buy Super Bowl commercials.

Those weren't the days.

And now we've entered the crazy era of AJAX and AJAX-related start-ups where a new hybrid rule set applies. Companies no longer need to raise lots of cash, no longer need lots of people, no longer need to even directly sell anything at all to be considered successful. They need revenue, of course, but that's mainly through advertising. And they need to create something people want to use. But Super Bowl ads? Forget those.

Lately I've been interviewing experienced entrepreneurs from these earlier eras and for the most part they have jumped into the new way of doing things. Recently it was Jerry Kaplan and Robert Carr, who together raised and lost something like $80 million inventing pen computing in the 1990s and being destroyed in turn by Microsoft. Today each man has a self-funded start-up with a handful of workers. In Carr's case, it is just he and his brother. Remember, this is the guy who led 250 developers at Autodesk to create AutoCAD 14 -- the most successful release ever of the world's number one CAD program. Now it is just Carr & Carr, and what's weird is they'll probably make more money as a twosome than Robert ever made at Autodesk.

What's driving this phenomenon is a lot of technology at the right point in its development combined with a lot of rich nerds who cashed out of the dot-com era earlier than the rest of us and can therefore self-finance their new ventures. But most importantly what's driving the new start-ups is the fact that broadband Internet is approaching ubiquity. This month 75 percent of Americans who have Internet service have broadband Internet service and that's probably the tipping point for our Internet futures.

Every market that involves the schlepping of bits is in turmoil as a result. This most especially extends to entertainment because we have always spent an inordinately large portion of our lives listening to music and watching bad television. The new era we're entering will provide a lot more of both, along with more good stuff, too. It's becoming a viewers' and listeners' market, which is good in the long run for artists and bad for record and movie companies.

But everyone knows all this, right? I'm wondering what effect it will have on the venture capital industry, which isn't nearly as clear.

We're already seeing a change. To put things very simply, VC's hid after 9/11 and only recently began to invest again as an alternative to giving back to investors the money they've been sitting on (and taking management fees for) since 2000. Right now it is easier than ever to get venture financing because if these funds aren't fully invested -- even in bad investments -- the various partners will have to give money back that they've already spent.

So there is plenty of money available -- nearly $1 trillion -- but it is coming at a time when, as I have just described, a whole new class of start-ups has appeared that doesn't want VC money -- at least not very much of it.

So just as the VC industry morphed into excess and gluttony in the 1990s, so it is now reconfiguring itself for the realities of this millennium. The big question is, "What do we do with our $1 trillion?"

And the answer is that the VCs are reconfiguring the food chain to take their cuts at a different level.

The old model was for top firms (those run by intelligent people) to look at 800 deals per year and invest in two to six, pumping them with enough money to assure success while also killing off the founders and pushing for an early IPO and VC cash-out. The other VC firms just watched what the top firms were doing, then bought in on B or C rounds where the risks and returns were proportionally lower.

The new model is venture capital masquerading as a combination of hedge funds and investment bankers. Seed rounds are the only rounds and they are limited to angels, friends, and family. Very few companies go public and those that do are unique in their niches. Acquisition has always been the other exit strategy, but if the VCs don't have a piece of the company being acquired, they can't enjoy the benefits of a sale, so what's to do? The VCs start acquiring companies, that's what, in a classic hedge fund maneuver called a "roll-up."

A roll-up means buying many companies in the same market niche, say convenience stores. A private equity group buys, for example, four to five chains of convenience stores totaling 2000 locations. They consolidate the chains saving fixed costs, obtain some economies of scale through bigger purchase orders, but mainly they sell off poor-performing stores for their real estate value, and eventually take the new company public or sell it for a profit to an even larger competitor.

Today's high-tech version of VC-managed roll-up means buying a bunch of similar high-tech companies, consolidating their products and services, then selling the whole or taking it public, simple as that.

What's driving this trend beyond the simple needs of VCs trying to find good places for all that money is Google. Will there ever be another Internet success to rival Google? Not in this decade there won't. So rather than even trying to repeat Google, VCs participate in the Google ecosystem, the best example of which is YouTube, which just made a few VCs a LOT of money when it was purchased by Google for $1.65 billion.

But the very success of YouTube strongly suggests that there won't be another YouTube, simply because one site downloading 58 percent of all Internet videos and that site, in turn, being acquired by the second-biggest video downloading site that also has more money than God, well the YouTube guys would have to commit mass suicide to blow their lead at this point and I don't see that.

But this doesn't mean there aren't a lot of suckers, er, motivated investors out there for the other 99 video-sharing sites. They just need some visibility, hence the roll-up. Buy 20 such sites for $200 million, throw away the bad technology and (hopefully) the poor-performing people, get everything running under one brand name, then either take it public (doubtful) or sell it to Barry Diller, Rupert Murdoch, or some other tycoon who needs to be a part of the latest Internet miracle but may not fully understand the nature of that miracle.

Buy west and sell east, they'll call it, and the strategy will be a key one for the next decade. It will buy a whole new fleet of Porsches and jets for the boys and girls of Sand Hill Road.

And if you are an engineer with a good idea, it will bring the certainty of faster liquidity and maybe even a double payday when your company is sold and then when it is resold as part of the greater whole.

So I am not saying this is bad at all. I'm just saying that the game has changed.