2011 - The Year of the Patent
Friday night at dinner, I was talking to a friend of mine who works at a small consulting firm. He recently started conducting some due diligence for a company that some might call a “patent troll.” He was quite fascinated by their business model.
For those that don’t know, a patent troll is a company who buys and enforces patents against alleged infringers in a manner considered as unduly aggressive or opportunistic, often with no intention to further develop, manufacture or market the patented invention (Wikipedia Definition).
Publicly, many such companies state that their goal is to assist small inventors against large corporations. In practice however, much of the revenues of such companies comes from licensing patents and filing lawsuits for infringement of patents.
The conversation with my friend got me thinking. In 2011, the technology M&A market was quite strong. However, patents played an in important role in forcing some major acquisitions this past year. Take Google for example. I believe they acquired more than 20 companies in 2011. While Google’s acquisitions were typically small by design (often companies with little or no revenues but strong management teams), they spent $12.5B (that’s billion with a B) to acquire Motorola Mobility. This was their largest acquisition ever.
Why did they do this? Google is known for its high gross margins (60%+). and high revenue per employee ($1MM+). Motorola Mobility on the other hand is nowhere near as lean. I have to assume that Motorola Mobility’s gross margins are under 30%, and their profits are probably much smaller.
It is likely that the ongoing patent wars with Apple over Android are at the center of such an acquisition. Also, this deal came soon after Google lost the bid to purchase Nortel’s patents.
This is a great example of the several high profile patent related news items of 2011. 2011 was the year of the patent.
Why you will fail to have a great career
A passionate TedxTalk by Professor Larry Smith - University of Waterloo
I do wonder however what the definition of a “great career” is…
Predicting the Future
One thing I have learned from working in Venture Capital is that investing is a very personal process. A lot of factors influence how a person views business opportunities. Everything from a person’s background (where they grew up, their experiences, their parents’ occupations, their mentors) to their expertise (what they studied, where they studied, where they have worked, what they have failed at, their interests) influences this. Take a look at Business Insider’s recent article showcasing Ten Billionaires Giving their Best Investment Advice. You will notice that each person would invest their money differently. As I said, it is a personal process.
However, there is one common theme across these individuals: They have all developed an opinion on how the world will change. Based on these opinions, they have shared their investment recommendations…aka predictions.
As a result, to make predictions, I believe that one must first develop a viewpoint or an opinion about how the world will evolve over the next several years. Of course, this opinion is not static. As technologies evolve, and as markets mature, so do opinions and viewpoints.
Therefore, one thing every early-stage investor needs to be able to do is develop sound viewpoints. For example, when Sequoi invested in Google, they believed that a vast amount of content will span the Internet and that people would need a new way to find this content. A more current example: many investors have invested in the Education space - perhaps they believe that today’s high cost of education is unsustainable?
In any case, entrepreneurs, like investors, are in the business of making predictions. They are betting on how they think the world will evolve over the next several years. That is why Entrepreneurship is so difficult. But this is also why the entrepreneurs who stand out are the ones who make bold predictions.
Financial Projections - An Exercise in Creative Writing
I think that spending the time to create financial projections is a good exercise. However, no matter how carefully you choose your numbers and no matter what assumptions you make, things will not go according to plan.
But that’s ok!
Early Stage Financial Projections Should Focus on Expenses, not Revenues
The reason it is useful to go through this process is to help you understand the cash needs of your company. Based on my experience talking to early-stage entrepreneurs, most companies raising initial capital have little to no revenue. Even if they have revenue, they tend not to have a repeatable revenue model. As a result, it is important for such companies to understand their expenses well. When building their financial projections, expenses should be their focus.
Some Expenses to Consider
Of course, some of these are fixed costs while others are variable costs depending on how aggressively you grow the business. This list is not exhaustive.
But what about Revenues?
Every business is different. So revenues will depend on the company’s business model(s).
What sources of revenue will you have?
Also, don’t forget that there is a lag between when someone agrees to pay you and when you receive those proceeds!
How far should your projections go?
Most early stage investors realize that your initial set of financial projections tend to be an exercise in creative writing. It is simply impossible to predict your future revenues if the company is just getting off the ground. As a result, I’d say the first 12-18 months is typically what investors are interested in. Investors want to get a sense of how far a round of funding will take the company, and this is why they pay attention to company expenses much more than revenues.
Pay Attention To Your Switching Costs
Switching costs are the costs of switching from one product to another. For example, if you’re a Windows user, there are significant costs involved in switching to a Mac. You will need to learn a new operating system. You will need new software applications. Your hardware will need to be replaced. These learning and monetary costs make it difficult to make the switch. As a result, you’re “locked-in” to using a PC because of switching costs.
Historically, switching costs for many services on the Internet have been low. For example, it is just as easy to read your news on CNN or on MSNBC. OR, it is just as easy to buy your daily deals from Groupon or Living Social. When I worked for Bing, this lack of switching costs for users to try Bing was a major motivator as we competed with Google. It remains to be seen whether Bing will continue to gain Search market share, but with low switching costs, it is possible (of course there are many factors involved).
Today however, successful Internet services have managed to significantly increase switching costs, which makes them that much more difficult to dethrone. For example, as a user you have made a significant investment growing your friend count on Facebook, your followers on Twitter, or your connections on LinkedIn. With growing connections, the value you receive from these services continues to grow, and as a result it increases your switching costs. Therefore, as your connections grow, it becomes less likely that you will switch to other services offering similar functionality or benefits.
If you’re a startup, this is important. Not only do you need to build a compelling experience, solve a real need, and have a clever distribution strategy, you need to pay attention to your switching costs!
Venture Capital - A Look At The Numbers
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There has been a lot written about how the Venture Capital industry is shrinking. It is helpful to understand why. Frankly, there are many reasons for this. However, one simple force behind this phenomenon is the following: VENTURE CAPITAL IS REALLY REALLY HARD!
Lets look at the numbers:
- Let’s assume, we have the luxury of managing a $100 million dollar fund.
- Let’s assume it has 2.5% management fee and a 20% commission.
- Since Venture Capital is a hits business, let’s assume you’re able to invest in 10 companies (2 winners, 5 companies that simply return capital invested, and 3 losers)
A historical rate of return in the public markets is around 8% (I think). This means that a successful venture firm should comfortably beat such public market returns. Considering venture partnerships tend to be 10 years long, 1.08^10 = ~2.15 so let’s assume that for this fund to be successful, you need to provide your LPs a 3X return.
If we spread out our risk and invest $10 million in each company (over the course of their lifetimes), the following will happen:
- 3 losers would lose us $30 million
- 5 companies would return $50 million
- 2 winners would need to create the fund’s returns
But how much do those two companies need to return?
First, let’s incorporate the fund’s management fees: 10 years * 2.5% per year * $100MM = a whopping $25MM in fees!
In order to get a 3X return, we need $300 million, meaning the 2 winners need to create $381.25 million of value!
-30+50-25+0.8*X=300 gives us X=381.25
This is a staggering number considering the fund would need this return with only $20 million invested in those 2 winners. Of course, these numbers simplify the situation. For example, investors would likely invest in more than 10 companies. Investors hope to invest more money in their winners and less in the losers. However, it doesn’t always work like that. Etc etc…
This is why Venture Capitalists look for the potential of 10X returns when they invest in companies. This also shows you how hard Venture Capital really is. For a return of $381.25 million dollars, the two companies need to produce a valuation of $1.9 Billion, assuming our fund is able to hold 20% ownership stake (which in itself can be very difficult, due to follow-on rounds, dilution, and diversification challenges, not to mention the valuation climate these days).
There just aren’t that may exits which are greater than $100 million dollars. I’d say between 50-100 in total per year recently.
A hard look at the numbers tells us why VENTURE CAPITAL IS REALLY REALLY HARD!
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