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

Posted by bernardlunn 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.

Groupon IPO: Can Andrew Mason Skate To Where The Puck Is Headed? June 5, 2011

Posted by bernardlunn in IPO, Online Advertising, Uncategorized.
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Most commentary is negative. The current financials look pretty awful. Even worse, the current value proposition to merchants does not look sustainable. They are basically pitching a loss leader. Every merchant understands a loss leader. But if the loss leader does not lead to profitable clients it is just a loss. As the old saying goes ‘it is easy to sell a dollar for 99 cents”.

The positive spin is “the numbers looked awful for Amazon as well, look at Amazon now”. Its a bit like saying Google had no idea of how to make money when they launched but look at Google now.

So is Andrew Mason as smart as Jeff Bezos?

Amazon’s ability to invent the future is extraordinary. They did it first for e-commerce. Even more remarkably they did it again with Amazon Web Services (AWS) when the reinvented the hosting business and created the Infrastructure As A Service category.

The answer of course is, we don’t know. Investing in Groupon is investing in a massive market that is in the process of fundamental change AND investing in a great entrepreneur. I have no idea if Andrew Mason is a great entrepreneur, only time will tell. But I can see the massive market that is in the process of fundamental change. So can Google, Amazon, Facebook, Twitter, eBay, Craigslist, Apple, Microsoft as well as legions of Groupon clone startups.

The market opportunity is so massive that Groupon is totally right to choose a “go big or go home” strategy. This is a network effects game and the winner will be a huge winner.

At stake is the $150 billion local advertising market.

Actually, at stake is the whole evolution of the online advertising business. That is why Google was willing to pay $6 billion. That is why the Google acquisition fell apart on fears that the deal would fall prey to Anti Trust action. (Don’t fall for the “brave entrepreneur walks from $6 billion offer” fairy tale).

Here is why:

At stake is the whole evolution of the online advertising business.

Advertising has evolved to address the famous line “half of my advertising is wasted, I just don’t know which half” through 4 different versions:

* Version 1, pre Web, “we cannot tell you who is looking at the ad”

* Version 2, CPM, we can tell you who is looking, but we have no idea if they are interested

* Versions 3, CPC, we can tell you how many showed interest by clicking, but we have no idea if they will buy anything”

* Version 4, Groupon aka CPA aka Cost Per Action or Cost Per Revenue. In Groupon’s current iteration, the loss leader 75% off list price deal (50% off to the consumer), the vendor is telling the advertiser/merchant “we can tell you how many people will buy the loss leader, we cannot tell you how many will return as full paying customers later”.

Of course, a loss leader proposition is unsustainable. If that is all Groupon can offer, run, don’t walk from this IPO opportunity. But if you think that their loss leader proposition is their foot in the door to the next iteration of commerce/advertising, they could be an Amazon scale company. And you never got a chance to buy Amazon stock on the cheap and you probably never will.

The losers in this next iteration of commerce/advertising are obviously the yellow pages print advertising books that land on my porch and get taken straight to the recycling bin. But they are already dead, the funeral notice just did not get posted. And like the AOL dial-up subscribers, inertia is a wonderful thing!

But the other losers are all those invested in CPM and CPC. They won’t go away but they will be impacted by a proposition that is fundamentally more attractive.

So where is the puck headed? Actually I indulged in some science fiction speculation about what Twitter could do with Twitter Annotations (they dropped that ball). This is about a future of ecommerce that is real time, mobile and social. Foursquare and Loopt are also in this game from another direction.

In the future we are likely to see consumer agents negotiating with multiple vendors via exchanges that get a cut of the action. No, that will not be a 50% cut of the action. Think more like the less than 5% vigorish that payment vendors take. Merchants are incredibly margin aware, they will fight tooth and nail with Amex over 1%. But at the scale we are talking about, 1% is a really, really good business – that Google, Amazon, Facebook, Twitter, eBay, Craigslist, Apple, Microsoft all lust after. All the Groupon clones are simply acquisition bait for those behemoths. The question is does Groupon have a shot at getting into the behemoth class. That comes down to “is Andrew Mason like Jeff Bezos in 1996?”. He looks the part but only time will tell.

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

Posted by bernardlunn in capital markets, IPO, social networks.
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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?