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Who will create the Netscape of the Blockchain era? May 27, 2014

Posted by Bernard Lunn in capital markets, Fintech, Globalization, India.
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This is one of a series called Explorations down the BItcoin rabbit hole.

The Blockchain is exciting because The Perfect Copy Machine has its flaws.

Let me unpick that, starting with an anecdote.

In 1992, somebody showed me the Internet (thanks Charles Rawls). I ignored him. Silly me! The reason I ignored it was that I am not a developer and could not see how to use it.

The next time I saw the Internet was in 1996. I was in India and needed to use email in an Internet cafe. A developer showed me Hotmail.

The rest, as they say, is History.

In between those two events, a student at University of Illinois at Urbana–Champaign co-wrote the first browser for the Internet (thanks Marc Andreessen).

The Blockchain does not need a browser, but it needs something like a browser that makes it accessible to ordinary people. Today we only know the Blockchain because of Bitcoin. Now I will play the Long/Short game that FT journalists use in interviews:

Blockchain: Long

Bitcoin: Short (it’s primary value is to teach us that Fiat currency is like Winston Churchill’s description of democracy “lousy but better than any of the alternatives that have been tried”).

My inner editor is saying, get to the lede  (thanks Owen Thomas). What is wrong with The Perfect Copy Machine of the Internet? Simple: I cannot value something because it can be copied for free. That has been a dream opportunity for developers to make fortunes by offering ways to navigate the oceans of freely-created digital data. It has been a nightmare challenge for creative people, who had over time learned how to control of the analog copy machine, but then lost control of the digital copy machine.

However that is not where the Blockchain is needed. Creative people will finally find ways to make a living using The Perfect Copy Machine (as musicians are finding with iTunes and Spotify and writers with Createspace).

That is a First World problem and it is being solved.

I think the Blockchain will find use in the Rest of the World. Then it will come back to the West.

This is a “First the Rest then the West” story. To think about this, travel to Kenya and see where a digital currency/mobile wallet accounts for 30% of GDP. No, it is NOT Bitcoin. It is M-Pesa, derided by techies as utterly simplistic but massively useful to the billions emerging into a global middle class (which is the biggest story of the 21st century). One reason that M-Pesa works is because individuals can prove who they are using the most basic mobile phone. Yes, that is right your mobile number is your identity!

Like the other 7 billion people on the planet, I am unique. That is scientifically true, check my DNA. But my identity can be copied and my work can be copied. Again that’s a Western World problem and I can live with it. What if the title to my house or the access to my bank account could be copied? That is not fanciful; anything that has access to the Internet is accessible to criminals who can steal any of my assets that are recorded digitally (stealing is another way of saying copy it without my permission).

What if there was a way to protect the uniqueness of assets (creative or land or financial or whatever) that was not controlled by anybody other than you? That would be a powerful enabler for the billions emerging out of poverty who will then buy the products and services that our children and grandchildren in the West will be creating in order to make a living.

The Blockchain could give me the same control over all my assets as WordPress gives me for over my scribbling. 

That is why I am excited about the Blockchain. Other people share this excitement, but it strikes me that it is like the excitement for the Internet around 1992 before the browser made it accessible. Making the Blockchain accessible to the 7 billion people who will soon have mobile phones (it is over 5 billion today) will create a seismic shift.

If you are building something like that, I would love to hear about it.

This is one of a series called Explorations down the BItcoin rabbit hole.


Oculus Facebook deal will accelerate equity Crowdfunding and change the world. March 30, 2014

Posted by Bernard Lunn in capital markets, start-ups.
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The Oculus founders got $2.4m of free seed funding via Kickstarter. Let’s say that had been a traditional Angel or Seed VC equity round for 25% of the company. Those seed funders would have got, in aggregate, 25% of the $2bn that Facebook paid, which is a substantial $500m.

I believe that the Oculus Facebook deal will accelerate the equity Crowdfunding revolution. Yes, this is good news for the future, even if a lot of people who gave free funding to Oculus via Kickstarter in return for a beta product and a T Shirt feel a bit burned today.

FWIW, the terms were clear, the folks who ponied up cash were promised an early version of the product and got what “it said on the tin”. As Matt Asay points out on ReadWrite, this is the same issue as people who contribute to open source and watch an entrepreneur get rich.

Personally I think how millions of people make a living as we emerge out of the Great Recession – the crowdfunding story – is more interesting than how a bunch of overstimulated people ramp up the stimulation to the max on the dial – the VR Oculus story. Page views – the currency of the Internet – will undoubtedly prove me wrong.

Tales of an early stage/seed funding bubble get a wry laugh outside Silicon Valley. The Oculus story is also about a “unicorn” ($1 billion plus exit) spotted outside the Valley. Unicorns are rare enough, but Unicorns outside the Valley leads one to refer to Skype – and who else? Well now it is Skype and Oculus. Oculus is from Southern California, which might as well be Ulan Bator (capital of Mongolia) to the Sand Hill Road VCs. If Oculus had been in the Valley they would have easily got Angel funding – and given 25% to those Angels.

Hmm, being outside the Valley is better, you just get free equity financing via Kickstarter?

Not so fast, this is the last deal like this. Nobody wants a bunch of T Shirts plus being the first kid on the block with a new toy for $500m of equity value.

Kickstarter, which was born in New York, is an unexploded bomb on the tree-lined streets of Sand Hill Road. The economic impact of Crowdfunding will be felt outside the Valley. It is a simple need issue. Crowdfunding is much less needed in the Valley compared to Europe, Asia and other parts of the world that have so far been less impacted by the digital revolution. Or compared to LA or New York or New Jersey or (a few other places in America where most people live).

However we are still in the really, really early days of crowdfunding, the days when we have not yet moved from the “first they laugh at you” phase. There are also different forms of crowdfunding. As an adviser to startups, I recently had conversations with two entrepreneurs both of whom were looking at Crowdfunding as a way to get their dreams realized:

1. Niche electronic product, using Arduino. The entrepreneur lives in UK and has no access to the VC world.

2. SaaS product. The entrepreneur lives in New Jersey, close enough to some good VCs. The bigger problem is that he is older than is considered optimal by VC. Of course no VC would reject him for that reason, other reasons would be given (as this article on ageism in the Valley describes so vividly).

The old joke from the early days of the Internet – “on the Internet, nobody knows you are a dog” – has a new life for entrepreneurs who are not young white males living in the Valley. Crowdfunding means that nobody knows that you are old, female, colored or live in the middle of nowhere when you are seeking funding. You can pay a friend to star in the Kickstarter demo video.

The fact that Kickstarter is now in the UK is a big deal, a sign that this is a global revolution, but it is only a start, we need to see this in every remote corner of the globe. An entrepreneur in Africa (where mobile money disruption is happening for real) should be able to tap into both local and global markets using these networks.

This has revolutionary implications for the VC business. The cost of building the first MVP has already plummeted to the extent that, in many cases, no external funding beyond Friends & Family is needed. The Angel/Seed VC round is now needed to fund the go to market phase. If Crowdfunding takes an axe to those go to market costs, the balance of power between talent and capital will shift dramatically.

The SAAS entrepreneur does not need funding to develop the product, he has built it on his own time. He is looking at crowdfunding as part of his go to market strategy, by selling equity at a bargain basement price to early adopters in his niche who will give him good feedback and evangelize the product after launch. Selling Equity is not part of a capital raising strategy, it is part of his go to market strategy. After the Oculus Facebook deal, this could become the norm. Peter Lynch, a legendary investor who is up there with Warren Buffet, advised investors to invest in what they knew (check out the company that makes a product that you and your friends love). The gaming enthusisasts who backed Oculus on Kickstarter knew what was good well before the VCs who made money by watching them. Many VCs today are like an A&R guy watching the audience for a hot new band and recording the enthusiasm on his clapometer – “the kids seem to like these Beatles”.

These days, retail investors have to wait until the easy money has been made by VC, in order to invest at IPO time. Yet these are the people who spot the brilliant new products well before the VCs do.

This brings our attention to which Crowdfunding networks will win and how will they evolve? I tend to think of Kickstarter and IndieGoGo when I think of Crowdfunding. That will annoy all those building other networks, but this is a classic winner takes all network effects market. I can envisage two maybe three networks in ten years time, but I cannot envisage 5, let alone 10 or more. The winning networks will have to scale to cover all the Four Crowdfunding options which are:

1. PreOrder Plus Reward. This is how Kickstarter and IndieGoGo work today. This is how Oculus got funded via Kickstarter. This is relatively easy from a regulatory POV as it is about e-commerce rather than financial markets, so this is easy to globalise.

2. Equity. This is where regulatory complexity arrives (for good reason, this is where scam artists will operate). Even if the primary use is PreOrder Plus Reward, you may still want to offer Equity and it makes the process dramatically easier if this is done on a single platform. The JOBS Act in America leads the way. Even though other countries pioneered this, most countries will take the lead from America or miss out on the wealth/job creation from innovation. I think that networks that combine PreOrder Plus Reward with Equity will win out over pure Equity funding platforms such as Angel List. This is where the Oculus Facebook deal changes the game. The funders of a future product will expect equity in addition to beta product and T Shirt.

3. Debt. Why add this to Crowdfunding networks when perfectly good Peer Lending networks already exist? The reason is that the loan is done within context of the product being built/launched, there is less collateral or cash flow but the lender might still be motivated to lend because they know the entrepreneur and/or share the passion. In some cases equity will be appropriate (it’s a big market and there will be an exit) and in other cases debt will be appropriate (it’s a niche market and a big exit is unlikely).

4. Donation. Some wealthy investors may prefer to donate (and circumstances permitting, get a tax write off).

Crowdfunding networks will have to be big to do all four on a global scale, but the opportunity is massive.

Many VCs want to believe that the entrepreneurs who use Crowdfunding to get started will need them when they want to scale. It certainly worked that way in the case of Oculus. I am not sure that will be true in future. Crowdfunding naturally works in markets that are not capital intensive. The VCs don’t want to stuck investing in capital intensive businesses (like renewable energy, new healthcare drugs & devices, the kinds of products that take serious R&D $$$ before a launch is feasible). Other sources of funding such as Hedge Funds can jump in when they see momentum at a later stage.


Disruptive Fintech: Bits Of Destruction Hit Wall Street. July 11, 2013

Posted by Bernard Lunn in capital markets, SAAS.
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Bits of Destruction is a phrase coined by Fred Wilson of Union Square Ventures to describe the disruption that incumbents face from digital ventures whose primary costs keep falling thanks to Moore’s Law.

Consumer finance has already seen successful ventures such as Mint. Will the same thing happen in the B2B markets for financial services aka the capital markets aka Wall Street?

At the 30,000 foot level, this seems inevitable. A financial transaction is simply matching buyers and sellers (or lenders and borrowers). The Internet is very good at that.

This “disruptive fintech” market is moving fast. Already $10 billion has been invested in disruptive fintech ventures.

Fintech (financial technology) used to mean selling financial technology to financial institutions, who used that software to provide financial services to companies and consumers: but that game is in its final innings and the winners have already been declared. The new game is providing financial services directly to companies and consumers via software-driven networks. This game is in its first innings and has decades of opportunity ahead; most of the winners have not been declared, most of them have not even started yet.

For decades, the big financial institutions ruled. They could invest in IT and their scale made them attractive vendors to the Global 2000 scale companies and they needed scale to reach consumers via physical branches. But then three things happened at the same time to disrupt this status quo:

1. The financial crisis made the big financial institutions “pull in their horns”, making them more cautious. Not only are all the usual organizational antibodies fighting to stop disruptive innovation. That is standard innovators dilemma. But the financial crisis means that even if a CEO musters the courage to fight those organizational antibodies, she will be constrained by their balance sheet, aggressive regulators and nervous investors. The absence of the big financial institutions opens a window of opportunity for other entrants.

2. It became dramatically easier to build financial technology. The combination of the cloud stack and open source software has taken a great big ax to the cost, timescale and risk of building financial technology. This is classic 10x disruption. What used to cost $10m and take 3 years now costs $1m and takes 3 months.

3. It is possible to reach customers directly online and through their smartphones. The low cost of building fintech is meaningless if the big  financial institutions are still the only gateways to customers. You would then still need a lot of Rolex wearing, Beemer driving sales guys to sell to those Big Banks and that cost has not come down at all. But now that nearly 50% of the world’s 7 billion people have mobile phones that get smarter all the time, it is possible to reach consumers of financial services directly. And doing this digitally can be very cheap. Doing this well is still a mix of art and science that very few people understand, but that knowledge is propogating rapidly. The key point is that Big Banks are no longer the only way to reach consumers of financial services.

These disruptive Fintech companies all have software at their core, but they don’t look like what we think of as software companies. They don’t license software, they usually look to their market like a digital venture or a business service or a regulated financial institution.

HP Autonomy. When You Need Forensic Accounting For Enterprise Software, Who Ya Gonna Call? November 22, 2012

Posted by Bernard Lunn in capital markets, Corporate Strategy, Deal-making, Enterprise Sales.
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Wow, what a story! It makes me wish I was till writing the Enterprise Channel for Read Write Web. It is a fascinating story because how you see it depends on where you sit. This story sits at the intersection of accounting, software technology, enterprise sales and business strategy. I have sat at all those intersections.

The best Forensic Accountants usually make money from their skills by shorting stock. Folks like Jim Chanos who spotted problems at Autonomy don’t need to know a lot about running an enterprise software company to know that when cash flow is way less than profits, something good is not up. They look for simple signals such as high receivables and low deferred revenue. You don’t need years of running an enterprise software business to know that those signals are worrisome (or exciting if you make your money shorting).  Of course if, like Larry Ellison, you have years of running an enterprise software business and had your own issues with revenue recognition, you will quickly come to a conclusion that the price being asked for Autonomy was too high.

Why did the massive number of highly paid accountants and lawyers from fancy firms not read those same signals? I am sure they asked a few questions around this but got snowed by the replies. That is when they should have got advice from a grizzled veteran of running an enterprise software sales team who has seen every technique for boosting revenue at the end of a quarter or year (channel stuffing deals, deals done on the 35th of the month, bundling deals with disguised discounts – the gaming ingenuity is endless). Then you need an accountant who has a passion for understanding the nuances of IFRS and GAAP accounting standards as they relate to revenue recognition (yes, they do exist, a quick bit of online searching will surface them and I am sure they can use a consulting gig).

Parsing through the “he said, she said” stories, my guess is there was something wrong in the accounts, something that was either aggressive accounting or fraud (I will let the lawyers parse that one as I am sure they are doing) but nothing even close to enough to justify the $5bn that HP is claiming. HP needs to decide whether they are a consumer company or an enterprise company. The Autonomy acquisition was part of a strategy to ditch the PC and the consumer business and emulate the IBM turnaround under Lou Gerstner. HP clearly wanted to do the deal, knew they were over-paying and were OK with that as part of a broader strategy. If HP had stuck with that strategy and executed well, the price paid for Autonomy would be a footnote in history.

It looks like Meg Whitman leans to the HP as a consumer tech company strategy. That fits her eBay past and the prevailing fashion in Silicon Valley. She may execute brilliantly on that. What clearly does not work is marching determinedly north (enterprise) and then a little later marching determinedly south (consumer). The HP Board is rightly getting a lot of flak for this kind of flip flopping that destroys value really fast. Nor will a fudged strategy work (“a little bit of his and a little bit of that with chocolate sprinkles on top”). Focus matters. Strategy means clarity. “Which direction do we go, Sir?”

Looking at this from a modern software perspective, this mess adds to the move from perpetual licensing to subscriptions and transactional revenue models. These new models simply don’t lead to the same frantic “must hit the numbers this quarter by bringing in that sale NOW and maximising every $ on that sale”. Subs and trans revenue is fairly stable and predictable. Nor do subs and trans models leave as much room for gaming. I suspect the Boards of enterprise software companies that still rely on perpetual licensing will be debating this subject more vigorously than before the HP Autonomy story broke.

Where Do Niche Enterprise Software Companies Go To Retire? October 10, 2012

Posted by Bernard Lunn in capital markets, Enterprise Sales, Enterprise Web 2.0, SAAS.
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Many years ago I worked for Misys, after they acquired a company that I worked for. The founder, Kevin Lomax had simply taken the Hanson Trust model (for industrial companies) and applied it to software. Misys was a good exit option for the founding management team and Misys had a simple model that worked very well for a long time. The basic model worked as follows:

1. Buy a mature enterprise software company in a niche market. Mature meant lots of Maintenance Fees, which has good revenue visibility, almost SaaS like. I worked at Kapiti when Misys acquired the company. This was Misys’s first foray into banking software, their initial market was Insurance.

2. Buy other companies in the same niche, become the dominant vendor and get economies of scale. Fairly soon after buying Kapiti, Misys acquired ACT (a public company that had a couple of bad quarters and was available at a good price). ACT owned Kapiti’s two major competitors – Midas and Kindle. Overnight the instructions changed from “beat the crap out of those guys” to “compete, sort of, but do it nicely and for goodness sake don’t get into a price war”.

3. Then buy lots of young and more technically leading edge companies and sell that into the market that you already dominate.

So, what is wrong with this picture? Today, Misys is a shadow of its former glory. It was nearly bought by Temenos and now is a bit vulnerable after they walked away from the deal. In 1996, when Misys owned  Midas, Kapiti, and Kindle (representing the number 1, 2 and 3 by market share), a tiny upstart run by a great entrepreneur called George Koukis decided that Misys was vulnerable and could be taken on! That was some crazy strategy, but he was right. His company was Temenos. The fire had gone from the belly of the Misys folks, but it burned fiercely at Temenos. (Watch George Koukis, a Greek, talk straight about the Greek Crisis, a refreshing entrepreneurial take on a tired old story).

The big question for all the holding companies that emulated Misys and all the Private Equity buyouts and roll-ups is how do you keep that fire in the belly? How do you go for growth when you already dominate your niche? The basic strategy is to move into adjacent niches. This requires a start-up/entrepreneurial mind-set, the kind of skills that the company had in its founding days and then lost.

Misys would have been fine had they not had a really driven entrepreneur like George Koukis coming after them. There was no disruptive technology or new market to worry about. Temenos had no tail winds to help them. The same is not true today. The legacy companies are being attacked by lots of Koukis like entrepreneurs and these entrepreneurs have the huge tail wind of working with native cloud technology. The old-software company’s retirement home is not as serene as it used to be.

Is Workday The Breakout Enterprise Software Company Of The Decade? October 8, 2012

Posted by Bernard Lunn in capital markets, Enterprise Sales, Enterprise Web 2.0, SAAS.
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It has been a boring decade in enterprise software.

Where is the big enterprise software winner of the last decade? Where is the Oracle or SAP of the last decade? Or less ambitiously, where is the TIBCO, Cognos or Hyperion of the last decade? So far the only one to make it into the big leagues is Salesforce.com and it is unclear if they will actually make the breakout from their CRM niche to something bigger.

Workday has the ambition, funding, founder experience, breadth of offering to be this winner. This one will be interesting to watch, the SaaS Index is getting a new bellwether stock to join $CRM very soon.

Four Gates That Multi-$billion Ventures Pass Through. September 28, 2012

Posted by Bernard Lunn in capital markets, Enterprise Sales, IPO, SAAS, start-ups, Strategy Workshop.
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I also think about these Four Gates in the form of a funnel, with lots at the top and very few at the bottom (just like a sales funnel):

Gate #1: Conceptual Clarity.

Gate #2: Prove the Concept.

Gate #3: Scale within Niche.

Gate #4: Expand and Dominate.

It takes totally different skills to go through each of these four gates. Few founders have all the four different skills needed, which is why so many ventures fail as they attempt to pass through these gates. Even harder is the fact that the skills, techniques and attitudes that make you successful going through one gate are exactly the opposite of the skills, techniques and attitudes that make you successful going through the next gate. Each gate requires a wrenching pivot.

Gate #1: Conceptual Clarity.

This is the “fit to the future” phase. This is where you have a vision of “a world where….”. From this you have a mission for the venture along the lines of “in this future world, we will…”. Finally, you have a strategy, as in “we will do this by….”

There has been a lot of fruitless debate about whether concept or execution is more important. This debate is silly, because you must have both. A bad concept that is brilliantly executed will be nothing more than a tough uphill slog with relatively little reward at the top if you get there. On the other hand, a brilliant concept with weak execution is nothing more than “woulda, coulda, shoulda”.

In consumer web ventures, the investment in this phase is coding an early version of the site; these ventures are usually founded by developers who can invest their moonlit coding time, knowing that the best way to articulate the concept is to show something. In enterprise software, the investment in this phase is talking to lots and lots of potential customers to really understand their pain points both now and the likely pain points in the future world that you envisage. The founder is often a sales executive in an established company who keeps hearing the same request from customers that his/her current employer has no interest in fulfilling. They start with a crystal clear understanding of the pain, but only when they team up with a great developer do they create a solution to that pain. The established vendors are not being totally blind, nor are they only inhibited by the innovator’s dilemma from cannibalising their core business. Usually a technological breakthrough is needed as well. Thanks to Moore’s Law the world is awash in technological breakthroughs but most of them are solutions looking for a problem. What differentiates the great ventures is a crystal clear understanding of the problem, because they have heard the pain described by so many customers and prospects.

I look for conceptual clarity in 4 dimensions:

  1. Large enough market. A niche might make for a great venture that can be bootstrapped or flipped, but  these are criteria for ventures that can “go the distance” through the four gates into multi-$ billion in value.
  2. Massive disruption hitting that market. This is the kind of disruption that creates an existential threat to the major players in the market – think of Skype vs telephone companies or Google vs traditional advertising. If it is not disruption of that scale, the existing vendors will add the features they need to stay competitive (“adding that feature” may mean acquiring your venture, so this is fine for ventures that will be acquired before they go through all these gates).
  3. You have a 10x proposition. You have to be 10x better or faster or cheaper than the incumbents. That seems like a high bar, but it needs to be this big to overcome the start-up risk that you are asking customers to take. Tactically you may start by offering say 3X knowing that as the technology rolls onwards you have much more in reserve, but you must see where that 10x is coming from.
  4. You really, really want to do this more than anything else in the world and deep down you believe that you are the best person to pull this off. You are saying “damn the torpedoes, full steam ahead”. If you want people to take that risk with you, you had better believe it yourself deep down in your heart and gut. You also must be ready to commit to at least 10 years with 60 hour weeks, forget about a balanced life for a while.

Here are the two things you do NOT need to have at this stage:

  • A strategy that seems viable to most people. Most great ventures look totally ridiculous to most sensible people in their founding days. You do need a couple of smart people to believe in the strategy, whether they be co-founders or investors. But get comfortable with the fact that most people think you are crazy (unless you actually are crazy, there will be times when you doubt yourself and when you think most people are right).
  • Any proof that any of the four things on that checklist are true. Anybody who asks for proof at this stage does not know how this works and does not deserve to be your partner.

Many great entrepreneurs have conceptual clarity but are weak at articulating it, or too busy executing on the next phase. At this stage nobody cares about your concept. Only after you have passed the next gate does anybody care. Enterprise software ventures tend to be bootstrapped from customer revenues, not from VC, so the founders learn to focus their pitch on the immediate needs of customers who are ready to make a commitment now, leaving out all the futuristic, big picture stuff which would only scare potential customers. However, somewhere in the back of their mind, the great entrepreneurs carry a conceptual vision that is a lot bigger than the immediate solution that they offer to get through Gate # 2.

Gate #2: Prove the Concept.

This is the “fit to today’s market” phase. This is also what VC call “traction”. Many entrepreneurs stumble at this point because they are not consciously making the transition from thinking about the future to executing on the present. The future that you envisage may or may not come to pass. If it does, you may strike gold. However that won’t help you get traction with customers today. All they are concerned about is problems they have today. Your customers maybe happy to “shoot the breeze” about the future, but they will only spend their money on problems that they have right now.

That almost certainly means you get traction in a niche that is tiny compared to the big vision in your concept. This process of digging deep into a niche and focussing 100% on the present day needs is a vital step in turning dreams into reality. It is also 100% opposite to what you do to get through Gate #1.

In enterprise software, getting through Gate #2 means getting the first three paying reference customers. This is a tough job because most customers prefer to wait until you have these three references before committing; one way to drive enterprise software founders crazy is to ask them about this chicken and egg problem. These need to be real enterprise-wide deployments with customers paying 6 figures. A few logos of customers deploying the software in one small area and paying a few thousand dollars won’t make the grade. Lots of enterprise software ventures reach this stage and become cash flow positive without raising any VC, but then stumble at the next Gate.

In consumer ventures, getting through Gate #2 means proving fit to market in a niche. So the service has to work and deliver what those consumers want. In the lean startup model, this is when all that pivoting takes place. However great entrepreneurs don’t pivot at a conceptual/strategic level, they got through Gate #1 with conceptual clarity, but it may take multiple tactical pivots to get traction in a specific niche.

Gate #3: Scale within niche.

This is the “make it work as a business” phase. This is when you throw out the lean startup guide book and start working like a real business with serious amount of capital and real management bench strength. Blowing it at this stage for lack of resources – human or financial – is dumb.

During the last decade, most enterprise software vendors that made it past Gate # 2 got acquired. VCs mostly shunned enterprise software during this time and it takes huge amount of self-sacrifice by the whole team to make it past Gate # 3 without VC.  At this stage – you have the 3 reference customers, you have proved the concept – the acquirer will not consider your revenues to be meaningful, so you will be acquired for your R&D value with a bit of credit for the quality of your customer relationships. If you are lucky, you hit a market just at the point where two behemoth vendors who compete like crazy absolutely must, must, must have this technology….. If you raised VC, the acquisition value at this stage will usually be a disappointment to investors. As VCs usually get liquidation preference, this will be an even bigger disappointment to founders and management. If you bootstrapped past Gate # 2, the value you will get from the trade sale will still be life-changing as you don’t have to share the spoils with VC. However the big money, the fame and fortune, is reserved for those who make it to Gate # 3. One way to look at this is, don’t raise VC unless you are determined to make it past Gate # 3.

Entrepreneurs who want to build enterprise software ventures that make it through this gate need to make the tough transition from founder-led sales to a scalable, professional sales team. This is harder than it sounds for reasons that I describe in this post.

For consumer web ventures, the big obstacle at this Gate is proving a scalable and profitable revenue model. There are now trade offs and conflicts to be managed between the needs of free users and the different needs of paying customers (i.e advertisers) and that is often hard for the entrepreneur who won in the last Gate through their self-proclaimed single focus on user experience. This is when we see the free users (“if the service is free, you are the product”) start to get annoyed as the company starts to monetize them more aggressively (think of Facebook or any other social media venture), but a great entrepreneur and management team can navigate their way through this challenge.

Businesses that make it through this phase are “in the catbird seat”. You have a profitable, scalable model that you can grow with internal resources as long as you like. You will be fending off acquisition offers all the time, both from financial buyers (private equity funds) as well as strategic buyers. You get to choose when and who you sell to. Or you may choose to go all the way to Gate # 4.

Gate #4: Expand and Dominate.

This is the post IPO sustainable public company phase. This is where ventures grow into their original conceptual potential, moving beyond the niche orientation that you need in order to get through Gates 2 and 3.

For consumer technology ventures, consider the difference between Apple and Google and all the batch of 2011 IPOs. Apple and Google look good on all financial metrics, they built a superb monetization engine, not just superb products.

In the enterprise software space, only one company has broken through into the big league during the last decade and that is SalesForce.com. There have been plenty of SaaS IPOs, but only a few of them have escaped the “small cap hell” by getting a valuation over $2 billion. It remains to be seen if this decade will produce more big winners, but that is the subject of another post.

The “expand and dominate” Gate #4 is about getting back to that original founding conceptual clarity, of realising the big picture potential. All the long years of the earlier Gates are simply laying the groundwork to make this possible. This is another wrenching pivot. The skills, techniques and attitudes that got you up to Gate # 4 are all about focussing on a niche, constraining ambitions for the future while concentrating on the immediate opportunities. If you have done a good job in the transition through Gate # 3, you will be able to leave the quarter by quarter growth to a highly competent team. That frees the founder CEO to focus on expanding into adjacent markets and dominating their market. Dominate may sound harsh to some ears but it is what public market investors expect, that is what the high valuations given to fast growth tech companies are based on.

Entrepreneurs that make it through Gate # 2 get the opportunity to exit and that can be a good result if they have bootstrapped to that point. Entrepreneurs that make it through Gate # 3 get the opportunity to exit and that is a good result for founders, management (this is when those stock options become life-changing) as well as any investors who are fortunate enough to be along for the ride. The Silicon Valley VC orthodoxy for a long time was that no founder has the right profile to make it through all the 4 Gates. Therefore VCs have usually tried to either sell the business at each of these Gates or find professional management to replace the founder CEO. (I refer to the Founder CEO as the key, even though there are often co-founders it is one of them who emerges as the leader). That conventional wisdom is being seriously questioned today as we witness the failure of “professional managers” from big companies to drive the growth of start-ups. When you look at the really great success stories, you tend to see one highly charged entrepreneur who takes it all the way through these 4 Gates – think of Gates, Ellison, Page, Zuckerberg, Bezos, Jobs, Benioff. Their ability to pivot and personally change at each of these Gates is the story of their success. It would be crazy to see these entrepreneurs in their founding days and envisage them as the CEO of a multi-billion $ publicly traded company, yet some of them actually do that. The current VC fund structure, with its need for exits to return money to the Limited Partners, is not conducive to backing entrepreneurs all the way through these four Gates. So we are likely to see some innovation in this area as the rewards for backing entrepreneurs through all four gates is very big.

Is Facebook Worth $100 Billion? Not If Competitive Advantage Period Is Halving With Each Generation Of Technology May 2, 2011

Posted by Bernard Lunn in capital markets, IPO, social networks.

Many pundits call this “The Facebook Era”, meaning that Facebook has the same level of dominance as Google, Microsoft and IBM in their glory days. Plenty of investors seem to be backing this view with some serious $$$. The current valuation of Facebook on the private markets is around $70 billion.

That $70 billion valuation is a mighty big pair of shoes they have to fill. By the time they do an IPO they will need to show a valuation more like $100bn, to give current investors and the IPO investors a return.

We don’t have reliable earnings numbers for Facebook. That will only come when they go public and file reports with the SEC. So we can only go on revenue numbers that get bandied about. Parsing through all the reports in various blog posts, the revenue growth looks tremendous:

2009: $700m

2010: $2bn ($1.86bn from ads, balance from other lines)

That is a growth rate well over 100% which is staggering at that scale. That is $1.3bn in new revenue in one year. They talked about $1.2bn in the first 9 months of 2010. If they did $2bn in the full 12 months, it means that they did $800m in Q4, which would be an annualized run rate of $3.2bn. In other words, they would be on track to double again to $4 billion in 2011.

There is almost no reliable data on profit margins for Facebook. So we cannot do any PE or PEG comparables. But let’s assume that Facebook’s margins are similar to other large ad-monetized web technology ventures such as Google (that subject alone could be multiple blog posts, let’s just take it as an assumption for now).

If we assume that, we can do some PSR (Price to Sales Ratio) against comparables like Google, Yahoo, Demand Media and eBay. These are all publicly traded web tech companies that monetize primarily via advertising. I left out AOL, their price is very low for good reasons. Demand Media is the highest at 7.78, Google is 6.3. Let’s take Google as the benchmark. They are the current kings of the web.

Let’s say Facebook does an IPO in early 2012, showing $4 billion in revenue in 2011. To get to $100 billion, Facebook would need a multiple that was 4x Google’s. Here is the math – Google PSR is 6, 4x that is 24 and 24 * $4bn is $96bn. Google’s growth rate is around 27% (that is growth in last year, lots of debate whether that will accelerate or slow, let’s just take it as their growth rate for now). Facebook’s growth rate is around 4x that at 100%.

There is some blog chatter indicating EBITDA in 2011 of $2bn. Yes, EBITDA is not the same as net profit. Nor is blog chatter the same as audited financials. But for now, lets take that EBITDA number as audited net profit. That makes Facebook at $100 billion on a forward PE of 50. If their growth is really over 100%, that makes PEG = 0.50 which indicates a bargain.

So, with a couple of assumptions, the uncrowned King Of Social Media may be able to wear a $100 billion crown at IPO time.

One assumption relates to the fact that Facebook is still private and so we have no idea if these numbers are even close to accurate. There are no audited accounts that ordinary folk can take a look at. But lets for the moment make the assumption that those numbers are accurate.

The other assumption is more complex. Built into these Facebook projections is the assumption that Facebook can keep growing at these rates for a long time. That relates to what classic management theory calls Competitive Advantage Period (CAP) and what Warren Buffet calls “competitive moat”. To put it in simple terms, “how long can the company charge high rates for something before lots of competitors storm into the market and bring prices crashing down”? So, the big question is:

Has Moore’s Law Shortened The Competitive Advantage Period?

The big question for Facebook, which is clearly “minting money” today, is how many more years can they continue to do this? The stock boosters talk as if it is forever, that is clearly not true. But is that window 20 years? Or is it 10 years? Or is it 5 years? Or is it less than 5 years? This is fundamental to how you value the company.

A little bit of tech history helps get some perspective:

  • Wave # 1: IBM, mainframes. This lasted about 25 years from 1965 to 1990. I am counting from when the “minting money” phase started not from when the technology was invented or launched into the market.
  • Wave # 2: Microsoft, PCs. This lasted about 12 years from 1988 to 2000.
  • Wave # 3: Google, Web. This lasted about 6 years from 2004 to 2010. Now we are into current days so this is a lot more controversial. But we can see that the stock market no longer views Google as a growth company (their PEG demonstrates this), they have changed CEO and the new CEO is saying that social is the next wave they have to master (and we all know who the master of social is).

IBM, Microsoft and Google still generate huge amounts of cash. The question is the acceleration in those cash flows. That started to slow when they reached the end of their Competitive Advantage Period (CAP). If the above history is even close to accurate:

We are seeing a halving of competitive advantage window with each successive wave of technology. 

Is that some weird, ugly cousin to the virtual Moore’s Law?

We do not see this shortening of CAP in markets that are not impacted by technology. For example, Coca Cola still has great moat and that is why Buffet still owns a lot of Coke shares. The same forces that enable incredibly rapid growth – think of the time it took Facebook and Groupon to get to over $1 billion in revenues – may shorten the CAP. In other words, what Moore’s Law giveth it also takes away.

This matters if you want to invest in Facebook at a $100 billion valuation. If you can believe they will grow at current rates (around 100% a year) for 5 years and then slow to say 50% for another 5 years, that $100 billion valuation is quite sensible. But if they only have 1 year at 100% and 2 years at 50%, the numbers simply don’t add up.

If Social is the current wave, what is the next wave? Mobile is the obvious contender.

Mobile is fundamentally different. The app experience is not simply the browser experience on a small screen (like TV was more than Radio style talking heads and online news is more than a newspaper converted to HTML). From a business point of view, the App Store is the first significant addition to the monetization arsenal since Cost Per Click. The mobile phone is the one device we “cannot leave home without”, it is with us whatever we are doing. Location awareness may be the game-changing innovation that will disrupt the long-heralded local commerce market.

More importantly the growth of mobile dwarfs anything that went before. There are over 2 BILLION people with mobile phones. This is where the other big part of my theme comes in – “global”. Most of those 2 billion folks with mobile phones are outside developed markets like America, Japan and Europe. That is a good news and bad news story. The good news is that 2 billion people is one heck of a big market and it is quite likely that we will see at least another billion users soon (there are over 6 billion people in the world). The bad news is that most of them have tiny amounts of discretionary income compared to users in developed markets.

If the next wave is mobile, then the question is will Facebook dominate mobile?

Facebook clearly understand the challenge. But that is not enough. IBM understood that PC was the next wave, Microsoft understood that Web was the next wave and Google understands that Social is today’s wave. History shows that the leader in one wave never becomes the leader in another wave. So, if mobile is the next wave, then Facebook probably will not dominate that wave.

Of course, it is possible that Mobile is not another wave, it is not fundamentally different, that it is simply another way to be Social. Facebook clearly have that view. But again history is a guide. IBM saw PCs as just devices to connect to a mainframe, Microsoft saw the Web as just another feature within Windows and Google saw Social as just more stuff for a search engine to index; they were all wrong.

What do you think? Is Mobile another wave or just a feature of the Social wave? If it is another wave, will Facebook dominate that as well?

10 Reasons To Be Cheerful (About The Macroeconomic Outlook) August 31, 2010

Posted by Bernard Lunn in capital markets, Predictions.
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I made my 2010 Predictions in Dec 2009 and half year update in June 2010. My predictions were gloomy on the macro picture but positive on tech and online media. In June I turned more positive on the macro picture. Here is why;

1. Bull Markets “climb a wall of worry”. They always have and always will.

2. Too many commentators are bearish, much of it crazy doomster talk that sells blog page views (and is good for canned food, Montana cabins and guns). I am not simply being a “knee jerk contrarian” by pointing out that this consensus pessimism is positive. When all the commentary is negative, traders/investors move to cash. And cash needs to get a return somewhere, so people will invest and some of that investment will lead to great companies and good jobs.

3. Most commentators are US centric and so are reporting from where this recession originated.

4. This recession hit the “chattering class”  worse than usual. The old saw applies, “it is a recession when your neighbor loses his job and a depression when you lose your job””. So the chattering class, often blogging for free or peanuts, will tend to talk about depression a bit more.

5. GDP and other macroeconomic statistics miss all the free agent and entrepreneurial activity, particularly in the most dynamic job market – America.

6. The global rebalancing is happening. This means that global demand is no longer dependent on the American “consumer of last resort” (who was actually just using their house as an ATM). Wages are rising in China and India (“Chindia”). The labor arbitrage is narrowing and a that means jobs will return to Western economies. The higher wages in Chindia means that Western firms will have a couple more billion consumers to sell to.

7. The American rebalancing is happening. This is shifting investment from property (fundamentally dead money other than construction jobs) to investment in business (when I read about a “seed financing bubble” I get optimistic).

8. People follow trends beyond reason. When things are going up they exaggerate how far it can go up. When things are going down they exaggerate how far it can go down. We are clearly in that latter phase.

9. This point is deliberately left blank. Most people miss the downside surprise. But equally most people miss the upside surprise.

10. We are animals and need our animal spirits, so we will work, trade, invest and shop our way through problems. Cheers mate!

In case you think I am a “perma-bull”, here is one example of my gloomy view and advice from Oct 2007..

SaaS Index Insights: The Bull & Bear Case On Salesforce.com (CRM) August 22, 2010

Posted by Bernard Lunn in capital markets, SAAS.
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This is an extract from the SaaS Index Insights Report, which is available on CapitalMarkets.Com, price $125. Order here.

Salesforce.com (CRM) is a bellwether in the SaaS market. There are 3 reasons to think CRM is over-valued. There are also 3 reasons to think CRM is under-valued!

The 3-Point Bear Case On CRM

First, what is the case for Salesforce.com (CRM) being over-valued?

  1. PSR compared to peers is high. PSR (Price Sales Ratio) for the SaaS Index average (as of Aug 20th) was 5.00 and Salesforce.com is 9.01, indicating an over-valuation of 85%. Last quarter this overvaluation was “only” 60%. Given their market leader status that is not surprising. But for the first time, this level of overvaluation is flashing a warning signal. Concern factor: medium.
  2. Marc Benioff is selling shares. This was announced in the quarterly report on November 25th 2009. The % of his shares that is selling is significant. He has announced that he may sell 2,750,00 shares out of a total of 13,371,006 shares he owns. That is 21%. Whether investors are concerned about this remains to be seen. Insider selling is often a trigger for smart outsiders to sell. And the short sellers have picked up on this and are using it to drive their case. But it also may not mean anything. Maybe he wants to give serious money to charity and who can fault him (or Bill Gates) for doing that? Investors do not seem to be concerned so far, evidenced by the stock performance since he started selling. Concern factor: low.
  3. Their SaaS platform play has strategic issues. This is a more complex issue. Long-term growth will require moving beyond the original core market of sales force automation systems. They understand this very well. That is why they built the Force platform. It is also probably why they raised $500m in convertible debt, so that they can acquire businesses in adjacent markets. But making the transition from one market to being a platform for multiple markets is difficult. Very, very few companies have ever made that transition. Those that have made the transition are valued very highly. Taking a long-term position in Salesforce.com is largely dependent on your view of how well they will manage this transition. We have dedicated a separate section to this issue. Concern factor: Low for short-term traders, high for long-term investors.

The 3-Point Bull Case On CRM

Second, what is the case for Salesforce.com (CRM) being under-valued?

  1. Internet market leaders are never cheap stocks. Waiting for these leaders to become bargains has seldom worked.
  2. They have executed excellently to date. They have challenges ahead of course but their track record indicates they will manage them well. Long term investing is about confidence in management and they have earned that confidence.
  3. SaaS/Cloud is going mainstream and they defined the market and still lead it. They serve as a proxy for many investors to invest in SaaS. They have a big enough market cap to play this “pseudo Index” role.

How Did The Market View CRM Last Quarter?

In short, CRM outperformed the market significantly. In our view, the market was giving due credit to great Q-Q revenue growth in the last quarter. Analysts were negative on the last quarter and the stock went up. Most of them missed the great Q-Q momentum. Not wanting to repeat that mistake, analysts are positive on the latest quarter. But we think they are wrong. We finally think that CRM is due for a significant correction.

Why? The same reason we were bullish last quarter – the Q-Q revenue momentum. This quarter was not as good. It is not bad, but at CRM’s lofty valuation “not bad” is not nearly good enough.

What Does The Latest CRM Qtr Report Tell Us?

What we are looking for in this report is primarily Q-Q revenue growth.

If they grew by more than last quarter, that means they have accelerating growth. That would be amazing given a) their size and b) their high growth last quarter.

First, here is what we wrote last quarter:

“To recap, last quarter they reported Q-Q growth of 7.11% by adding $23.5 million of new revenue. To match that 7.11% this quarter they would have to add about $25 million this quarter.

Anything better than that means a fantastic result.

We will be looking for any “red flags” ie concerns. But barring that we are focused on Q-Q revenue growth.

What did they report? $377 million revenue. That is $23m in new revenue, which is almost the same as the prior quarter. As a % Q-Q growth that is 6.5% versus 7.11% growth in the prior quarter.

Our analysis? Very, very good. Not quite “knock it out the park” but close.”

What about this quarter? They got $17m in new revenue, less than the prior quarter. On a % basis, they grew 4.51% Q-Q, which is great for a company over $1 billion in annual revenue. But it is still less than the 6.5% last quarter and the 7.11% in the quarter before that.

This is not just the law of large numbers. The CRM growth momentum may be slowing a bit. At this level of valuation, CRM cannot even afford for that to be a question mark. The shorts may have a good quarter.

[i] Extract from 10Q: Marc Benioff,  adopted a fifth Rule 10b5-1 trading plan (the “Fifth Plan”) on September 1, 2009.Under the Fifth Plan, up to 2,750,000 Shares may be sold in open market transactions at then current market prices on Mr. Benioff’s behalf at a rate of 10,000 Shares per trading day. Sales pursuant to the Fifth Plan are expected to commence on November 30, 2009 and continue for approximately one year. Sales under the Fifth Plan are subject to certain restrictions, and may be terminated at any time. The Fifth Plan also provides for gifts of up to 275,000 Shares to funds or organizations qualifying as public charities pursuant to Internal Revenue Code Section 501(c)(3). As of November 25, 2009, Mr. Benioff had beneficial ownership of 13,371,006 Shares. Actual sales transactions will be reported through filings made with the Securities and Exchange Commission as required.