This post was triggered by an interesting question that Wil Schroter from Go Big Network asked me.

Venture capital, like any asset class, has a natural cycle to it. As in the bible, it has followed roughly a seven year cycle. One can argue dates and duration, but these have roughly been 1980-87, 1987-94, 1994-2001, 2001-?. Our last cycle clearly had a significantly higher beta than the others, causing the current one to be much more moderate.  Many people have commented that the number of "quality" businesses started (taking a long-term perspective) in any given year, tends to grow in a gradual, linear fashion. While I don’t know if this is true, it certainly feels right. What causes the cycles to peak and bottom tends to be capital flows into the business and the number of companies started. The public markets and general economy are the other key factors as corporations tend to buy technology when the economy is expanding along with share price, and they tend to aggressively cut budgets when share prices plummet (to get Earnings up to offset the falling P/E).

During the last bottom in 2000-1, assuming you could raise the capital, you had a pretty open competitive landscape. Since corporations were not buying, you had a somewhat limited view of customer demand. But, you had the time to get the kinks out of your business and to do a slow roll into the market place. As a result, there are quite a few companies that are in the vanguard of their space, doing $40-80m in revenue today. They got ahead, positioned themselves well and when corporate and consumer buying came back, they took off.

Today, there is an increasing amount of capital flowing into the business. You are seeing brand name funds that had cut their fund size from $800m-1B back to $400m, now out raising another $600-700m fund. With every $4B Skype acquisition or $600m Myspaces purchase, fund size grows in $50 and $100m chunks. Consumers and corporations are also buying services and products at a healthy clip.

To make matters worse, the cost of entry for many of the new businesses is dramatically lower. So, you are seeing a 1000 Flowers Bloom. You have 20-30 different search engine plays, 10-20 podcast services, legions of anti-spam companies and many more over populated spaces. VC firms are targeted given market spaces and dropping one or two plays into them. When aggregated across the many firms around, you get a lot of plays popping up in each.

What is an entrepreneur to do? Life is not dire. There are still many great opportunities around but you need to make certain you don’t get swept up in the euphoria. Here are my two cents, in random order:
1) Build to Last: figure out if you have a product or a company. many of the quick launch companies are feature sets, packaged for a quick flip. As Jason Fried has said, building to flip is building to flop.
2) Know Thyself: determine what you do really well (what customer need you meet best) and target that with laser like focus. get happy customers using your product. swing for the fence "platform" plays are very expensive and very scary in this kind of market.
3) Burn, Baby, Burn: keep your cash burn down. these periods often become a war of attrition. you do not want to fail just short of the finish line nor cross the finish line with so much capital raised that you have no equity left. the instinct is to pour cash in to accelerate and beat the new entrants. the reality is that the market advances at its own rate and cash burn does not change it. don’t win the battle and lose the war.
4) Skate to Where the Puck Will Be: listen to the overused Gretsky quote. if the opportunity is obvious and publicized, it is obvious to everyone in Menlo, Chicago, Shanghai and Moscow. Figure out where the logical choke points are going to be in the future if current trends continue to play out. think of services (hosted or otherwise), products or plays that will solve many of these. for example, as more and more people came online, the ability to make secure/anonymous payments grew more important. Paypal figured this out early.
5) Quality is Job 1: when the dust settles, it will be the companies whose products work consistently, simply and intuitively. Don’t over engineer.

While I don’t think we are on the verge of a precipice, I would be very careful in how you approach your business, how you spend your money and how enthusiastically you drink the coolaid. I will write in the future about the risk of ad based models, but remember, if more and more plays earn their keep through advertising models, there are going to be a lot of dead bodies when the next recession hits and ad budgets are slashed. Just sip at the glass and remember that gravity still exists…

Short rant. Elections today. Lot of calls to our home from recordings of politicians to get out the vote. Sometimes technology and automation work to the detriment of society. This is such an occasion. If we have a do not call registry for telemarketers, how come politicians can spam us? Is there a political do not call list? These guys can’t be too bright. Wouldn’t you want to check to see if someone is on a do not call list before ringing them. Kind of works against your purpose of encouraging people to vote for you. Just a thought…
(let me know if any of you know how to stop these calls)

Search on the web is in a lot of pain right now. Content, including enormous amounts of user generated videos, audio files and test, is exploding at an exponential rate. There are over 31 millions blogs, including this one, growing at 70,000 per day. I don’t know about any of you, but I have grown increasingly disappointed with the search results I am getting from the engines. It has become particularly poor in the past 6 months.

The beauty of Web 2.0, the social web, is that anyone can have a
voice on the internet. There is almost no friction to creating and
publishing text, video and audio. A number of companies, like Revver, Tagworld…disclosure: both affiliated portfolio companies…, Myspaces, Flickr and Veoh, democratize the creation, publication and promotion of media. Blogs give the individual voice. They also are giving the search engines headaches.

The next generation of search solutions is attacking this problem from different angles. Strategies range from collaborative tagging approaches like del.icio.us to hybrid algorithmic/tagging technologies like Wink. In each case, they are trying to add intelligence to the process, often supplied by human intervention versus automated indexing using spiders.

One service I love is Pandora. It does an incredible job digging into the "musical DNA" of a given song or genre and intelligently picks similar songs for listening. It does a much better job than any other preferential technology or service I have come across. Its developers have analyzed over 400,000 songs from
15,000 artists and categorized them across 400 musical
traits. Scaling the Pandora model has taken significant effort since much of the cataloging is done by their trained listeners. Brian Quinton has a great posting that describes the Pandora service.

Riya is another amazing company. Once you have uploaded your photos to its site, using facial recognition technology, it will auto-tag/identify individuals in your photographs. While Pandora leverages a "man in the loop", Riya’s technology is automated. It has an incredibly impressive hit rate.

People are eagerly embracing the next wave of the internet and the self-expression it brings. However, they are also crying out for better solutions to help them find what they want, when they want it. There are going to be significant opportunities for companies that can bring intelligence and relevance back to the search process. It looks like Pandora’s Box has been opened.

A friend of mine, Jed White, recently asked on a post a great question. When do you pull the plug on an investment and walk away. He is has a blog at http://spaces.msn.com/myelectricmayhem/

Hi Matt, great to see you in the blogosphere!  I’m also
writing a blog, which occassionally concerns the difficulty of being a
young entrepreneur in the midwest: 

But your post today brings up a different issue.  How do
entrepreneurs know when to pull the plug?  Is it "never say die", or
are there some more rational markers that would suggest even to Steve
Case or Steve Jobs that enough is enough?

My partner, Ed, has always said that it is hard to kill a company. It is not often that one wakes up and realizes that a recent deal was a mistake and shuts it down. Companies and management are resilient, and often, if faced with a dire situation, dig deep, drop the burn and can muscle their way forward for some time before either succeeding, getting sold or going out of business. VC’s, loath to take the financial and emotional hit, will generally work with the company to push off the day of reckoning. But why?

You try to keep a company alive until the market turns in your favor. I would argue that the number one macro factor that determines success is market acceptance and readiness. It is very difficult to predict when a market turns (remember "right product, wrong decade"), and, in fact, it is usually not until a company has landed a few customers that one can determine a trend. Until this happens, you are best off dropping your burn dramatically while accelerating the number of product/service permutations to see which work or don’t.

A company that can get its cash burn down, can be the master of its own fate. It can usually pull together small amounts of capital to stay alive while it experiments and waits for the market to turn. Investors, however, are best off setting short-term milestones for the company (e.g. landing a pilot, getting a beta launched, closing 3 deals in a given vertical, etc). This is the only way an investor can get feedback that the company is or is not making progress.

When do we pull the plug on a deal? When we lose confidence in both the market opportunity, and more importantly, the team. A good team will find a way to reorient the company in a new direction. A bad team will complain that they do not have enough capital, it is not their fault and that they need more options or salary to make it worth their while. A decisive team that proactively takes aggressive action to stretch out its runway (and acknowledges its dire reality) will engender confidence in its investor group. If things are going poorly and the team can not show any kind of credible vision, the investor has a very difficult decision to make. If the company is also burning considerable cash, then this usually seals its unfortunate fate. It is the failure to attract third party capital (read validation) that often deals the company a death blow.

Resilience is a key factor in the venture business. I have been amazed by how often teams manage to survive. They will say that they can not manage the business with less than 50 people and a $600k budget. However, as things get dire, they somehow manage to get the budget down to $300k and 20 people, stabilize the business and then ramp it on the other side. Never, say never and recognize your reality early…

Jim Clark once said that great companies are not built, but rather willed into existence. Clark knows a few things about this, as he is the co-founder of Silicon Graphics, Netscape, myCFO and Healtheon/WebMD. Progress is never linear, and often, successful companies flirt with death before grabbing the golden ring. AOL nearly went under on several occasions, and survived only because of Steve Case’s determination. Look at Steven Jobs’ role in Apple’s rebirth. Entrepreneurs should never underestimate the power one person has in driving success.

Along this line, I just saw a very inspiring and touching movie tonight called Emmanuel’s Gift. It has won many festival awards and can be rented at Blockbuster. It is a great movie to see with your kids. Emmanuel was born disabled in a small town in Ghana. The disabled in Ghana are ostracized as many view it as a curse from God. Many of the disabled eventually resort to a life of begging. Rather than following this path, he decides to ride a bicycle with only one leg across Ghana in order to change the country’s perspective of the disabled. He now travels the world, speaking with world leaders and celebrities about the cause of the handicapped in Africa.

What struck me as amazing about this story is that a boy, born in an impoverished village in Ghana, abandoned by his father and orphaned by his mother, could rise up to become a global figure for change.  Through his actions, he  has affected the lives of over 10% of his country. (Yes 1 in 10 children born in Ghana are disabled!) It reinforces why I love venture capital. It shows that small companies, small groups of people can have an enormous impact on the world. Our job is to figure out which opportunities and which entrepreneurs have the potential to do this.

Regional investing is the topic of many a venture debate. If you are outside the Bay or Boston areas, why even bother?  Being a VC from Chicago, I get to hear a variety of jokes from my Valley peers. Have I seen any good meat packing deals lately? Can we leverage the Mob to help a portfolio company close a sale? You can figure out the others. Other regions take similar stereotypical ribbing. My partners and I draw even more stares from people when we tell them that after 27 years of successful investing nationally, we have chosen to focus almost exclusively on the Midwest region.

There has been a great deal written about why the Midwest has not exploded given the wealth of resources here. Other regions have had similar amounts of ink spent. Shannon Clark wrote about this a short while ago in his post "Why I moved to Berkeley, a reaction to the Great Chicago Tech Debate". There have been even more initiatives and studies about how to kick start things here, including what can government do (McKinsey, AT Kearney, etc). Despite all of this, we remain more confident than ever that this is one of the great, untapped venture markets in the US. Why?

Let me give you a personal example and then expand from there. I grew up in La Jolla. When I was young, you were either in the Navy or in real estate if you lived in San Diego. There was lots of sage brush, but no biotech firms to be seen anywhere. Today, San Diego is arguably one of the top three biotech hubs in the world with hundreds of biotech firms. What happened? The simpliest answer is Hybritech. Hybritech was purchased by Eli Lilly and its founders took their new found wealth and started a variety of new companies like La Jolla Pharmaceutical. These firms succeeded and spun off and so on and so on until you had a massive biotech industry. Of course, the 75 degrees every day does not hurt either. Boulder had similar experience in storage when IBM located their storage operations there.

VC’s live or die based upon the timing of their investments hitting the inflection curve. There is the old saying about backing the right product in the wrong decade. So, in essence, we are making a bet not only on our portfolio companies here hitting the curve, but also on the region doing so. What metrics or guidelines do we use in judging where this region is on the curve? We have one simple one, borrowed from Jack Welch. Our companies (or opportunites that we see) have to be #1 or #2 in their space and run by people taken seriously in their respect industry as thought leaders. There is nothing more painful than being the #5 player, trying to explain to your prospective customers why they should buy your product versus one from the other 4. Using this metric, we are seeing an increasing number of opportunities where there are leaders. Examples in our portfolio include: Stereotaxis (the only magnetically guided catheter system in the market), Feedburner (#1 feed manager and RSS ad network in the world), Imago (the #1 player in the 3D atomic probe space…machines that see atoms), Performics (one of the largest online marketing firms) and Cognitive Concepts (#1 auditory process software company…part of Houghton now). Outside our portfolio, you have OptionsExpress, 37 Signal, Univa (#1 grid computing services firm), Navteq, Motorola, etc.

We have the resurgence of Motorola just as wireless applications are exploding, the largest navigation company in the world (Navteq) as location based application are hot, the largest medical device hub in the world (companies representing nearly $80B in sales), one the deepest and best funded university research infrastructures in the world and the largest customer base both in terms of population and corporations. And, more importantly, we have more and more entrepreneurs that are leaders in their field and starting companies here.

 

I will write in the future about why we see venture capital as being so difficult here (and it is) and what the core challenges to things really taking off here are.

However, I’d highly encourage entrepreneurs and companies to stay put in the Midwest and other regions. The tides are changing. Quality guys & gals like Shannon who have headed to the coasts, the door is always open to come back and join the party, roll up your sleaves and make something happen here!

I’d like to see what readers think about different topics. I have not come across any products which allow you to insert simple (often boolean) surveys into the side rails of blogs. If anyone has come across a solution, please let me know.

Michael Arrington wrote a great piece in Techcrunch on one of the latest additions to our portfolio network, TrustID. Their newest service, IDFreeze, is targeted at protecting consumers from the growing issue of identity theft. I recently became a customer ($7.95/mo) and will report back on the experience.

As Michael writes:
"TrustedID launched their first product, IDFreeze
yesterday (and announed funding by Draper Fisher Jurveston) to help
protect consumers from identity theft. I met with co-founder Scott
Mitic today about his company.

Identity theft is a really big and really expensive problem. In the
U.S. alone, ten million people per year fall victim to identity thieves
– and sometimes it takes years to track down what’s happened, shut down
fake credit accounts in victims’ names and restore their credit and
name to good standing. Shredding mail and other personal documents is
not enough to protect yourself, either. Last year, over 50 million
consumer data records were lost by corporations. The FTC estimates that
identity theft costs our economy about $50 billion per year. For more
information on identity theft, see here."

Brad Feld, one of my fellow board members at Feedburner, has written on occasion about his love/hate relationship with United. Tonight, Brad, I was thinking of you. After United made us wait for two hours due to "mechanical" difficulties, we lost our plane (and gained another 5 hours of layover in Salt Lake City) when the septic truck servicing the plan accidentally rammed the plane. The driver supposedly hit the plane perfectly along a seam of rivets, taking the plane out of service. I am only sorry I did not have my digital camera out to capture the SLC police giving the guy an alcohol test on the tarmac…

A recent New York Time article describes Google’s latest broadside on Microsoft.
Writely is a very simple and slick online application that is a blending of Word, a document management system and an intranet. Multiple writers can collaborate on a single document and then post it to blogs, websites or store for future use. Much like 37Signal‘s applications, its attractiveness is in its simplicity and ease of use. It also further demonstrates that the future of applications (licensed and hosted) is around collaborative functionality. With broadband penetration growing and connection reliability greatly improved, hosted, collaborative applications will continue to take share from silo’d, traditional applications. Further developments in wireless like high speed EVDO services, will further drive
this. It will be interesting to see what Microsoft’s (and others) response will be as their strength has come from their control of the desktop, not the web.