Tuesday, June 29, 2010

Amazing, Smart or Crazy?

My fondness for early stage investments often prompts me to develop a new method with which to filter, evaluate and pursue deals. One of my current methods is to group interesting early stage companies into the following buckets: “amazing,” “smart” and “crazy.” Many companies don’t quite meet the criteria I set to receive these labels, and occasionally, special companies will fall into more than one category. This is an imperfect framework, but nonetheless useful for me as I evaluate the worthiness of a given early stage project.

Amazing” companies are the mainstay of the Israeli venture scene. The business case of these companies is predicated on having a superior technology solution for a technology problem that in turn has meaningful business implications in a very large market. These are companies whose products are incredibly difficult to develop, and whose product claims are met with incredulity or otherwise elicit a “wow” response. Competitors will scratch their heads and dismiss the claims as preposterous, but “amazing” companies will be vindicated at the end of the day. Finally, these companies are unique in that they are actually able to create shareholder value by merely delivering a working product (which honestly can’t be said of most start-ups). But alas, too many Israeli entrepreneurs and investors think their company is a diamond(amazing), when in fact it is just a shiny stone(interesting). The bar should be very high for these companies at the early stage, especially those that require significant amounts of cash for R&D. "Amazing" companies may ultimately be acquired merely for their IP, product and development team, but these outcomes are few and far between. From my portfolio, past and present, I put Altair, Dune, Soluto and Storwize in this category. Other "amazing" BVP portfolio companies would include Tilera, Miasole, and Vertica.

Smart” companies seem to be Bessemer favorite. These companies solve challenging business/market problems with well thought out solutions that are largely business in nature, such as a new product concept, pricing model or marketing approach. They are borne of the founders’ epiphany that something valuable can be built around a market inefficiency or anomaly. They may be technology-driven, but rarely rely on technology innovation. As a result, the founders of these companies usually possess a strong understanding of the target market, including the economics, psychology and politics that drive it. The risk around these companies is largely execution, but when done properly these companies can quickly disrupt an existing market or create a new one with a surprisingly simple, yet smart approach. From my portfolio, I feel that both Soluto, and my recent undisclosed investment, fall in this category. Other “smart” BVP companies include LifeLock, Gerson-Lehrman Group, Diapers, Yodle and Open Candy, among others. 

Crazy” companies come with bold or wacky assumptions about consumer/customer behavior that are simply impossible to prove without trying. These are companies whose products are greeted with indifference (who needs it?), scorn (it’s annoying!) and ridicule(they will never build a business). And with a great degree of uncertainty baked into the plan, a lot of improvisation is required in the early years. In contrast with “amazing” companies, “crazy” companies typically have products that are straightforward to develop, but rely on untested methods of distribution, customer engagement, and/or monetization. And in contrast with “smart” companies, “crazy” companies lack a business model and operate in ill-defined market segments. I deliberately use the pejorative term “crazy,” because entrepreneurs and investors alike should recognize the immense risk of their plan so that pride does not keep anyone from pulling the plug when things clearly aren’t working out. Aside from ICQ, Israel has only had only a handful of successful crazy companies, which makes funding them more difficult. BVP has its share of “crazy” companies, which time has made very “smart.” These include Skype, Yelp, and LinkedIn, and more recently Hunch, Sonic Mule and Wix

Over time, the distinction between each of these three labels may blur, as some “crazy” companies succeed and become “smart”(Twitter, Facebook), and some “amazing” companies succeed and become "smart" (Google). It’s fair to say that being a “smart” company should be the end goal of every start-up, but this is precisely the point. It’s hard to come up with a smart model at the onset and even harder to succeed at execution. But if you think you can, we are certainly interested. I also recognize that many “amazing” and “crazy” companies will be acquired long before they are able to prove they are also “smart”. Finally, it should be noted that falling into one of these three categories does not by itself guarantee success… however doing so can help early stage investors, like myself, feel their early stage risk is money well spent.

Friday, June 4, 2010

Axis Pulls an Ace in First LTE Exit

Last month my portfolio company, UK-based Axis Network Technology, was sold to Korea-based Ace Technologies for $35M. It was a great outcome for all involved as BVP was the only institutional investor (£3M), following several years of bootstrapping by the entrepreneurs, Simon Mellor and Steve Cooper. Unlike most of my investments over the past 2 years, Axis was not an Internet company, but rather an RF subsystem company focused on being a key enabler for 4G wireless base stations.

At the time of the investment in the summer of 2007, this was a very contrarian decision. But something struck me about the entrepreneurs and the proven market for remote radio heads they were addressing(in 3G).  The strength of their entrepreneurial spirit was manifest in their decision to bootstrap their venture by first finding customers and then developing products based on this intimate understanding of the customers’ needs. Furthermore, I was excited by the fact that Axis was following two familiar and successful paths in the telecom subsystem segment.

The first was exploiting a shift within telecom OEMs from in-house development to third party merchant suppliers like Axis. This has been played out successfully multiple times by other start-ups over the last decade, including a former portfolio company of mine, Dune Networks (sold to Broadcom), in the switch fabric segment. The second was paving the path for software/IP to replace low margin hardware, or rather exploiting the commoditization of existing hardware rather than developing yet more complex hardware. As a result, no OEM or competitor could match Axis’s price/performance, which made them the de facto standard in the LTE and WiMAX radio market. I love these themes and will continue to invest in them should new ventures come my way.

For my readers, the take away here is that contrarian investment in out-of-favor sectors can still be made wisely and profitably. However, the entrepreneurs and investors need to practice the same capital efficiency and scrappiness that we have come to expect in Internet start-ups. Leverage the innovation of others, engage with customers immediately, focus on the customer’s business pain, start with a minimal viable product (MVP), and pursue a business model that can be profitable even without massive volumes. 

Axis is the first LTE focused start-up to be acquired, and likely one of only a handful of WiMAX start-ups to ever deliver venture returns to its investors. Congratulations and thanks to the Axis team! 

Thursday, June 3, 2010

Israel Deserves a Real High Tech Policy

A new High-Tech Committee headed by Ministry of Finance Director General, Haim Shani, presented several recommendations yesterday to revive and buttress the local high tech industry. Here they are with my commentary and star rating:

1) Safety Net for Institutional Investors (**) – The idea is to encourage local pension funds to invest in Israeli high tech and Israeli VCs by backstopping their losses through a “Safety Net”. While I agree that the lack of a local financial backbone is a problem for Israeli VCs, and even an anomaly compared with our US and European counterparts, I think this recommendation is flawed. You need a safety net when something is indeed very dangerous or when it is at least perceived to be dangerous. So assuming Israeli VCs are only perceived to have bad performance and are actually quite attractive investment vehicles, then the government doesn’t have much to lose and the industry should gain as a whole with anchor Israeli institutional investors. If, however, Israeli VC performance is not that appealing relative to other asset classes, one must ask what perverse incentive this may create, and what business the government has using tax payers’ money to prop up a failing industry? Such a move may bring needed local LP dollars, but would create a certain moral hazard with investment managers and their LPs using this tax payer stop loss mechanism to invest in overly risky ventures. My recommendation is to leave the risk there, but make the potential reward sweeter by offering tax incentives for gains from investments in local high tech. This creates a natural incentive to invest in venture capital in Israel, without the moral hazard or riskless investing.

2) Encouraging the founders of start-ups not to sell “early” (*) – This popular maxim says that Israel would be creating many more IPO candidates were investors and their founders not so eager to sell at the first opportunity. I have heard this many times, but does this really make any sense or is this just a convenient excuse? Does anyone really think that that founders and their shareholders wouldn’t hold on to their shares two or three more years if they though their share value would easily double or treble? If this is what’s going on, VCs are not doing their job, and founders are surprisingly no longer motivated by money or fame. How could it be that we Israelis are quick to forgo future profits when it’s so obvious to everyone else that we are just hopelessly impatient? I know the names of too many now defunct start-ups who had the gall to reject various offers due to shear hubris. But can anyone point out at least three companies that sold too early and what disaster fell upon it and Israel post acquisition? There is no where near enough liquidity in the local start-up scene so someone in the Ministry is out of touch. If this recommendation goes into effect, it will affect the way investors structure their deals, because it will put founders at odds with both management and shareholders.

3) Prioritization of Chief Scientist Office (CSO) funds (****) – The idea is that the CSO should have some focus with its budget favoring sectors such as biotech, cleantech or semiconductor (my suggestion) which have a greater need for financial support due to capital intensiveness and long gestation periods. Finally someone has woken up to the fact that the CSO is a first come, first serve piggy bank for hungry start-ups. But let me add two other problems. The CSO has neither a mandate nor the ability to assess the viability of a given project, and a lot of the CSO grants are simply wasted on doomed R&D projects or companies. There must be a connection between recent private funding(which presumably is indication of the potential economic gain) and receipt of CSO money to help guide it.

Additionally, stop linking all CSO funds to R&D! How myopic and highbrowed can we be? High tech is not only about engineering and certainly not volumes of patents. Most of the most successful start-ups over the past 5 years have very little to do with engineering or patents (Facebook, Salesforce.com, YouTube, Skype, Zappos, would all be ineligible for CSO funds). In fact, I would argue that Israeli companies spend a disproportionately large share of their budgets on R&D compared with their US counterparts. Stop perpetuating this myth that that the success of Israeli high tech is dependent upon more engineering dollars. It’s quite the opposite.

4) Encourage corporate R&D through tax incentives (*****). Wonderful, by all means and have it apply to foreign R&D centers as well.

5) Provide incentives to employers of Arab-Israeli and Ultra-Orthodox engineers(***). This is commendable, and I like it, but believe it won’t solve much. Those minority populations are at a disadvantage in Israel for so many other reasons, such as their ineligibility to serve in the IDF(where critical experience is gained and vital connections are formed), and living too far from the center of high tech activity. The country’s inability to integrate them into the workforce is not unique to high tech, which suggests more is needed to make this truly effective.

I have several of my own recommendations for the High Tech Committee headed by Mr. Shani:

1) Encourage the creation of new micro VCs of no more than $50M along the lines of the original Yozma plan. These VCs would raise capital from private LPs, but would get generous matching dollars from the government. The $50M number ensures a focus on profits from carry (not management fees) and a focus on early stage investing.

2) Encourage angel investing through tax incentives. Angels have become a vital part of the entrepreneurial ecosystem, but much of what they do is ignored by the government. Give them additional incentives to keep investing. It would amount to a subsidy to the wealthy, but their role in germinating start-ups is akin to oxygen for our industry.

3) Create a Marketing & Sales fund to mirror CSO dollars on the R&D side. These dollars would go towards hiring marketing, business development and sales heads in Israel and outside; and include advertising dollars. This may not create as many local jobs, but successful sales and marketing supports our beloved engineers. It’s like teaching a man to fish, rather than just giving him a fish.

4) Invest more in education, English language skills, fundamental scientific research, and don’t cut the CSO budget. Also, bring more foreign companies and skilled foreign workers to Israel.