Seeing Both Sides

First 100 Days: Washington Has Become the New, New York

It used to be that anyone in the entrepreneurial world had to be keenly cognizant of what was going on in New York City.  If you were funded by VCs in Silicon Valley, Boston, or Bombay, it still paid to have your CEO and sales team have eyes and ears in NYC for two main reasons.  First, that's where the customers were.  CIOs of financial services companies were viewed as gods by many in the start-up community, controlling billions of dollars in IT spending and often willing to experiment with young companies and the next, new thing.  The large media companies, too, were seen as great early customers and hotbeds of innovation (I remember how thrilled we were when we secured Time Warner's ground-breaking Pathfinder division as a customer at Open Market back in 1995, thinking we had landed what would be the 800 lb gorilla of the Internet age).

And, secondly, NYC is where the big capital was - that is, after the company had matured past the VC financing stage.  The rules of the game for the start-up's ultimate goal, accessing the public market through an IPO, were set by the investment bankers and sales desk traders on Wall Street.  CEOs of pre-IPO companies were always shuttling into New York to talk up their companies, tell their story and get feedback to prepare for the public markets.

My how things have changed.  New York City feels increasingly irrelevant to most start-ups as both a source of customers and large amounts of capital.  Instead, Washington DC has in many ways become the New, New York.

This new dynamic was evident when I joined 100 CEOs from Massachusetts in a pilgrimmage to our nation's capital as part of my role as co-chair of the Progressive Business Leaders Network (PBLN).  Frankly, I was worried that our fate would be similar to all the other conferences I've attended since the economic crisis - that attendence would be down 20-30% from the previous year.  Instead, it was up 50%. 

As you would expect, the CEOs were keen to hobnob with the Washington elite and their peers.  But more importantly they were interested in how the new paradigm that the Obama administration is going to affect their businesses.  And like all good entrepreneurs (the bulk of our membership are CEOs of mid-sized and small young companies, not Fortune 1000), they were looking for insights and opportunities.  If you are playing in the $6 trillion energy sector, the $3 trillion health industry or even large parts of the $1 trillion IT industry that touch regulations (e.g., broadband, wireless), then what's going on in Washington DC matters to you.  Senator John Kerry repeated what has now become a common refrain from politicians:  "The next Google will emerge from the energy sector".  And it seems the US Government is determined to facilitate this by pouring billions to stimulate the sector.

To be clear, I'm not saying that there aren't many VCs in New York doing good work.  In fact, it is encouraging to see the NY-based entrepreneurial community flourish as much as it has, centered mainly around the transformation and digitization of the native advertising and media industries.  But for companies outside of NY, it is simply less relevant, whereas Washington has gone from being irrelevant, to suddenly centrally relevant.

Personally, I don't believe this power shift to Washington DC is entirely a good thing.  In truth, it makes me very nervous that we are entering an era where public opinion and public officials are against what has made this country so great and unique in the world - the aggressive pursuit of open markets, free trade and a strong distate for regulation and government intervention in business affairs.  Governments have never been good at picking winners and losers in the free market (see:  Japan, collapse of).  But, the reality is that this administration's ambitions are breathtaking and transformative.  Business leaders have never had a stronger reason to care more about following what's going on in the halls of Washington.

One of our portfolio company CEOs is amazing at spending all his time running around with clients and chasing new business.  Lately, we find ourselves coaching him to spend more time in Washington DC.  Last night, I was at a dinner with the founder of one of the most promising cleantech companies in the country and he observed that in 2008, he visited China and NYC ten times each.  In 2009, he has already been to Washington DC ten times.  It's a sign of the new reality, like it or not.

VC Rightsizing

The news came out yesterday that VC funding in the US was down in Q1.  Really down.  VC funding into start-ups averaged roughly $20 billion a year for many years since the bubble crashed and recently (2007 and 2008) had creeped up to $30 billion a year.  The Q1'09 figure was $3.0 billion, suggesting we are on a $12 billion runrate.

Although new financings may pick up a bit in the second half of 209, I would predict that VC funding for 2009-2011 doesn't exceed $20 billion per year and probably stays closer to $15 billion per year.

And guess what?  VC downsizing is ok.  In fact, it's a good thing. Frankly, I'm not sure the VC industry should be much above this range.  It's not that there are a lack of great entrepreneurs chasing great ideas.  It's simply the lack of good exit prospects.  We don't have input constraints.  Instead, we have output or exit constraints.

Clearly, the lack of attractive exit prospects is choking the industry right now.   VC fund after VC fund can point to portfolio companies that are growing rapidly, taking market share, even achieving profitability in many cases, but have no place to go.  The IPO market remains completely irrelevant to VCs.  Yes, Rosetta Stone had a successful IPO - the first one since March 2008 to be priced above the range.  And there are a few other interesting filings in the pipeline.  But don't be fooled by bankers bearing gifts and snake oil.  The IPO market may return modestly for some large, profitable companies will not return anytime soon for VC-backed companies.  You know it's a bad young company IPO market when the case studies the bankers cite are Visa and Mead Johnson

I attended a breakfast last week where JP Morgan's vice chairman, David Topper, gave his review of the macroeconomic picture, including the IPO market.  Although he was too polite to say it outright, his data clearly showed will be irrelevant to VCs for the foreseeable future.  He laid out the three criteria that are required for an IPO candidate:

1) IPO size of $200 million (implying a market capitalization north of $700 million). Without this level of float, there isn't enough liquidity in the stock to attrack investors.

2) Profitable, established business (i.e., not "approaching profitable" but proven profitable over many quarters if not years).

3) Minimal leverage.

Of these three, #1 is the real killer for venture-backed start-ups.  When I was an executive at Open Market and did our IPO in 1996, we executed an $80 million IPO - at the time, that was considered mid-sized.  In today's environment, where Google is trading at a 6-8x EBITDA multiple and typical revenue multiples are 2-3x, an IPO candidate would need to be throwing off $100 million in cash flow and/or generating north of $200-300 million in revenue while still growing fast.  These are incredible numbers for venture-backed start-ups less than 10 years old.

There are complaints about reforming Sarbanes Oxley - and I have added my voice to those complaints in the past - but I walked away from this breakfast with a greater appreciation for why one of the NVCA policy leaders recently said to me, "SOX reform is important, but no one is going to focus on that until restructuring the financial system as a whole is done."

I also appreciated why my friend and mentor, HBS Professor of entrepreneurship Bill Sahlman, told me last week that he thought the VC industry needed to shrink in half.  Going from $30 billion per year in outflow to $15 billion per year would mean just that - and it will mean more VC personnel departure and fund shut downs.  And, again, that's ok.  It's worth noting that the last time annual VC funding dipped below $20 billion was in 2003, which saw $19 billion in VC investment.  2003 was one of the best vintage years in the last decade, as many are arguing 2009-2010 will be.

Maybe I'm simply a rose-colored glasses optimist, but at the end of the day, an industry that quickly adjusts to new realities is a healthy sign.  Until we figure out an alternative exit vehicle (and maybe someday the overall public market health will allow some liquidity to filter down to the VC-backed world, but don't hold your breath), we can't absorb more than $15-20 billion in annual VC investments anyway.  So let's get the industry back to that level and vigorously deploy those dollars in as productive and rewarding a fashion as possible.

Top 5 Take-Aways From CTIA

The annual wireless industry trade show, CTIA, had some interesting trends this year.  Putting aside the fact that Las Vegas feels like a ghost town, cab lines are uncharacteristically short, and my personal frustration that I find myself agreeing with an arch-conservative economist Arthur Laffer’s editorial in today’s WSJ on how Obama’s estate tax policy creates perverse Vegas incentives (!), here were my top 5 Take-Aways from CTIA:

1. The Lights Are Still On.  The wireless industry is clearly a bright spot:  secular trends for the industry’s growth and innovation remain strong.  That said, the show was meaningfully affected by the recession.  On the positive side, 2008 saw 1 trillion text messages (up 3x from previous year) and double-digit growth in revenue and subscribers.  Content and applications are exploding as everyone is trying to follow iPhone’s pioneering moves and (finally) smart phones and the mobile Internet are becoming mainstream in the US.  That said, conference attendance was down 20% as compared to last year by some estimates and show floor had a much, much emptier feel than usual. 
2. Innovation is happening, but VC investment isn't.  Analyst firm Rutberg & Co reports that overall VC investment in wireless was down 30% in 2008 as compared to both 2006 and 2007, sharper than the 15-20% average VC investment decline in technology.  I predict 2009 will also be a bad year for wireless VC investments.  The conversations I had with VCs all rhymed:
   1.  “There are very few big ideas left in wireless”.
   2. “We already have a number of chips on the table and don't see the need for more".
   3. “The bar is very, very high right now”.
   4. (most damning) “The big guys (carriers, handset players, operating system owners) own too much of the value chain – there’s too little room for entrepreneurs”.
3. Device fragmentation is here to stay.  iPhone’s explosion from nowhere over the last two years is impressive, but the entrenched competitors, Blackberry and Palm, are fighting back.  Blackberry’s open application store was a ho hum launch, but at least they recognize that a thriving, open application store is now table stakes and all the major content players are jumping on board.  One carrier executive told me that every device manufacturer (think Nokia, LG, Samsung) is coming to them looking for help on their content and application store strategy.  That’s not going to make things any easier on the leading application developers!
4. Video is mobile’s Next Big Thing.  Everyone is talking about delivering high-quality video on mobile.  With 22 million consumers in January 2009 accessing the mobile Internet according to Comscore, double last year and likely to double again in 2010, rich content on the phone is clearly the next big thing, and video is a huge driver of that.  GenY consumers are watching news, weather and sports on their phones as if it were the normal function of the device as opposed to a full-blown miracle as compared to only 5 years ago.  (Full disclosure:  I’m an investor in mobile video leader Transpera and so am highly biased here, but I’m also seeing the numbers explode!).
5. Carriers seem to finally get it, but it’s too late.  Carriers are seeing their content revenue (ring tones, ring backs) flatten out and seeing voice minutes saturate, so they are all over applications and advertising.  That said, it’s probably too late.  The industry is ripe for disruption.  The landline businesses are dragging the diversified players down and their entrenched, proprietary strategy will be hard to sustain as the world moves more open and off-deck.  The commoditization of communications infrastructure is a movie we’ve seen over and over again (see Railroads, Bankruptcy of) and it may take 10-15 years, but we will see it again here.  The communications companies are at risk at becoming the next Newspaper industry if they don’t adapt fast.

Anyone else there have other observations?  Comment away or send me an email.  You can also follow me on Twitter at www.twitter.com/bussgang.