Recently in The Deal Category

In my last VentureCast, I started out by claiming that I was going to talk about two things: conferences and my Deal or No Deal blog post on VentureBlog. Well, it turned out that I rambled on for over a half hour talking about conferences, so I decided that my discussion of Deal or No Deal could wait. But that long wait has ended. In this episode of VentureCast, I go into a bit more detail on how I think about acquisition offers and startups in the context of what has become an acquisition economy (by virtue of the very limited number of IPOs that have been launched in the last handful of years). If you're interested in hearing more about Deal or No Deal, this VentureCast is for you!

There continues to be a lot of discussion in venture capital and entrepreneurial circles alike about the onslaught of early acquisitions being made by the folks at Yahoo, Google, InterActiveCorp and increasingly Fox Interactive Media. The question I am often asked goes something like, "isn't this really bad news for venture capital?" After all, if all the "good companies" are bought up before they have the chance to raise venture money, how will we VCs make any money?

Early acquisitions are nothing new. While it feels like they are occurring at perhaps a faster pace for the time being, it has always been the case that the "good companies" attract lots of attention quickly and end up with early acquisition offers. Sometimes entrepreneurs accept those early buyout offers. And sometimes they don't. But when the do it is by no means an indictment of the venture capital industry. It is simply a decision made by an entrepreneur at that particular point in time that the risks associated with continuing to build enterprise value in the future are outweighed by the certainty of a particular price paid today. To my mind, these acquisition offers are just like the new TV game show Deal or No Deal.

For those of you who haven't seen Deal or No Deal, it is one of the more brain dead game shows created. At the beginning of the game, a contestant stands in front of 26 models holding briefcases in their hands. Each briefcase contains a particular dollar amount, ranging from one cent to one million dollars. The contestant picks a briefcase but does not get to look at the dollar value in that case. She then proceeds to pick a half dozen briefcases, the dollar values of which are revealed. As each case is picked, its dollar value is removed from the board of potential winnings. Once the first six cases have been chosen, a fictitious "Banker" is asked what price he will pay in exchange for the case held by the contestant (this is perhaps the most glamourous job ever held by a statistician -- for insight into the Banker's psyche, you can visit his ridiculous Bankers Blog). In theory, the Banker knows no more about the contents of the contestant's briefcase than does the contestant herself. If the six cases eliminated were all low numbers, the Banker will offer a number in the tens of thousands of dollars. If the cases revealed high numbers, however, thus indicating a higher likelihood that the contestant holds a low dollar value in her chosen briefcase, the Banker will offer a buyout of mere thousands. The contestant then has to choose to take the offer based upon the information available or risk potential losses while turning over some more cards. The case picking and Banker offers continues until the contestant either takes an offer from the Banker or has chosen all of the cases and gets to reveal what is in the briefcase she originally picked.

Entrepreneurs who receive acquisition offers early in the lifetime of their companies are essentially faced with the same conundrum as that posed in Deal or No Deal. Relatively little information has been revealed about the long term value of the company, yet the entrepreneur must decide whether or not to take the offer and, in essence, stop playing the game. As can be seen from the game show itself, in many instances taking the deal early on is a good idea because as each new briefcase is opened, the perceived value of the case being held by the contestant goes down, as do the buyout offers from the Banker. However, in many other instances, as time goes on and risk is removed (all the low numbered briefcases are picked), the buyout offers from the Banker increase to substantial dollar values.

Some recent acquisitions and acquisition offers reveal the parallels to Deal or No Deal. Companies like Flickr, Delicious, Bloglines, Writely, etc. had early success and were offered solid amounts of money to sell very early on. Little had been revealed about their long term value but the early indications were excellent (the first briefcases picked were low numbers) and therefore Yahoo/IAC/Google were willing to pay millions of dollars to buy them early. On the flip side, Friendster had similar early indications of high long term value and accordingly Google made an offer to buy the company based upon those early indications. In that instance, however, the company decided to open a few more briefcases, and, unfortunately, each new briefcase revealed negative news about the long term value of the business (in other words, the briefcases all held high numbers). As a result, the offers from Bankers to buy the Friendster business have fallen precipitously. Another twist on the same theme is the Facebook story. Early indications on the Facebook were excellent and the management decided to pass on the first set of acquisition offers. Yet, as the Facebook continues to open briefcases, they keep finding nothing but good news. Thus, if the rumors are true, with each additional piece of good news, the Bankers have offered larger and larger numbers to buy out the company. The folks at the Facebook, however, continue to refuse buyout offers and play on. With any luck, their value will continue to go up until such time as they choose to sell or take the company all the way (I suppose, to kill an already wounded analogy, sticking with the original briefcase you chose and discovering it holds a million dollars is the equivalent of a startup going public).

I don't for a second want to suggest that the long term success of companies is purely a question of chance. Nor do I want to suggest that the key to financial success in a startup is only about selling at the right time. Unlike the contestants on Deal or No Deal, entrepreneurs have a lot of influence over what dollar values are revealed in the cases they choose to open. Successful entrepreneurs systematically eliminate risk while building increased value in their companies. While some factors are outside an entrepreneurs control (e.g. market adoption), many of the risks are influenced by the smart choices made by entrepreneurs along the way.

Ultimately there will come a point in time when each entrepreneur will have to ask him or herself, "deal or no deal?" That some entrepreneurs will choose "deal" early in their company's life cycle is not an indictment of the venture capital industry, it is merely an indication that the Yahoo and Google Bankers are making offers some entrepreneurs cannot refuse. That's good news for entrepreuners. And as companies mature and additional briefcases are opened, in many instances the Bankers' offers continue to grow. And that will prove to be good news for VCs as well. I just pray that Toby Coppel isn't replaced by Howie Mandel any time soon.

Evolutionary biologists have an interesting theory about venture capital. Well, they think the theory is about peacocks, but the same principles apply.

Biologists wrestled with the question of why peacocks have such big tails. After all, the peacock's tail is pretty to look at but completely useless to the peacock. Beyond useless, it can actually get in the way if a peacock is trying to escape a predator. In a world of ruthless efficiency weeding out evolutionary misfits, why in the world would a peacock evolve such a big, clumsy tail?

Sex, of course. Peahens like long tails, so a peacock with a big beautiful tail is more likely to mate and produce offspring. But that just pushes the problem back a level – after all, peahens shouldn’t like long tails if it makes their mates (and thus their children) more likely to be eaten.

Except that they have another incentive: they want to mate with only the best peacock to maximize their children’s success. But it’s hard to tell a good peacock just by looking at it (I know I can’t). You can’t tell if he’s healthy, has good eyesight, and can run fast. Since the peahen only sees the peacock during the mating ritual, she has to guess.

The tail resolves this dilemma. After all, it makes the peacock pretty easy for predators to spot and catch. It takes a clever, fast, healthy peacock to have such a ridiculous disadvantage and still survive. The bigger the tail, the bigger the disadvantage and the better the peacock has to be to survive. Though not useful by itself, it is useful in instantly communicating something that would normally take a long time to observe. For peacocks, size does matter.

By now, the relationship to venture financing should be obvious. Some features venture investors seek in a company are not directly related to the chances a company will succeed. Instead, many of the items are “peacock feathers” – ways for a venture investor to be sure the company is not just puffing up for the mating ritual.

Until today it has been my practice to avoid directly discussing the companies in which I have invested. That is not because I have nothing to say about them. I could write a whole other blog about them. Nor is it because I am not enthusiastic about the businesses they're in. I am wildly enthusiastic about all of the businesses in which I have invested -- that's why I invested in them. But it has never struck me as that relevant or interesting to the VentureBlog readers. But for every well-reasoned rule there is an equally well-reasoned exception. Thus, please forgive me for heralding my latest investment on VentureBlog. It almost seems inappropriate not to blog about this one.

It is with great pleasure that I write about having invested in Six Apart. As many of you know, Six Apart is the maker of Movable Type and TypePad. Since its inception, VentureBlog has been powered by Movable Type. It is a wonderfully powerful piece of software that embodies the simplicity we have all come to expect from blogging software with the incredible flexibility and extensibility of the finest modern application software. I am also a big fan of TypePad, which powers my personal blog, SaysMe! TypePad is the yin to Movable Type's yang -- it embodies the flexibility we have all come to expect from application software with the incredible simplicity and reliability of a rock solid hosted service. As I've said before, "I think that blogging software is revolutionizing the way people communicate--whether to share pictures with family members or distribute a product spec to an engineering team" and Six Apart is at the forefront of that revolution.

Of course, there's more to Six Apart than powerful software. As elegant as I think both Movable Type and TypePad are, to quote myself again, "it's the people, stupid!" The Six Apart team is phenomenal and getting better every week. I don't invest in products or ideas or business models. I invest in entrepreneurs. And Ben and Mena and Barak and Andrew and Loic and Michael . . . and the list goes on . . . are some of the most dedicated, smart, creative, persistent, honest entrepreneurs I've had the good fortune to spend time with. It is my great pleasure to join the Six Apart Board and help build what I believe will be a hugely successful and influential company in the months and years to come.

"Star Wars" made $800 million worldwide, nearly 50% more than "Empire Strikes Back". However, at $33 million, "Empire" had more than twice the budget.

That seems logical, since series was already a hit by then. Star Wars, on the other hand, was a big risk - George Lucas had only one minor hit and one major miss to his name. Taken as a group, movies in that category lose money. Studios make most of their profits from successful sequels. They now negotiate the sequel rights at the time the first movie is filmed to lock in their option on all the actors and characters.

The same principle applies to Silicon Valley.

Man has Venture Blogging come a long way since we started VentureBlog a year and a half ago. At that time, the only way that there would be robust discussion and debate about venture capital related topics in the blogsphere would be if Andrew and I took different sides of an issue and duked it out on VentureBlog. Now folks like Brad Feld from Mobius Venture Capital and Fred Wilson from Flatiron Partners are discussing and debating VC issues of real interest and import. While Venture Capital still remains quite individualistic and, at times, enigmatic, VC bloggers have gone a long way to help demystify what has for years been a bit of a black art.

It struck me just how much information was being shared these days as I read a set of posts about Participating Preferred Stock by Brad and Fred. While there are real world implications to decisions made by VC's and entrepreneurs about Participating Preferred Stock, this is still a pretty esoteric topic. As recently as a year ago, the posts about venture financings were pretty rudimentary (here's what Joi was talking about, and here was my effort to just put the terms in context). Brad and Kevin Laws (at VentureBlog) upped the anti with deeper analysis of Preferred Stock. And now there is a debate raging online about the use and appropriateness of Participation in Preferred Stock. The real debate, mind you, is in the comments of Brad's and Kevin's pieces (we VC's are far too gentle on one another but entrepreneurs are more than willing to call BS when they see it).

Hollywood star power exists in Silicon Valley too

In a previous article on similarities between the hit-driven nature of Hollywood and Silicon Valley, I discussed the tendency of perception to become reality (see Believing Makes It So). Projects that manage to convince each necessary participant that the others believe it will work (customers, financiers, talent, etc.) will get the chance to succeed. Those that fail in one of those will never get off the ground, no matter how good the core idea.

This leads to the situation that frustrates so many starting out in the business: everybody wants somebody else to validate an idea. When everybody is looking to each other, the market tends to reduce evaluation down to the lowest common denominator. When people are trying to predict how others will judge a project's success, they cannot be overly sophisticated in their evaluation methods. Instead, they use very simple, visible cues.

The simplest, most visible cue is evidence of past success. Admittedly, this is odd in an industry where success is as much (if not more) luck than skill, and is actually a confluence of many factors rather than one person's contribution. Beyond that, success helps even if the past success has nothing to do with the new venture.

Before starting my career in Silicon Valley, I was a strategy consultant working for a number of major Hollywood studios (see here for some of my writings on the music industry). Despite the fact that Hollywood and Silicon Valley don't really connect (except through Steve Jobs), business in both places is very similar - and very different from the rest of the country.

The reason is simple: both regions thrive on hit-driven industries, whether it be entertainment or high technology. A great deal of effort is expended on thousands of projects every year, but all of the money is made from a very few, high profile hits. Most of Hollywood targets consumers and relies on massive publicity, so it is more familiar to most Americans. Silicon Valley had a short burst of such publicity during the Consumer Internet craze, but for the most part remains tied to business press and trade publications, so the inner workings are more hidden from view.

The hit-driven nature of business leads to many similarities. Over the next few articles, we'll talk about the similarities as a way of exploring how the venture industry works. We'll begin with one of the most basic: why buzz is important to an early stage company.

I am often asked if things are feeling better in Silicon Valley. Are things looking up? My answer is essentially "yes." Things do feel better. Serial entrepreneurs who sat out the early 2000's are getting back into the game. Deal flow has picked up across the board. The public market for technology stocks is opening up . . . a bit. Later stage venture investors are more enthusiastically looking for opportunities to put money to work. The environment really is feeling better. But as much as it's feeling better, it has just been that, a feeling. Until now.

I've written about Fenwick and West's survey of venture financings before. Fenwick has been tracking venture financing terms since the second quarter of 2002. In this quarter's survey (First Quarter 2004) Fenwick is reporting a noticeable and uniform upturn in venture financings. For the first time since 2002, the number of up rounds (51%) exceeded flat (19%) and down rounds (30%) combined. In fact, the percentage of down rounds decreased in every series, most notably in Series E and higher. Terms generally followed price as well, with less punitive liquidation preference and anti-dilution being the norm. Given all that, I would say that we have our first quantitative piece of evidence that the venture financing environment is on the upswing. That's good news. I hope that the trend continues.

Ok, that said, despite the apparent evidence of an upswing, lawyers can never leave well enough alone, can they. The Fenwick survey points out, "it is important to bear in mind that most of the companies that raised funding this past quarter last raised funds 12-24 months ago, when valuations were depressed." Sure, that's true, but the environment still feels better to me. So we'll have to wait and see if the trend continues.

What do you do with your time when you're a retired Internet mogul? Some would say the thing to do is go on vacation. Instead, Steve Case has decided to buy vacation. As is announced tomorrow morning in the Wall Street Journal, Steve Case has recently purchased a 50% interest in a elite vacation club called Exclusive Resorts. Exclusive Resorts is in essence a high end timesharing company -- but unlike the 1 bedroom condo in Tanglewood my family enjoyed a week each summer when I was growing up, Exclusive Resorts has over 30 multi-million dollar homes (in places like Wailea, Los Cabos, Telluride and Whistler) that club members can use at any time (at least so long as someone else hasn't reserved the house). Exclusive Resorts was started by Brad Handler, Ebay's first attorney and another Internet Retiree. Handler started Exclusive Resorts after he found a lack of great vacation experiences available for his family, including his two small children. Like Case, Handler determined that there was no better way to enjoy retirement than to make a new career of vacationing.

What strikes me as significant about Steve Case's investment in Exclusive Resorts is that he is not only investing his money but also a significant amount of his time. Case has gone on the Exclusive Resorts board but, more significantly, he is scouting properties, soliciting board members and advisors, recruiting executives and generally lending his good name and power of persuasion to the enterprise. There is no question that Exclusive Resorts will get great value out of Case's involvement. It is precisely the sort of value that entrepreneurs should look for from their investors, be they angels or Venture Capitalists alike.