Technofile Europe

It's official: shopping clubs kick off a new phase

Today Amazon announced the acquisition of our portfolio company BuyVIP, confirming a deal that had been widely leaked via the Spanish press since the weekend.  This deal was done at the same time as BuyVIP's nearest rival, Barcelona-based Privalia announced a whopping €70m funding round.  The markets are abuzz with further transactions among private sale clubs and private equity firms.

What does this mean for the market pioneered by Vente-Privee, variously referred to as private sales, shopping clubs or short-duration sales?  Until Groupon and its many deal-of-the-day clones exploded onto the scene, the private sale market was the fastest-growing business model most of us had ever seen.  

The torrid growth continues, but the market dynamics are about to change.  The first phase was about speed of execution,the next phase will be about scale and cash.

Originally, the private sales model offered brands a way to quietly feed excess inventory to loyal brand followers, much like out-of-town outlet malls.  But with European private sale revenues exceeding €1bn in 2009, up perhaps 40% on 2008, the shopping clubs had become a significant channel in their own right.  I suspect brands were surprised at how quickly this new channel ran away from them.

Brands are waking up.  They're learning how to play the various shopping clubs off against one another.  In the coming months and years they will drive harder bargains.  Inevitably, the clubs will have to start buying more inventory if they want to continue to pass on discounts of 60-80% to their members.  That approach has been the norm in the US market for some time. This is why Privalia needs so much capital and why BuyVIP will now benefit from Amazon's balance sheet.  Look out for more scrambling for cash among the other clubs in Europe.

The last two years were all about the land-grab.  Vente-Privee expanded into the UK, Germany and Spain, with mixed success.  BuyVIP and Privalia battled it out in Spain and Italy.  Privalia became the first serious player in Latin America by building a beachhead in Brazil.  BuyVIP fought over the German market with incumbent Brands4Friends, and the latter expanded haphazardly into Austria, the UK (by investing in SecretSales) and Japan. BuyVIP also entered the Dutch, Polish and Portuguese markets through partnerships. In the meantime, domestic players dug in at home: Showroomprive, Private Outlet and BrandAlley in France, SecretSales in the UK, KupiVIP in Russia, and many others.

Hundreds of millions of euros have been spent on acquiring members, feeding a whole sub-industry of SEM agencies, affiliates, lead  hustlers, etc.  A lot of that spend has been inefficiently duplicated as the same fashion-hungry shoppers are hoovered up to join multiple clubs.  That in turn drives up marketing costs for everyone, which is ultimately not sustainable.  

Fixing this will require consolidation.  There are only two gorillas in the space today: Vente-Privee in Europe and Gilt Groupe in the US.  If the others move quickly enough there can be a third, perhaps a fourth, with enough scale to push down member acquisition costs, and enough clout to stand up to the brands.  Then it will be a race to IPO.  Why Vente-Privee has not yet issued shares to the public is one of the enduring mysteries European investors love to grumble about.  I suspect Gilt Groupe won't be so reticent.

And for consumers... it's all good news.  Shop on!

Related articles by Zemanta

• Privalia receives $95m venture capital boost (ft.com)
• Amazon Buying European Fashion Shopping Club BuyVIP (paidcontent.org)
• Private shopping club Brands4friends ratchets up €1m in sales in a single day (eu.techcrunch.com)
• Vente-Privee: designer brands for smart shoppers! (myfashionlife.com)

Tech market predictions for 2010

Following my mediocre performance with last year's predictions, let's hope that this year will see more action in the market, and hence more of my predictions coming true! 

If last year's theme was the waiting game, I see this year's as the spotty recovery.  There will be some big successes -- major IPOs, spectacular M&A deals -- but they will represent spikes in an otherwise halting market.  Picking the right assets and the right timing will be key for for investors and entrepreneurs alike during 2010 (and probably into 2011).

Here are my punts for the year (in no particular order): 

1. SaaS sales productivity will not recover in line with economic recovery.  The people-based sales model for software is broken and established vendors will see margins suffer, while newcomers with pure or near-pure web-selling models will take market share.
2. Useability design returns to the heart of web applications and services.  We've had a wonderful UI revolution with the iPhone, making most established websites look clunky. New web apps and e-commerce sites will be wildly successful not because they have more features, more data, more widgets, but because they are just easier, faster, smoother to use.  Quite a few established businesses will struggle to re-invent their interfaces and will lose share as a result.
3. The year of Location-Based Services (LBS). Not content with cracking the Wintel duopoly, Google finally kickstarts the LBS market by attacking it from every point in the value chain at once: a new phone and mobile OS (who needs handset makers?), a new sales channel (who needs operators?), its own geo-aware apps (who wants to pay map royalties?) and -- boldly -- its own base of potential LBS advertisers in the form of 100,000 retail outlets receiving Google decals with 2D barcodes this week.  If this doesn't do it for the long-awaited promise of LBS, what will?
4. Cache & Carry. The continuing increase in solid-state memory capacity helps make HD video ubiquitous. With 32GB SD cards now available, consumers will be able to store and move their favourite movies and TV shows at will. Computer manufacturers will start to ditch optical drives. Now if only Apple would open up its devices to external memory cards.... it would be a perfect world!!
5. The scale of the greentech bust will startle investors and entrepreneurs, as it becomes clear that the investment horizon and capital consumption of most ventures are beyond the scope of traditional funds.  As a result, 2010 will start to see the emergence of new types of funding vehicles, perhaps long-dated venture funds (20 years?) or hybrid equity/debt vehicles to better serve this market.
6. Microsoft buys RIM in an admission that its mobile strategy has failed, and that corporate Blackberry users are the last stand in its effort to retain control over the desktop and email.
7. One of the many startups flogging micropayment or mobile payment platforms will finally take off, kickstarting a desperately-needed revolution in the charging model for content.  This has to happen, this year or next.  But it will probably require the distribution power of a large partner, like a Google, a mobile operator or a financial services firm.
8. The much-awaited Apple tablet will be huge and possibly disruptive.  Everyone is projecting features onto this device, borrowing from the iPod below and the MacBook above.  But the real game-changer is the killer feature we don't know about yet.  My hunch?  It could become the perfect home entertainment control system for non-geeks -- imagine the tablet connecting seamlessly to the Web, your iTunes, and your speakers, with streaming music and videos served up by Lala...  Worth dreaming about.
9. Shakeout in music streaming.  As Spotify launches in the US this will be its year of reckoning: the company will either be crushed by the sheer scale of US freeloaders, or its ad-based revenue model will finally get the throughput it needs to be viable.  Look for serious jostling and grandstanding as music majors renegotiate with streaming services and digital distributors like iTunes.
10. Finally, I lamented last year that it was time to fix, really fix videoconferencing, and yet my pleas remained unheeded.  But this demo at CES made me think that -- just maybe! -- 2010 will be the year that a credible alternative emerges.  If Skype & HD TV makers can do this at home, why not the office?  Polycom RIP (and good riddance!). 

Scoring my 2009 predictions

Here it is -- the moment of reckoning for last year's predictions.  Looking back, 2009 feels like the year the world froze, waiting for stimuli to kick in and new policies to emerge from the fog.  Everyone was in a holding pattern, trying to keep the boat from leaking too much.  As a result, the  most frequent verdict on my 2009 predictions is 'sort of true, but not yet'.  

Let's call 2009 the year of lost momentum.  Both positive and negative trends slowed to a trickle... 

Next week I'll try to divine 2010 tech market trends, but in the meantime, here is a summary of my 2009 calls and how they fared:  

1. SaaS vendors who are not already at the inflection point of positive cash-flow will go bust. FALSE. We haven't seen any major players or even mid-sized VC-backed vendors disappear as yet, but don't kid yourself -- it's coming...
2. Outsourcing will come back into favour.  And it will be cheaper & better than ever, thanks to SaaS-style delivery of business apps built on VoiP communications platforms like Intelepeer. TRUE, but hard to prove.  The line between adopting a SaaS app and outsourcing a business process is blurring.  This trend continues.
3. Ad-supported digital media sites will see a massive shake-out – few generic newsletters or blogs will survive.  NOT YET.  Undoubtedly hundreds of thousands of small web sites have died (who noticed?), but even established ones like Salon.com continue to limp along, bleeding cash.  More high-profile disappearances are on the way.  But the most unexpected development in late 2009 was the decision by big media to try to reverse the tide of free content and re-establish payment models.  The shake-out continues. 
4. Social networks will see their values collapse, and many will disappear.  SORTA TRUE?  The monetisation model continues to elude, and most valuations that are bandied about are ephemeral.  Twitter did not get bought, MySpace is struggling, and smaller social networks (and regional plays like Tuenti) are picking off niche audiences. Where to from here?
5. Microsoft will continue to lose share in the browser market [and] will make defensive acquisitions, like Xobni. TRUE/FALSE.  IE's share of browser useage is down perhaps another 10% between 2008 and 2009 (see embedded chart, courtesy TheCounter.com).    But so far the Evil One has been slow to buy its way back into innovation, making only 2 acquisitions in marginal areas (healthcare software, games) vs 16 deals in 2008 (!).   If I were an investor I'd be screaming for a dividend!
6. CPA and creative rich media ads (games, viral video) will outperform other types of online advertising.  Expect consolidation among online ad networks. TRUE. The overall online ad market was flat to stagnant in 2009.  Video ads were one of the few bright spots (according to e-marketer, see table below). Quite a few networks were acquired, though most not for big values.  The exception was Google's acquisition of AdMob.  Hi-Media bought AdLink. Orange acquired Unanimis.  And Fox acquired UTarget, ClickDiario and Directa Network.  Etcetera.,.
7. Consumer appetite for innovation will slow, compounding Apple’s challenge in dealing with a sick Steve Jobs.  [...] don’t be a shareholder while they figure it out. FALSE.  Apple just keeps on cracking, and the market keeps on lovin' it.  If you had bought shares at the time of my prediction, you would have doubled your money by now.  And that's before the release of the eagerly awaited iTablet  iPanel  iSlate or whatever. 
8. A lot of local newspapers and offline magazines will disappear in 2009, which is kind of sad.TRUE.  The Star Tribune, Heartland Newspapers, Philadelphia dailies, Chicago Tribune, Chicago Sun-Times and many other city and community papers closed. Here's a summary. The one bright spot on the media horizon is the continued experimentation with new ways to fund investigative journalism (like the American News Project/HuffPost JV and News21). 
9. Project management tools like Daptiv, and construction industry SaaS vendors like BiW and will thrive as governments pump gazillions into ‘stimulating’ infrastructure projects. NOT YET!  As should have been predictable, stimulus money is crawling through the economy like molasses...
10. The shake-out among European VCs will continue at its glacial pace.  TRUE.  No one has formally shut up shop (do they ever?), but a growing number of funds are slowing or stopping to invest while they wait wait for a window in which to raise a new fund...  

And the one item from my wishlist...

• Somebody fix videoconferencing, puh-lease!  There must be a better way between Skype video and a $150k TelePresence implementation from Cisco.  This would be a great time to go to market with a Polycom killer!  STILL WAITING...

Stay tuned for a gaze into the 2010 crystal ball.

The hunt for growth is on

The news that GSI Commerce has acquired private shopping club Rue La La for $350m has put the small but excitable world of European shopping clubs and their investors into a tizzy.  The concept of members-only short-duration sales online was a European invention, and the largest players in the category remain European -- a rare exception to US dominance of Internet business models.  And yet the first shot of M&A was fired within the US.

This deal gives some comfort to the many European VCs who have placed bets with vendors over here.  One of the big unknowns they all faced at the time of their investment is what the ultimate capital markets value of these businesses would be.  The pessimistic view is that these are lowish gross margin businesses that would eventually trade like mature online retailers of branded goods, eg around 1x revenues.  Amazon's acquisition of Zappos for just under or just over 1x revenues (depending on whether you net off returns) earlier this year seemed to confirm this view. (If you like transaction forensics is your cup of tea, here is a good analysis of the Amazon/Zappos deal).

But this view does not take account of the extraordinary growth rates the buying clubs are experiencing.  Rue La La is on an annualised revenue run-rate (based on Q3) of $112m, and is said to be forecasting $230m revenues next year.  This resembles the 2006-2007 trajectory of market leader Vente-Privee, and puts Rue La La only slightly ahead of the runners-up in Europe, including BuyVIP and Brands4Friends.  So now we know what growth is worth in this market: over 3x run-rate revenues.

This reflect a broader trend in the technology and Internet markets as the US emerges from recession and the rest of the world muddles through it.  Growth is at a premium, and the tech industry -- cash-rich as it is relative to other industries -- will increasingly seek to convert cash into growth.  Cisco's recent acquisition of security managed services firm ScanSafe for $183m is another prime example.  Scansafe's revenues in 2008 were said to be just $23m, but supposedly doubling year on year.

For a venture capital industry hungry for exits from aging portfolios this is a spot of good news.  But clearly it is those companies that can return to growth quickest in the recovery who will be first in line.

Listen up Gordon

Fred Wilson had a great post last week responding to a suggestion (by Tom Friedman of the New York Times) that the government put its stimulus money into venture capital rather than the auto industry.  The sentiment is a good one, but the idea is bad, as I highlighted last year.

Gordon Brown and the propeller-heads at NESTA would do well to digest Fred's post carefully, as they are already ahead of the US in making this bad idea a reality.  As in the US, there is no shortage of capital for good ventures in the UK.  Any money from the government is likely to flow to bad business ideas or bad investors, depress returns for good investors, and crowd out smart money.

Don Dodge suggests some alternative ideas for $1bn to promote entrepreneurship here.  I hope Gordon reads blogs as well as policy papers.

My tech market predictions for 2009

For some reason I’m always closing deals in December/January, so my blog runs dry for a while.  But here they are, late again – my tech market predictions for the interesting times we call 2009:

1. SaaS vendors who are not already at the inflection point of positive cash-flow and controlled churn will go bust, unless their investors have very deep pockets indeed.  It will be hard to sell your way out of this slump. The economic environment plays to SaaS, but most of the business models ain't there yet.
2. On the other hand, outsourcing will come back into favour once the market settles a bit.  And it will be cheaper & better than ever, thanks to SaaS-style delivery of business apps built on VoiP communications platforms like Intelepeer. 
3. Ad-supported digital media sites will see a massive shake-out -– few generic newsletters or blogs will survive on their own.
4. Social networks as a category will see their values collapse, and many will disappear.  Even the Facebook gorilla will never grow back into its $15bn valuation, no matter how many whoppers.
5. Microsoft will continue to lose share in the browser market.  By integrating more apps into Gmail, Google is creating a platform that threatens Outlook/Exchange.  For this reason Microsoft will use its massive cash pile and low valuations to make defensive acquisitions, like Xobni.
6. CPA and creative rich media ads (games, viral video) will outperform other types of online advertising.  Expect consolidation as the few online ad networks with cash try to acquire growth.  Targets will include disruptive networks like Specific Media and online lead gen specialists.
7. Consumer appetite for innovation will slow, compounding Apple’s challenge in dealing with a sick Steve Jobs.  Since we’re still absorbing last year’s fabulous gadgets, the company has some time to develop a new roadmap.  But don’t be a shareholder while they figure it out.
8. A lot of local newspapers and offline magazines will disappear in 2009, which is kind of sad.
9. Project management tools like Daptiv, and construction industry SaaS vendors like BiW and others may well thrive, as governments pump gazillions into ‘stimulating’ infrastructure projects everywhere.
10. The shake-out among European VCs will continue at its glacial pace.  Timing can be a real bitch, but this downturn is all about the moolah.  Those with  cash have a shot at a winning strategy (tricky though it may be to find).  Those who don’t, won’t get to play.

As always, one item for the wishlist (I didn't get my dumbed-down cellphone last year...):

• Somebody fix videoconferencing, puh-lease!  There must be a better way between Skype video and a $150k TelePresence implementation from Cisco.  This would be a great time to go to market with a Polycom killer!

Finally, I still see this is a great time for European entrepreneurs.  In fact, many will fare better in this market than their US peers, having always been more frugal and used to operating with fewer financing options.  The maturation of serial entrepeneurship in Europe will continue.

Stay tuned for news from the Mobile World Congress (fka 3GSM) next week...

I hope Marx got the last bit wrong...

"Owners of capital will stimulate the working class to buy more
and more of expensive goods, houses and technology, pushing
them to take more and more expensive credits, until their debt
becomes unbearable. The unpaid debt will lead to bankruptcy of
banks, which will have to be nationalized, and the State will
have to take the road which will eventually lead to communism."

Karl Marx, Das Kapital, 1867

Thanks, Peter, for the heads-up!

Scoring my 2008 predictions

Well, 2008 is over and what a year it has been!  It's time to score the predictions I made a year ago and to start thinking about a new set of predictions of 2009.  As one of our portfolio company CEOs wrote to me today: "2009 should be a hoot!"

Before I get to the hoot, let's see how I did with 2008:

1. A combination of US recession and the waning efficacy of online ads will hit the Internet advertising industry hard.  MOSTLY TRUE, although the final numbers are yet to be released. I suspect the combined slowdown of Q3 and Q4 will lead to a nearly flat year for offline advertising and a lowish growth year for online, with the bulk of the spoils going to performance-based networks like Google and specialised online lead gen companies like Zieltraffic (for financial services) and Internet Media Group (for online education).
2. The Structure of Networks -- social and otherwise -- will migrate to the core of the Web, replacing the Structure of Documents on which it was originally built (HTML and all that).  Someone will figure out that applying the Google PageRank concept to networks of people is even more interesting: if we can identify influencers and how information flows among them, we can really start targeting campaigns. NOT YET REALLY, although the trend is clearly in this direction.  During the current downturn, a lot of investment will go into increasing the efficacy of online advertising.  Facebook founder Mark Zuckerberg understands this clearly, though he hasn't worked out quite how to monetise the idea.
3. 2008 will the year of the Return of the ERP Vendor.  SAP, Oracle and the midmarket vendors will make progress with their own SaaS offerings and will shrink the valuation gap with the pure-play SaaS vendors.  HALF TRUE, the valuation gap has shrunk from 3-4x revenues to 1-2x.  But this has more to do with the general bearishness of the markets than with the success of ERP vendors' SaaS offerings.  Keep an eye on Oracle, who are doing their best to steal some of the Web 2.0 sizzle with new offerings.
4. The Web 2.0 financial bubble -- fuelled by VC cash being round-tripped between startups buying and selling ad space -- will pop as a result of the weaker ad market and the failure of 100s of undifferentiated 'feature' startups to gain traction.  TRUE, here's a list of 10 in particular, but the roster of the dead runs into the 100s with more to come.
5. The mobile web will continue to be stymied by the difficulty of discovering content on mobile devices.  iPhone and other large-screen devices will help commuters surf the old Web, but mobile browsing won't take off until someone invents a new search paradigm that works on mass market mobiles. TRUE.
6. As a result the mobile advertising market will fail to take off... yet again.  TRUE.
7. What on earth is UWB?  Anyone remember? Anyone care?  STILL TRUE.
8. The success of the Nintendo Wii will spark a whole host of new physical interactive video games, providing a boost to vendors of chips to the console companies.  FALSE so far. Wii continues to rock'n'roll, and the imitators are far behind.  But in a bow to the new innovation leader, both Sony and Microsoft are working on motion-sensing controllers for their PS3 and Xbox platforms.  Meanwhile the Wii continues to stoke the creative juices of independent developers -- here are Wired's faves.
9. Social networks will see huge monetisation efforts and some applications and ad networks will make a financial killing.  But their performance will be erratic and useage of networks will be highly volatile as consumers get tired of being poked, zombied and voted HOTorNOT. I think this is TRUE.  Social networks (broadly defined and including YouTube) have failed to live up to their lofty valuations, which were based on unrealistic advertising yields. The advertising bust has blown this issue wide open.
10. Some element of Open Source or "free" distribution models will become part and parcel of every software vendors' go-to-market strategy. Again, NOT QUITE YET.  This will take more time.
11. [Bonus, more of a hope than a prediction]: 2008 will mark the return of the Basic Business Phone, and it will be a runaway bestseller.  Nokia or someone nimbler will launch a high-performance phone that makes phone calls, has a long battery life, global coverage, and a simple, fast interface.  And absolutely nothing more!  I so wish... I'M STILL WAITING!!

That makes it 6/10, which is worse than last year's score of 7/10.  I need to steer clear of technology developments themselves -- those predictions always underestimate how long it takes for innovation to find the right application and to get adopted...  Stay tuned for my shot at 2009.

NESTA-Brown Ventures LLP

Just when you thought the US Congress was gunning for a monopoly on bad ideas, along comes the stumbling Brown administration with a whopper of its own.  It takes the form of a purported £1bn venture fund for UK technology start-ups, supposedly left behind when 3i decided to get out of the venture game to focus on growth equity and buyouts.

Fred Destin does a great job dissecting this issue here.  All I would add is that governments playing VC rarely leads to an increase in the number of successful companies.  Post-war reconstruction (via 3i) may be the exception, but that was only due to the complete absence of private sector funds.  There is no shortage of investment funds for start-ups today.  In fact, the industry is still trying to work through the overhang created by record fundraisings in recent years.

I suspect no one has told Brown that VC funds -- unlike hedge funds -- can't pull out of a market on a dime.  They're usually locked in for 10 years, which makes it pretty difficult for them to react to a recession by pulling back.

Government intervention in the venture capital industry has at least 3 deleterious effects:

1. it prolongs the life of bad ideas and wastes the energy of the people involved in them;
2. it crowds out smarter private investment; and
3. it pushes valuations to unnatural levels which makes it more difficult for the few successful companies to raise follow-on financing.

Oh... and most government funds (or funds benefiting heavily from tax breaks like VCTs in the UK, or FCPR funds in France) attach so many strings to their investments that their portfolio companies are strangled by shareholder constraints that prevent them breaking loose from the pack.

If Brown wants to promote the technology industry, he should reduce the bureaucratic and tax barriers to setting up private venture funds, support basic R&D at universities, and consider tax breaks for entrepreneurs.

Death, taxes and financial regulation

As the global banking sector convulses with the most comprehensive restructuring in memory, voices on both sides of the Atlantic are calling for tighter banking regulation in order to prevent a future meltdown.  Heads had to roll and a number of senior executives have lost their jobs, while others find themselves inadvertently turned into civil servants operating state-owned banks. 

Relatively speaking, that was the easy part.  The question now is: how to regulate the industry better without stifling financial innovation?

There is no shortage of ideas coming from European and US regulators, many bad (executive pay caps, short sale bans), some good (clearinghouses for private financial contracts).  The only thing we can say for certain is that there will be amendments to existing Basel II and Mifid regulations, as well as new initiatives to increase disclosure and fiddle with capital adequacy rules.

As a participant on the margins of financial markets, I hope regulators err on the side of improving the transparency and liquidity of existing financial innovations, rather than try to constrain the complex financial products whose reckless distribution got us into this mess.  

The fact is that every link in the chain of this financial crisis -- subprime mortgages, credit default swaps, counterparty defaults, off-balance sheet investment vehicles -- was beset by the same fundamental problem:

insufficient information to
(a) gauge value, and
(b) understand dependencies.

This was an information crisis.  The new financial instruments and their markets simply got ahead of risk managers', CEOs' and regulators' ability to keep track of them.  And this is in spite of all the technical tools to manage this information being readily available.

We have a vested interest in this problem, through our investment in FRSglobal.  Until this year, FRS provided necessary but unexciting solutions to banks to calculate risk and to automate regulatory reporting.  Today, FRS is talking to regulators all over the world about how to improve everyone's visibility of risks and interdependencies among banks.  FRS CEO Steve Husk blogs about these issues here. 

The crisis is the catalyst that is finally bringing together risk management, business analytics and reporting -- a 3-way marriage software vendors and consultants have talked about for a decade, but which no one has yet consummated.  It's time for CFOs to have a single view of risk exposure, and to report on that view to both their boards and the regulators. 

To this end, FRS has made two acquisitions in the past 3 months: Swiss-based vendor of integrated risk management solutions IRIS (see Gartner's take here), and SAP/Business Objects subsidiary SECAM+, a specialist in regulatory reporting for the UK securities industry. 

Traditional ERP and even banking systems vendors acknowledge that the new paradigm of risk management and reporting is a highly specialised activity, requiring purpose-built analytical tools and extensive banking domain knowledge.  For this reason, incumbents like SAP and Temenos are partnering with FRS to deliver unified risk management to their clients.

It's only the beginning of the consolidation in this market and a lot of uncertainty remains.  But to death and taxes, we can undoubtedly add 'more regulation' to the list of certainties.

What does the crisis mean for growth capital and VC?

A lot of people have been asking me what impact the global financial crisis has on the business of venture capital and growth equity.  The short answer to this question is: not much.  The slightly longer answer is: not much, yet.

Let me explain.

If you are currently raising a venture capital or growth capital fund, the paralysis of investors worldwide means slower decision-making and a longer fund-raising cycle.  You may even lose some previously committed investors who are now conserving cash to cover losses in other asset classes.  If you have recently raised a fund then you are in good shape.  As banks, non-bank companies and consumers are rapidly finding out, when credit is tight cash is king.

But what about the impact on our business of investing in businesses?  Our existing portfolio companies will feel the crisis on two fronts: commercial performance and exit horizon. 

First, a prolonged recession will make it harder to land customers and grow revenues.  This means that business plans will take longer to achieve.  The exception may be in countercyclical or recession-proof segments, such low-priced entertainment (eg, games), discount retail (eCommerce), cost-reduction tools (eSourcing, supply chain optimisation), and products that address the current crisis directly (like compliance software, or trading platforms for previously 'hidden' financial assets). More on the latter category in a future post.

Second, as the IPO window remains shut for longer and M&A activity slows, there will be fewer buyers for companies and acquisition prices will be depressed.  We already saw throughout 2008 a flight to quality: companies with strong topline growth and high profitability are still being acquired and achieving good valuations.  The companies best able to survive this environment are those with strong 'operating leverage' -- that's VC-speak for high gross margins.  High margins reduce the effect of slower revenue growth and give companies more flexibility to reduce their cost structure as the market slows.

For investors, the key is to be able to wait for the right time to sell a company. This means both the internal timing (strong operations, good growth, a clean balance sheet) and external timing (market interest).  Companies that are profitable or close to profitability have a huge advantage in this market.

The impact on the private equity industry will vary drastically.  At the top end, LBO funds have already seen a huge increase in their equity cost as they refinance debt packages with equity, while their companies' earnings decline.  This is a continuation of the shake-out that started a year ago.

The second most affected category will be early-stage VC.  Most VC-backed companies are loss-making and were valued at the time of investment on the basis of aggressive growth forecasts, or expected strategic value on exit, or both.   Slower growth and a longer-time-to-exit means they will need to raise more capital, probably on worse terms.  This increases the equity cost of their investors and extends their investment horizon, depressing rates of return. 

Already we are seeing VC firms increase the follow-on reserves for existing portfolio companies, which will mean less capital available for new investments.  In the last downturn, many shifted their focus to later-stage investments, leading to a funding drought for pre-revenue companies.  More on the dilemma for early-stage companies on Fred Wilson's blog here, and Jason Calacanis' here.

The least affected, in my view, will be growth equity and midmarket buyout firms.  Growth equity portfolio companies typically have little or no debt financing and are cash-generative (or can get there quickly).  This means they can adapt their operations to slower market conditions, invest in discrete growth opportunities, and wait for the right time to exit.  The best ones will be acquired for the quality of their earnings by savvy buyers even during the downturn.  Growth equity investors can focus these businesses on improving the quality of the business and finding pockets of higher growth while positioning the business with potential acquirers.

Lastly, the more unpredictable effect is on the making of new investments in the technology markets.  In the 2001-2003 downturn (which was heavily weighted toward the technology industry) few entrepreneurs felt confident enough to write aggressive growth plans, and as a result it was difficult to find quality companies to invest in.  But I think this one is going to be different.  Here's why:

First, this recession is going to be more generalised, similar to the banking-led industrial downturn of 1980-82, with a correspondingly smaller effect on the technology industry itself. 

Second, the European investment eco-system is far deeper and more mature than it was in 2001.  Back then, a nascent VC and entrepreneurship market was nearly wiped out by the collapse in stock market values.  Today, we are tracking thousands of European technology companies that have shown more than 5 years of continuous growth, are profitable and in many cases geographically diversified.  This represents a very deep pool of potential investments, which are supported by a broad universe of specialised lawyers, bankers, recruiters, and angel investors.  So, I think that for investors with funds, good research capability and a broad network of sources for dealflow, there will be no shortage of investment opportunities.  Equally, for entrepreneurs with capital-efficient businesses, that have demonstrated an ability to prosper in good times and bad, there will be no shortage of investment capital.

Let's see how it plays out.

Partech and the fate of the transatlantic investor

There was some blog buzz in recent days about the announcement that the European partners of transatlantic VC firm Partech International are splitting from their US partners.  This follows last year's creation of Balderton Capital by Benchmark Europe's partners, and has precipitated a debate on whether it makes sense for VCs to invest in both the US and Europe from a single partnership.

It started with a French press release, followed by Mike Butcher's comment on TechCrunch UK here, picked up on the HEC blog here.  According to an anonymous VC who contacted Butcher, the split proves that the idea of a US/European VC "does not work" due to lack of synergies between companies and potentially mismatched returns cycles.  He does acknowledge that more synergies are possible in later-stage investing. 

This is an important debate, and one where I have a strong view, since our investment model owes part of its success to exploiting the benefits of a single fund investing across the US and Europe.  Thanks to continuing globalisation and -- in particular -- the advance of SaaS and cloud computing, national boundaries matter less and less for tech companies.  As a result, the need for effective cross-border investing will continue to grow.

A lot of funds have failed to make this model work.  In my view, the most common reasons are: (a) separate funds for Europe and the US (with different partners owning the economics of each fund), which makes true cooperation difficult; and (b) insufficient focus on exploiting synergy and arbitrage opportunities between the US and Europe.  Let me explain. 

Based on our eight years' experience investing across Europe and the US, the key factors to make this model successful are (in no particular order):

1. Invest from a single fund, in which all the investment professionals have equivalent economic interest.  This ensures everyone has the same incentive to support portfolio companies from either region, and everyone has a keen interest in making the right investment decisions in either region.
2. Make every effort to run a single, unified team with strong agreement on the investment strategy (allowing for some regional differences).  This is hard to do, but not impossible.  It requires weekly meetings ideally by video-conference, frequent inter-office visits, regular strategy offsites, a communicative and transparent culture built around collaboration and information-sharing, and a strong investment discipline throughout the team.
3. Exploit arbitrage opportunities between regions.  The development of new technologies and business models can occur anywhere first, for example, wireless technologies in Europe, or SaaS business models in the US.  By gaining early experience of these innovations wherever they occur, you can gain a first-mover advantage as an investor in the other territory.
4. Hold regular reviews of portfolio company needs and how to help them with operational issues in either territory.  Make sure that whichever investment professional is best placed to help (with executive recruitment, biz dev introductions, market entry strategy, etc) makes time to do so.

For entrepreneurs that have global ambition and a global market opportunity, a transatlantic investor can prove invaluable.  An ability to combine US best practices in business models (eg, sales tactics) with European cultural sensitivities is often the best way to make European companies a global success without breaking the business.   And in a weak dollar environment with the US in recession, an ability to get help expanding into Europe can be a life-saver for a US growth company.

At Kennet we have applied this approach with some success, supporting European companies like Kapow, Cramer (now part of Amdocs), Volantis, TradingPartners, Clearswift, Consul (now part of IBM), FRSGlobal and Exony as they crack the US market, and US companies like Daptiv, MedeFinance and NetPro as they expand their international presence including Europe.

As for the potential cyclical divergence of returns between US and European investments, these might be a welcome diversification for both the managers and investors in transatlantic funds.  Alas, the health of the exit markets for VC-backed companies (IPO venues, trade acquirers) are increasingly correlated, so returns cycles are likely to keep converging.

Image source: www.radicalcartography.net, with thanks.

Reporting from SIIA: SaaS hype hits Europe

This is a guest column from my colleague Evan Frank:

This past week I attended the Software & Information Industry Association’s OnDemand Europe conference in Amsterdam. The goal of the annual SIIA event is to bring together American and European SaaS entrepreneurs, schmooze over a few days of canal tours and canapés, and hopefully let US best practices rub off on what is a much more nascent industry in Europe.

Building a SaaS business the way it's being done in the US is much more difficult in Europe.

For starters, any individual European country is too small a market to build a business with real capital markets value, especially because on-demand applications tend to be fill niche gaps in enterprise application functionality.

Second, there is a certain cultural resistance in Europe to the sales model favoured by US SaaS companies, who rely heavily on over-the-phone inside sales techniques, saving face-to-face visits for large deals only. 

If you add to these barriers the challenge of multiple languages and slower acceptance of new technologies by corporations, it becomes clear that Europe has more than a few hurdles to overcome before SaaS market leaders can emerge.

Then there’s the hairy question of profitability and cash usage. Some astounding statistics were quoted at the conference, such as: the average SaaS business in the US consumes $72m of external capital prior to going public (!!).

The US market is clearly in land-grab mode, with both the public markets and private investors turning a blind eye to capital efficiency and profitability.  Some companies will follow market leader Salesforce.com and succeed (see DemandTec, Salary.com, Athena Health, Vocus, among others), with huge returns to investors.  But many will not, and they will have used up a lot of investment capital in the process. 

So what can we learn from this in Europe?

Well, first, profitability does matter (kudos to Fraser Davidson from August Equity for reminding us of the most basic financial tenet: that companies are worth the sum of their future cash flows), so you better have a plan that gets you into cash-flow positive territory.  Even though many of the US SaaS vendors were unprofitable when they went public, today the median company has EBITDA margins of 18%, with less than 15% of vendors still in the red, according to research by Jefferies Broadview.

And getting into profitable territory is clearly worth it.  The same research shows that SaaS vendors are trading at an average of 19x forward EBITDA vs 11x forward EBITDA for traditional licence software vendors.

Second, while there are good reasons for SaaS companies to raise external capital –- annual subscription cash flows are often 1/3 or 1/5 of an equivalent up-front license -- one shouldn’t abandon the basic principles of business building when it comes to scaling across Europe.  That means choosing your target countries wisely, hiring the right people, and adapting your product and sales approach to each country.

Third, while it takes perhaps more discipline and strong sales management, you can definitely sell software over the phone in Europe.  We're about to announce an investment in a company that does just that, and very successfully too. 

It's going to take a bit more work on our side of the pond to build big SaaS companies, but at least the Americans have shown us both how to do it and what pitfalls to avoid.

Web 2.0 washout

Andrew Orlowski produced an aggressive I-told-you-so article in Tuesday's Register, gleefully declaring the Web 2.0 bubble as burst.   The trigger was a short piece in the FT titled: "Web 2.0 fails to produce cash."

As I have commented before, most of the $1.5bn VCs have thrown at Web 2.0 startups went into cutesy but useless Web services.  Some went into infrastructure and enterprise services, but most of these didn't have defensible technology and were too easy to replicate, over and over (Backbase, Kapow are notable exceptions). 

Even the services that attracted gazillions of users no longer look so valuable.  The value of many kinds of ad space on the Web is dropping, and no one has more excess inventory than user-generated content sites.  That's right, Twitter isn't going to sell for billions of dollars.

The 'good' thing about this popping bubble is that most of the money about to be written off comes from VCs (and only very indirectly from your pension) rather than retail investors, so the overall economic impact should be minimal (on everyone except the VCs). 

The second positive side effect is that some of the key features hyped by Web 2.0, including tagging, sharing, the power of viral networks, mashup applications, instant communications and those ubiquitous lime-green logos are being rapidly subsumed into the general software and services markets.  Every vendor claims to be Web 2.0 compliant and within a year or two every vendor will be.  It's just not that hard.

[Pic credit: Lani Anglin]

What's in a name?

If nothing else the Carlyle Capital debacle is a good lesson in where to draw the line in extending your brand.  The Carlyle Group's partners owned only 15% of the fund, and yet they had lent it their prestigious name.  As a result the hedge fund's collapse has become a PR nightmare for Carlyle, when it could have been the disappearance of just another over-leveraged hedge fund, and little more than a (painful) personal investment loss for Carlyle's partners.  A lesson to remember for the next cycle.

My predictions for 2008

A bit late, but nevertheless here they are and -- as promised -- a more 'committing' set of predictions than last year's:

1. A combination of US recession and the waning efficacy of online ads will hit the Internet advertising industry hard, although "hard" is clearly a relative term.  Offline advertising may actually shrink, while online advertising will grow slower, perhaps even low double digits.
2. The Structure of Networks -- social and otherwise -- will migrate to the core of the Web, replacing the Structure of Documents on which it was originally built (HTML and all that).  Someone will figure out that applying the Google PageRank concept to networks of people is even more interesting: if we can identify influencers and how information flows among them, we can really start targeting campaigns.
3. 2008 will the year of the Return of the ERP Vendor.  SAP, Oracle and the midmarket vendors will make progress with their own SaaS offerings and will shrink the valuation gap with the pure-play SaaS vendors.
4. The Web 2.0 financial bubble -- fuelled by VC cash being round-tripped between startups buying and selling ad space -- will pop as a result of the weaker ad market and the failure of 100s of undifferentiated 'feature' startups to gain traction.
5. The mobile web will continue to be stymied by the difficulty of discovering content on mobile devices, Vodafone's new image search engine notwithstanding.  iPhone and other large-screen devices will help commuters surf the old Web, but mobile browsing won't take off until someone invents a new search paradigm that works on mass market mobiles.
6. As a result the mobile advertising market will fail to take off... yet again.  Those networks and technology vendors that were acquired in the past 18 months (Nokia/Enpocket, Microsoft/ScreenTonic, et al) will disappoint their new parents.  And the next generation of mobile advertising companies will have to make do with much less VC funding.
7. What on earth is UWB?  Anyone remember? Anyone care?
8. The success of the Nintendo Wii will spark a whole host of new physical interactive video games, providing a boost to vendors of chips to the console companies.  Perhaps a Wii Lite is in store?  Look to Japan for inspiration: this year's Christmas hit, Guitar Hero, was really a copy of a Konami game popular among Japanese teens in the late 1990s!  So why not portable versions of a DJ game like Beatmania or a competitive coordination game like Super Bishi Bashi? 
9. Social networks will see huge monetisation efforts and some applications and ad networks will make a financial killing.  But their performance will be erratic and useage of networks will be highly volatile as consumers get tired of being poked, zombied and voted HOTorNOT.
10. Some element of Open Source or "free" distribution models will become part and parcel of every software vendors' go-to-market strategy.
11. [Bonus, more of a hope than a prediction]: 2008 will mark the return of the Basic Business Phone, and it will be a runaway bestseller.  Nokia or someone nimbler will launch a high-performance phone that makes phone calls, has a long battery life, global coverage, and a simple, fast interface.  And absolutely nothing more!  I so wish...

Stay tuned.

MSFT unsolicited bid for Yahoo

At $45bn, Microsoft's proposal to acquire Yahoo must look like a godsend for Yahoo's beleaguered shareholders.  And at a 62% premium to Yahoo's last close, Steve Ballmer is clearly hoping to deliver a 'knockout' bid that the board can't refuse.

Oh, and just in case Yahoo's 10-person board (all but one of whom are independents) think they might softpedal the approach, Microsoft released the full text of the offer letter sent by Ballmer to the board, which is definitely worth reading here.  The timing is perfect, cruel but fair. Yahoo will find it difficult to resist.

In Ballmer's passive-agressive letter to the board, he berates management for failing to deliver growth after rejecting a merger with Microsoft a year ago.  But what's really interesting is the extent to which this is so explicitly a defensive manoeuvre against Google and in particular its scale and capital spending capacity.  Ballmer writes:

While online advertising growth continues, there are significant benefits of scale in advertising platform economics, in capital costs for search index build-out, and in research and development, making this a time of industry consolidation and convergence. Today, the market is increasingly dominated by one player who is consolidating its dominance through acquisition. Together, Microsoft and Yahoo! can offer a credible alternative for consumers, advertisers, and publishers.

For Yahoo's shareholders this is a great face-saving exit from a strategyless future.  But whether the combination will in fact create a viable competitor to Google in online advertising remains to be seen. 

I'm not dabbling in equities at the moment, but if I was I'd be long YHOO and short MSFT.

Royal to SocGen: please give it back

The French should be thankful every day that Nicolas Sarkozy -- for all his odd workaholism and his envy-inducing sex life -- became President.  Via Pierre Chappaz's blog comes this story:

Ségolène Royal, "shocked by the Société Générale scandal", demanded on Friday that "the €7 billion be reimbursed to those families who have been plunged into indebtedness."

Priceless. Thanks Pierre.

Time for risk management 2.0

The unrelenting waves of bad news coming out of the financial services industry these days all seem to wash ashore at the same place -- on the desk of the CFO and his compliance team.  Financial risk management just isn't what it used to be.  Or rather, the risks themselves have moved so significantly in the past 10 years that banks have not managed to keep up (except, perhaps, the whiz kids at Goldman). 

Time for a change, or as Steve Husk of FRSGlobal suggests in his new blog, banks need to decide whether they want to be Southampton FC or Real Madrid (really!).  It's time for a two-dot-oh look at risk management.

In my view 3 main factors have contributed to an exponential increase in the scope and complexity of risk.  First came an acceleration of innovation in financial instruments, with investment banks churning out weekly new spins on the securitisation concept to ensure they had something to sell to clients, something to trade in and out of to generate fees, and -- in many cases -- something for their prop trading desks to buy.  The sophistication of these products have come a long way from Bowie bonds to a finely-graded slice of sub-prime mortgage risk.

Second, the entrance of new market participants, including hedge funds, corporate treasurers and commodities offices, the banks' own SIVs, and -- finally -- consumers egged on by retail bank 'consultants', created greater liquidity but also volatility in the market.  The behaviour of many of these market participants was not predictable and their reaction in a crisis untested.

Third, capital moves at higher speed through many more jurisdictions today than ever before.  There is no such thing as a domestic or European or American capital market today.  The effects of US subprime mortgage defaults are being felt in every corner of the globe, much to the surprise, no doubt, of the poor souls who are actually defaulting.

And yet the risk management approach used by most banks is based on legislative concepts that were  developed decades ago, in a simpler world of capital offsetting measurable liabilities on balance sheets (Basel I, Basel II).  The IT systems on which these risk management processes run tend to be local financial accounting systems, perhaps even instrument- or business line- specific, with little integration with the global exposures of the bank.

Now that banks know their real exposure is much greater than previously thought, and with the threat of increasing regulation if they don't find a way to regulate themselves, it's time to dust off those formerly Utopian plans to develop a single view of risk within the bank.

For both banks and corporates the era of keeping multiple sets of books is drawing to a close.  There is simply too much risk in not having a single, accurate, reportable view of the financial position.  The board will want to see the same report as the regulator is reviewing.  And when the regulator calls, the CFO wants to make sure his reporting is fully transparent and auditable.

It's no longer good enough to delegate local regulatory reporting to country managers. Regulators from different countries are talking to each other and are likely to exchange information and continue to harmonise their requirements.  For a bank operating across the world, this means local financial reporting needs to be in synch.  For the CFO, it means reducing risk of local error, while increasing global visibility of the numbers. 

So while general IT spending by banks will likely tail off this year, spending on compliance processes and risk management will continue, benefting firms like Riskmetrics (which is going public today), Algorithmics, and FRSGlobal (disclosure: Kennet company).  It is likely to take banks years to consolidate their financial systems and arrive at a single, global view of risk and an ability to report on it.  The good news is that this is more a process problem than a technology problem.  Recent technical innovations, including all that Web 2.0 stuff, make it notionally easier than ever.  Time to get started.

Scoring my 2007 predictions

Apologies for the long silence, which was mainly due to an extended holiday absence.  Before you feel envious, it was our first multi-stage international trip with:

and we really could use another whole vacation to recover from it...

But back to business: in early 2007 I made 10 tech market predictions, so here's a reckoning to see how I fared.  On reviewing these I realised that many of them were of the slightly cheeky, undoubtedly-true-but-difficult-to-prove variety, so I shall resolve to to be more specific for my 2008 predictions (to follow) to keep it interesting.

Here is a summary of last year's predictions & my grade:

1. Web 2.0 technologies will begin to appear in serious enterprise apps, as vendors incorporate wikis, blogs and RSS feeds into their applications, starting with CRM and other consumer-facing apps.  TRUE, BEGINNING WITH SAAS VENDORS.
2. There will be very few high-value exits of Web 2.0 companies, but probably many more investments, leading to an eventual VC bust (in 2008?) not unlike the dot-com bust of 2001 (but smaller). HALF TRUE, BUST YET TO COME.  But come it will.
3. Actual adoption of Microsoft's new Vista operating system will underwhelm and Microsoft's share price will begin to suffer.  MOSTLY FALSE. Vista sales have not been what Bill expected, but it hasn't affected the share price yet.  MSFT is up about 35% over 12 months and outperformed NASDAQ by 10% or so.
4. We will see the first serious cracks in the indomitable Googleplex -- how many wheels will in fact come off?  Investors beware.... FALSE. But I'm definitely rolling this one forward!
5. Multimedia content for mobile phones (3D games, video, etc) will start to come of age, but more slowly than anticipated.  It will take time to overcome the many usability hurdles. TRUE, STILL TRUE, BUT TOO EASY.
6. Business software for the SME market will get a major boost, as vendors attack the midmarket with new, scaled down applications.  TRUE for both new and old vendors. New SAAS vendors are springing up to make business-level functionality available to SMBs.  Client-server giants like SAP are investing heavily in midmarket offerings.
7. Offshore technology vendors -- not content to do pure services work -- will continue to push into Western markets with their own product sets.  TRUE-ISH: it's still early days for Indian packaged software. The largest firms, like Infosys and i-Flex are still the main examples.
8. Expect to see lots of new applications for small vertical markets.  The combination of SOA and Web 2.0 technologies makes it easy to build apps for the long tail of micro markets. TRUE.  Lower cost of development and delivery has led to an avalanche of niche apps. We've seen everything from employee feedback management software through to environmental data reporting suites.  Great news for users and investors alike, although picking large enough markets will be key for the latter.
9. Consolidation in the WiMAX market will begin as the large chip and equipment vendors jostle for a piece of the infrastructure build-out.  Still too early for actual services of any scale though... TRUE. Cisco launched the first consolidation shot in December with the acquisition of Navini.  Sprint/Clearwire remains the biggest WiMAX network project, and it has been on shaky ground (but seems to be going ahead) . 
10. The line between information services and software functionality will become increasingly blurred, as more managed services effectively bundle both.  VERY TRUE.  The most interesting SaaS businesses we see are those that collect customer and industry data which has value in its own right.  Combining a software and data service can be very profitable and very sticky.

There you have it.  I'll call that a 7/10 caveated with the promise that I'll make meatier, harder predictions for 2008!  Stay tuned....

The battle for control of the GPS market comes to a head

 

This year's most exciting takeover battle in tech may be nearing a conclusion.  On Wednesday TomTom, maker of the ubiquitous GPS navigation devices, increased its bid for digital map-maker TeleAtlas by over 40% and snapped up 28% of the target's shares.  This follows an earlier hostile effort by archrival Garmin from the US to prevent TomTom from gaining control over the only remaining independent provider of maps.

This expensive bidding war caps a wave of consolidation in the industry which pits the two market leaders against each other and both against a new, gigantic entrant.  The opening shot of this set-piece was Nokia's agreement to acquire Navteq Corp, one of only two global providers of digital maps to the fast-growing GPS navigation industry.  Pretty much all the sat nav device and navigation software vendors depend on either Navteq or TeleAtlas for maps.  What Navteq and TeleAtlas do is expensive and time-consuming (hundreds of people driving around the world mapping roads), so they are not easily replaced. 

Garmin primarily uses Navteq and TomTom uses TeleAtlas.  In fact TomTom is TeleAtlas' largest customers, making up about 30% of revenues.  So when Nokia bid for Navteq (having already acquired navigation software vendor Gate5 last year), alarm bells must have gone off at Garmin's beach HQ in the Cayman Islands.  Nokia is gearing up to become a formidable competitor to the dedicated sat nav device market, planning to put GPS-absed navigation on both its high-end smartphones and mass market handsets.  To protect its own source of maps, TomTom made a heavily geared bid to acquire TeleAtlas for a whopping €2.1bn. 

The loser of this battle may well struggle to survive.  US anti-trust officials have not opposed the merger, but the European watchdog is still considering it.  They will of course require the winner to continue providing maps to the industry as a whole, including to the loser.  But for the ultimate winner there are many ways to make life difficult for rivals.  And huge margin benefits for itself -- saving TeleAtlas royalties could add as much as 15 or 20 points to TomTom's gross margin.

This is one fight TomTom cannot afford to lose.  Last week Garmin countered TomTom's initial bid with an unsolicited €2.4bn offer.  TomTom responded swiftly, raising its bid to €2.9bn this week.  At the same time it acquired 28% of TeleAtlas' shares from its leading shareholder and in the open market, effectively blocking any possibility of a Garmin victory. 

TomTom will surely win the day, but at what price?!  Its latest bid represents an 81% premium to TeleAtlas stock price before the bidding began.  TomTom will end up paying 9 x TeleAtlas' 2007 revenues or 38 x 2007 EBITDA.  For TomTom it's a choice between Winner's Curse or likely demise.  Meanwhile TeleAtlas' shareholders are laughing all the way to the bank.

From the sidelines, Microsoft and Google -- both of whom have a keen interest in mapping and navigation services for consumers -- are watching carefully...  If anyone could afford to fund the creation of a brand-new provider of global digital maps, it's them.  Watch this space.

Apple's coup

Last week saw a quiet but satisfying milestone in the tech markets.  Call it the delayed recognition of innovation versus scale.  Apple's market cap surpassed that of IBM.  Nice.

[Disclosure: I have none to make, unfortunately.]

A great day for tech buyouts

If ever we needed more proof that the technology industry is mature, we need look no further than today's announcement that HgCapital has sold two of its software companies for £500m in a secondary recap transaction.  When Hg acquired accounting software vendor Iris in 2004 in a head-turning £102m MBO, most observers thought they had overpaid. Just a few weeks ago (!), Iris announced the acquisition of publicly-listed diversified software group CSG for £100m and its merger with Iris. 

We don't have enough publicly available data to disaggregate Hg's financial returns in this deal, but we can speculate (what are blogs for? :-)).  Following the respective investments, Hg owned 62% of Iris and 86.5% of CSG.  Assuming a debt-equity ratio of 2:1, they would have used about £50m of equity to buy their positions and perhaps another £20-40m of equity to invest for growth.   From the sale price of £500m they would repay their debt (say, £100m), leaving £400m to the equity holders.  As a result Hg might have taken £280m for its investment of between £70m+, making a return of as much as 4x their capital.  And a very high IRR.  Not too bad.

On the buyside, Hellman & Friedman are clearly on a tear in technology, following their gutsy and highly successful flip of Doubleclick to Google, which I wrote about before.  What is interesting is that H&F are not only making bets on high-growth markets like Internet advertising, but also on consolidation in the more mundane parts of the software market (eg, accounting, legal and ERP software).

This maturing of the industry and the wide availability of debt financing for tech buyouts significantly broadens the scope of investment opportunities in technology beyond the traditional VC market.  It creates a large market for growth equity and buyout capital.  And it adds increasing depth to the exit markets for both venture and growth equity investors. Both are positive developments for technology entrepreneurs and investors.

Spare me your Blinkx

Last week saw the AIM IPO of video search engine Blinkx, which raised £25m on a market cap of roughly £180m.  A great milestone for European tech IPOs?  A prime example of a successful UK technology company reaching the public markets?  I'm afraid not.

I hate to play the curmudgeon here, but Blinkx really reminds me of everything that is wrong with AIM, and of the inescapable whiff of bubble around some Internet subsegments today.

Blinkx uses technology licenced from former parent company Autonomy to index video content to make it searchable.  Unlike Google's image search and other meta-tag-based search engines (like Pixsy), Blinkx will find video that contains audio matching your search terms.  It's a nifty approach and an obvious improvement on the way we search video today.

But Blinkx is a start-up with no revenues.  It does not own its own technology.  It's only achievement to date is having spent $14m of Autonomy shareholders' money indexing 7 million hours of video from 130 content partners.  To learn all this you'd have to do some digging -- look in the investor section of Blinkx's website and you won't find any financial information on the business at all. 

Let's be specific.  Autonomy's demerger filing shows that its "consumer unit" (= Blinkx) had $3.8m revenues in 2006, all of which was "generated by Autonomy salespeople who are not transferring to the Blinkx business".  The proposed revenue model of the demerged company is primarily advertising-based, but "no significant [advertising] revenues have been earned to date." The document is full of promises of potential future revenue streams as one might see in any (perfectly valid) start-up business plan.

As a consumer I'm delighted to benefit from the service.  But as a fund manager I should surely be shot for buying this stock.  Here's my take: Autonomy has managed to unload its loss-making consumer division ($5.1m in costs in 2006) to cash in on the Internet video hype.  Autonomy founder Dr Mike Lynch has clearly figured out that not only does he have the rocket-science cachet to attract investors, but he also has the understanding of public markets to pull it off, for the second time.  Perhaps this chart of Autonomy's own post-IPO performance jogs some memories?

 

It's unclear from the filings where the funds raised actually went, but we do learn that Lynch personally retains an equity stake now worth, oh, about £20m.

The most material losers in this sorry affair will be the investors in the new stock. The less tangible but more important loser will be the European tech IPO market as a whole.  As I wrote previously, floating companies that are not ready burns investors and harms the reputation of the market.  In the absence of a pan-European growth market, AIM is the best alternative we have.  But in order to become a liquid, reliable exit route it needs to raise its quality bar significantly.  Blinkx is a set-back to that effort.

Online ad market is smokin' (con't)

And the deals just keep on coming...  Having supposedly lost out in the bidding for both DoubleClick and 24/7 Real Media, Microsoft has agreed to acquire aQuantive for a cool $6bn, which represents a massive 85% premium to its Thursday closing price.  That's roughtly 12x 2006 revenues or 60x EBITDA.

This deal basically completes the elimination of independent ad-serving technologies with any market share.  Ad serving on the Internet is now controlled by Microsoft (Atlas), Google (Dart) and AOL (Ad-Tech).  It also brings Microsoft further into the digital marketing and advertising world than it perhaps wanted.  aQantive includes several digital marketing agencies (Avenue A, Razorfish, DNA), as well as two performance-based advertising networks, DrivePM and MediaBrokers in the UK.

The consolidation continues...

Apple's $4bn accident or stock scam?

Here's a squirm-inducing testament to the power of blogs.  Valleywag reports on yesterday's downward 'blip' in Apple's stock price caused by a blog reporting delays to the iPhone release.  The blog note, published on Engadget, was based on a fake internal email that appeared to be leaked from Apple.  The incident momentary wiped $4bn off Apple's market cap.  Om reports on the impact:

In the volatile 23 minutes of turmoil between the minute the disinformation hit the stock market at 8:55 PST and Apple’s announcement that the initial email “is fake and did not come from Apple,” nearly 15 million shares changed hands. That’s 60% of Apple’s normal volume in well under a half hour. That’s also an awful lot money lost for some investors - and gained for others - all of it because of a lie.

Information velocity does have its downside.  I'd like to believe that no one purposely benefited from this event, but that is probably naive.  It does not stretch the imagination to see that unscrupulous traders will get the idea that these blips can be replicated and exploited.  Two factors conspire to create a real structural problem for the public markets here:

1. Rumour moves much faster than anyone's ability to verify or deny (in fact, I'm pretty impressed with Apple's 23-minute reaction)
2. Near real-time trading capability is in the hands of millions of people, and -- more importantly -- billions of hedge-fund controlled dollars

I'm a big believer in unfettered markets and perfect stock pricing that reflects all available information, but today's laws and regulations are not really made to cope with this type of situation.  What will the SEC make of it?

[Credit: Realtimestockquote.com for the chart]

AIM performance disappoints

The raw numbers continue to impress: 130 IPOs on AIM in the first half of 2006 vs 48 on NASDAQ, as reported by fellow VC blogger Shantanu Bhagwat of Amadeus.  But this comparison tells only part of the story.  The volume numbers are misleading: the average AIM company is far smaller than a NASDAQ company (median revenues of $11m vs $95m), and the listing criteria are more lax for companies going out on AIM. 

We have been studying AIM IPOs for years to determine whether they are a viable exit alternative for our European portfolio companies.  The answer has so far been: not really; although heavy US regulations like Sarbanes-Oxley are certainly making the relative comparison more attractive (as reported earlier here). 

Now M&A boutique Innovation Advisers has published new research tracking the performance of AIM-listed companies over time.  It's perhaps not surprising that such research would be done by a US investment bank, and not a European one...

"AIM companies don't age well," says Eric Gebaide, the Innovation managing director who spearheaded the study. "Bankers tell you that the AIM welcomes small companies and that you are going to become public more easily and cheaply than on Nasdaq, but what they don't tell you is that two years after going public, your stock is likely to be worth less than half of its IPO price."

The numbers confirm our earlier anecdotal view on the market.  Over time most AIM companies tend to underperform, both in absolute terms and in comparison to their peers.  The study found that 2 years after IPO, AIM companies on average traded 57% below their IPO price (vs up 12% on NASDAQ), by year three the performance was -65% vs -26% on NASDAQ.  Here it is in pictures (thanks Eric):  

The implication is that only a small minority of AIM companies are equity success stories long-term. It's worthwhile to think hard about what makes those few successful.  Many AIM floats feel like companies that have run out of ideas. 

Companies that are able to sustain their "equity story" long term are the ones that thought of AIM not as an exit but rather as a way to raise capital for a clearly defined growth plan (be it organic or through acquisitions).  I think AIM can be very effective for this kind of play, but the risks to companies that float without a 24-month growth plan are significant.  And since most investors are locked up in their AIM shares for at least 12 months post-IPO, it is in their interest to help shape this plan.  Something to think about.

Whacky floatation ideas, part 1

I met a company today that had such bad ideas for getting funded that I can't help writing about it.  If only to warn the solitary entrepreneur who might stumble across this blog! 

The company in question is a mature technology vendor, selling to blue-chip enterprises, with tens of millions of Euros in revenues, good growth and consistent profits.  It sells a mix of established products and is developing some new ones which are not yet proven in the market.  It does not have to raise capital, but could accelerate new developments and its growth by doing so.  In other words, it's in a fairly strong position to choose the best funding route.

The company has debated whether to float on one of Europe's new growth company stock exchanges, or to raise capital from a private equity fund.  Fair enough -- the trade-offs are well-known (perhaps I'll write about them in more detail in future).  But the founder and his banker had some additional ideas:

1. Raise capital through a private placement to many institutional and private investors
2. Sell/allocate shares to as many of his enterprise customers as possible
3. Register the shares on the stock exchange so they can be traded (but without selling new shares to the public)
4. The founders would sell no shares; the existing investors have the choice of selling some

Here's what's wrong with this picture:

1. I don't know much about this type of hybrid private/public fundraising, but I would imagine this structure will attract mostly short-term investors who believe they are getting a pre-IPO discount.  They will be the first sellers once the shares are listed.
2. Wow - what a bad idea... Vonage anyone??!!?  Don't mix business and business.  The commercial benefits if the shares do well are marginal; the downside risk of alienating your customers if they don't is huge.
3. Without a public offering with a primary capital raise, the only liquidity will come from investors trading with each other.  Hard to imagine how this will generate enough external interest to create a minimum of liquidity.  The market in this stock is going to be very very thin.
4. A substantial fundraising is the founders' one chance to take some cash off the table.  Not selling may be "noble" but it's also stupid.  This might be the last time there is any option for liquidity -- the founders ought to take it up.  There is absolutely nothing wrong with cashing out a small portion of your equity along the way.

Don't float your dross on AIM

AIM fever continues unabated, with US and other companies preparing to float on London's lightly regulated stock market.  First it was the escape from onerous regulation in the form of Sarbanes-Oxley, now it seems to as much about the higher valulations achievable on European markets. 

Every week I talk to another small company that is looking to list on AIM or Alternext in lieu of seeking venture financing.  In some cases this is genuine competition to private equity investors like us. In others it feels more like taking advantage of a less discriminating market for tech company securities.

Alarm:clock Euro posted a salutary quote a few days ago from Danny Rimer of Index Ventures in a Business 2.0 article on the topic.  I don't usually republish stuff from other blogs, but this is a good point:

There is a chance it could all go terribly wrong. Let's not forget Pets.com and other problem children of the dot-com bubble, which the Nasdaq welcomed with open arms not so long ago. Investors will need to proceed with caution to make sure venture capitalists don't start dumping ailing startups on these "light touch" markets, with bankers and entrepreneurs playing along.

"You need to get these three parties to behave well," says Rimer, the London-based venture capitalist. "It may be a tall order, but if it's accomplished we could see something like the AIM becoming what the Nasdaq was back in the mid-'90s." In other words - a market for promising companies where investors actually made money, before the bubble started inflating.

We're all in favour of more liquidity options for European growth companies, but let's make sure we don't burn the very institutional investors we want to have buy into our companies when they're ready for prime-time.

Greenspan questions SarbOx

Well that was good timing.  Looks like there may be some discussion about revamping Sarbanes-Oxley after all.  Former Fed chairman Greenspan was quoted today's FT:

Alan Greenspan, former chairman of the US Federal Reserve, predicted yesterday the US would make "changes" to the burdensome financial and corporate governance requirements driving companies out of US markets.

Mr Greenspan initially supported the passage of the Sarbanes-Oxley law - the landmark 2002 legislation introduced after the Enron and WorldCom scandals - but said yesterday he was "disturbed" when companies started favouring London over New York for their flotations.

"The Sarbanes-Oxley Act has created significant problems for foreign investors with its regulatory structure," he said at a question and answer session at the Asian Financial Centres conference in Seoul, organised by the Financial Times. "I am nevertheless acutely aware and disturbed by the fact that initial public offerings have moved away from the US - and to a large extent have moved to London."

Thanks to Jeff Nolan for highlighting his comments.

Europe IPO markets in ascendance?

Yesterday's announcement that Nasdaq beat out other bourses in acquiring a 15% stake in the London Stock Exchange is a bold sign of the increasing attractiveness of European capital markets relative to the US.  I wish this were mainly due to improving investment conditions in Europe, but I think the truth is rather more negative.  The reality is that US over-regulation, in the form of Sarbanes-Oxley (SOX), is stunting the growth of US capital markets and pushing companies to explore overseas alternatives.

The numbers tell the story.  We recently analysed IPO activity among technology companies to gauge the climate for listings in the US and Europe.  To our surprise the number of European listings increased by 56% in 2005 over 2004, while the number of US listings was flat.  This is in spite of continuing optimism (and increased venture investment) in the technology industry as a whole.  What's more - in 2002 and 2003 80%+ of tech IPOs were in the US; in 2005 the split was 50:50! 

The real irony here--as software blogger Jeff Clavier, and Bill Gurley of Benchmark point out in their blogs--is that a piece of regulation that was supposed to increase transparency and hence the attractiveness of US capital markets appears to be having the opposite effect.  We're all for more transparency and accountability, but the costs of complying with SOX are simply too high.  Every private equity investor I speak to says they are thinking hard about how to avoid a US listing if they can get access to capital markets in Europe. 

On the positive side, SOX is leading to increased activity on a number of European capital markets, from London to Frankfurt to Paris, and this means more exit options for European companies.  So from a European investors' perspective, we have more choice today thanks to Messrs Sarbanes and Oxley.... And Nasdaq is clearly hedging its bets on this trend.