Billion-dollar basics
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by Joshua Jaffe
TheDeal.com
20, March 2006
Repeat entrepreneur Ramneek Bhasin is tired of selling his startups for only tens of millions of dollars apiece. Ten years in Silicon Valley have taught him a key lesson: To build a really big company from scratch, he needs help from venture capitalists before ever launching another startup.
Connections, expertise and capital are just a few of the things Bhasin believes venture investors bring to the table. "I had to find a media company I could vet my idea against, and in 48 hours I was in the office of [Home Box Office Inc.] CEO Chris Albrecht," Bhasin recalls of his latest startup project. "That's what a Rolodex can do for you. If you've got an idea that you think you can make into a billion-dollar company, you've got to go with investors that are connected."
Bhasin speaks from experience. He established his first startup, systems integrator WSB Technologies, in the early 1990s without raising venture capital and sold his stake in it for less than $10 million in 2000. His next startup, Vialto Corp., did rely on venture capital and Cisco Systems Inc. bought it for less than $100 million in February 2004. This time, armed with nothing but a one-line vision statement, he became an entrepreneur-in-residence in 2005 at the offices of Silicon Valley venture firm Storm Ventures LLC, which quickly hooked him up with HBO. One year later, he's confident his mobile consumer software startup, Mobio Networks Inc., is on the road to a $1 billion valuation.
Will he succeed? Who knows, but at least he's trying, which is relatively uncommon these days. Fewer and fewer entrepreneurs and venture capitalists are actually targeting initial public offerings or trade sales worth more than $1 billion. Instead, many entrepreneurs are creating companies that simply fill out a product void in an acquisitive publicly traded company's arsenal. And many risk-averse venture capitalists are content funding these types of one-product companies that may yield a 2 to 3 times return on capital invested.
Statistics bear out this hardly venturous financing trend. In the past four years, only five venture-backed information technology companies have achieved billion-dollar valuations (see table). Two were in China, one was based in Eastern Europe and the remaining two, Google Inc. and Salesforce.com Inc., hailed from the San Francisco Bay Area.
Worse, still, for limited partners placing their money with venture investors seeking oversize returns, since the end of 2001, only 19 venture-backed startups have even achieved valuations exceeding $500 million on the day of their IPO or trade sale, according to VentureOne, a San Francisco-based research firm. Last year, Sunnyvale, Calif.-based semiconductor company Advanced Analogic Technologies Inc.'s $462 million opening IPO valuation was the largest exit involving a venture-backed information technology startup based in the United States. That's hardly inspiring.
Today there's little hope of a return to the late '90s, when Netscape Communications Corp., Yahoo! Inc., eBay Inc., Amazon.com Inc. and Juniper Networks Inc. were the most visible of a swelling crowd of venture-backed startups commonly achieving trade sales or initial public offerings of more than $1 billion. The median valuation of venture-backed startups that completed IPOs declined from $454 million in first-quarter 2000 to $166 million in 2005. VentureOne reports there were 9.5 times more information technology company IPOs in 2000 than 2005.
Moribund stock markets have played a role in this decline, of course, but venture capitalists have contributed to shrinking valuations by building companies in preparation for swift trade sales. This means tying capital infusions more closely to milestones, building up customer and distributor partnerships differently and targeting smaller market segments, because those are the ones that the larger companies (and eventual acquirers) haven't filled in yet. Venture capital investors at 3i Group plc, for example, began explaining in 2002 that they were funding companies with the goal of selling them off in a few years for about $250 million. Other venture capitalists laughed at the London-listed venture firm, but they eventually took to mimicking that business strategy.
Not everyone has reduced their ambitions. A few entrepreneurs are still intent on creating durable and fast-growing companies that can generate the profits and growth necessary to achieve a valuation of more than $1 billion within five years. And they are finding a few venture capitalists willing to indulge them.
To Granite Global Venture's Thomas Ng, venture capitalists must continue to aim for $1 billion startups. "Today, in my profession, the objective is the $1 billion deal," insists Ng of the trans-Pacific venture firm, one of the few to hit the jackpot with one of their portfolio companies last year. "If you don't get $1 billion, it's hard to define who you are. Some of those 2-, 3- and 5-times returns can make back your management fees, but if you don't get 20-times returns sometimes, it's hard to make good overall return."
It's no easy feat, of course, to conjure up the ingredients for a billion-dollar company and then execute a business plan to make it happen. Those angling to join the billion-dollar club have adopted a variety of strategies they believe will carry them. Some target booming developing markets such as China, others focus on large markets such as retail real estate, which are ripe for some Internet-driven innovation. Still, others are simply banking on hundreds of millions of dollars in venture capital to carry them over the billion-dollar mark once the startup lists or is acquired.
Common among most of these successes is having an ambitious entrepreneur with a unique vision. "The hallmark of the greatest investments ever made is that when you make the initial investment, almost everyone you know thinks you are crazy," says Andy Rappaport, a general partner at August Capital who knows something about big exits. He co-led the first round of funding in 1998 for Atheros Communications Inc., a Santa Clara, Calif.-based semiconductor company that went public in February 2004 with a $747 million valuation and today is worth $1.1 billion.
What he's learned from building Atheros, in which August still holds shares, and from observing the growth of other legendary Sand Hill successes such as Netscape and Google, is that successful companies start out doing something much different from everyone else. That's because they embody the greatest insights and can upend established markets and industries while erecting high barriers to entry. In the pages that follow, The Deal examines some recent billion-dollar success stories as well as other startups that would like to think they are on the way to similar big-time fame and fortune.
Scott Bonham explains how no one had heard of Granite Global Ventures before one of its exits last year. People confused it with Granite Ventures LLC, a corporate venture capital firm that had nothing to do with Granite Global. That anonymity changed overnight following the sale of 40% of Chinese Internet portal Alibaba.com Corp.'s stock to Yahoo! in July 2005. The deal valued Granite Global's portfolio company at $4 billion. "By virtue of the Alibaba deal, we get notice, credibility and dealflow," says Granite Global managing director Bonham. "It's a virtuous circle, and it accelerated our coming of age."
Granite Global also invests in the United States, but it continues to believe that China, which the firm first targeted for investment eight years ago, is a ripe market to build billion-dollar companies. Managing partner Ng says the wide-open nature of the Chinese economy makes investments there more likely to yield billion-dollar startups than the developed U.S. economy. "In the U.S., proprietary technology gives you a premium and barriers to entry," he says, speaking from his firm's office in Shanghai. "In the U.S., it's about increasing efficiency and creating a better system. China is a consumer-driven market where people are coming from nothing. The successful companies are looking for products and services where the existing government system can't provide it."
But not everyone is going offshore. Rich Barton, CEO of online real estate portal Zillow Inc. — and previously the founder of travel industry company Expedia Inc. — believes the United States still offers some extremely rich targets. While working as the CEO of Expedia, which claims a market capitalization of $8.4 billion today, his target was the travel industry, where his online service destroyed the livelihoods of bricks-and-mortar travel agents.
With the launch of Zillow in February, his latest prey is real estate and mortgages, which together generate $90 billion in combined commissions each year. "I think online real estate is a gigantic, yawning opportunity that has been sitting out there a long time," says Barton. "I've been dreaming about it for a decade."
Zillow has raised $32 million from Silicon Valley's Benchmark Capital and Technology Crossover Ventures and today offers an advertising-supported online home valuation service. But his ambitions are clearly much larger — even if he won't detail them in print. What Barton will discuss is how to build a business that has a real chance at emerging as a standalone company worth $1 billion.
Barton cites the Pygmalion effect, or the theory that employees' expectations at a startup match the ambitions of the company itself. "Anyone going into a business thinking small is going to be small," Barton says. "Google didn't go into business thinking small. They want to organize the world's information. It doesn't get my blood pumping to develop features that will be acquired."
Other venture investors approach the billion-dollar challenge with brute force. They raise tons of money for startup entrepreneurs, driving up valuations of a portfolio company in successive rounds and building momentum for a high-flying IPO or trade sale. Case in point: Shanghai-based Semiconductor Manufacturing International Corp., a chip-manufacturing company that raised $2.2 billion in private equity from a consortium that included New Enterprise Associates of Baltimore and Palo Alto, Calif.-based DCM-Doll Capital Management and was valued at $5 billion when it listed on the New York Stock Exchange in March 2004.
Trying to repeat that trick is Internet phone company Vonage Holdings Corp., which has raised $658 million in venture capital, and its early venture capital backers, including Institutional Venture Partners of Menlo Park, Calif., and 3i. After seven disclosed rounds of venture capital from firms such as New Enterprise Associates, Palo Alto-based Meritech Capital Partners, Bain Capital LLC of Boston and others, Vonage plans to list in New York later this year in an IPO that would value it in excess of $1 billion.
Fundraising your way to $1 billion is certainly one way to get there. David Moll, CEO of Webroot Software Inc., hopes the anti-spyware company can grow into a large independent provider of security software with funding and a market-altering mix of products. And the undisclosed portion of the $108 million that the Boulder, Colo.-based company raised last year from Silicon Valley's Mayfield Fund, Accel Partners and Technology Crossover Ventures that didn't go toward cashing out Webroot's founding shareholders will surely help.
Moll concedes the reward for investors is lower because they are investing in a more mature company, but adds that the success rate is higher. Moll hopes the money, combined with the company's expertise in anti-spyware, will enable it to emerge as the next generation of security software leaders the same way anti-virus software specialists capitalized on anti-virus troubles.
"We've gained a huge amount of market traction, and we solve an incredibly damning problem," he says. "I don't view us as a niche product that's a void in someone's product lines. I view us as a visionary that solves the biggest, most rapidly growing security problems."
Of the five exits worth more than $1 billion since 2001, the two that raised the least money but ended up being the most spectacular deals were Google and Internet telephony startup Skype Technologies SA. They were both consumer technology plays that offered compelling value propositions for end users. Like eBay, which completed an IPO in 1998, they spread virally and geometrically.
Jason Green, a partner at Emergence Capital Partners, a venture capital firm that profited from open-source-software company Salesforce.com's IPO, another of the $1 billion-plus valuation successes last year, says that "these [types of startups] are the most compelling but hardest to identify early." Yet some venture firms absolutely excel at finding just these types of startups.
Sequoia Capital has been one of the two most successful venture capital firms in building large-scale independent consumer startups over the past three decades. From Apple Computer Inc. in the 1980s to Yahoo! in the 1990s and, in this decade, Google and PayPal Inc., the latter of which raised $70.2 million in an IPO in 2002 that valued the company at $864 million, the Silicon Valley-based firm has built its blue-chip reputation.
So what are partners at the firm doing now? In August, they reunited with rivals Kleiner Perkins Caufield & Byers and Sherpalo Ventures to invest $8.85 million in Podshow Inc., a San Francisco-based podcasting media startup. It marks the first time those three have combined on a deal since backing Google in 1998.
Podshow CEO and co-founder Ron Bloom believes the addition of Kleiner's John Doerr and Ray Lane, Sequoia's Mike Moritz and Mark Kvamme, and Sherpalo Ventures' Ram Shriram to Podshow's board is a peerless asset. He says it carries credibility when negotiating with big companies, connections to technology companies and insight into successful growth strategies. The startup's partnership with Limelight Networks LLC, for example, which led to the creation of a Podcast Delivery Network, resulted directly from a lead that Sequoia general partner Moritz provided. "We still have to do our job and hit the numbers, but we also applied the wisdom of using relationships to build relationships," says Bloom.
In November, Sequoia also invested $3.5 million in YouTube Inc., a San Mateo, Calif.-based video-sharing company that has been growing at an impressive rate since launching last year. Despite competition from Yahoo! and Google and an increasing number of startups each week, Roelof Botha, a partner at Sequoia Capital who sits on YouTube's board, explains the company is not concerned. "I think the company is very focused on what their competitors are doing, but even more importantly, they're focused on listening to their customers," he says. "Yahoo! Google and PayPal, it took a while for all of them to become high-revenue businesses, but the priority was to have a service that delighted the customer. We're going to listen to our customers and build a product that meets their needs and have that be our guiding light."
M&A activity in the online video search and sharing sector has already begun, but Botha insists that's not in YouTube's game plan anytime soon. "What we've found is that the key is building a great standalone business that generates cash and has a fantastic customer base," he says. "It's trickier if you have a designer approach to build a company to be sold. Build a great business, and you control your own destiny. Then you can decide what the best avenue is to pursue."
Yet for every startup in the consumer Internet segment that ends up generating the cash that allows it to determine its own fate, hundreds will fail. And the ones that grow to be considered successes will most likely be purchased by the likes of Microsoft Corp. or Yahoo! for around $50 million. Technology finance is very efficient and competitive today, driving venture capitalists and their entrepreneurs into the same emerging tech sectors, and then they soon find themselves falling into the clutches of eager corporate dealmakers.
That reality led Martin Tobias, founder and former CEO of publicly traded Loudeye Technology Inc., a tech infrastructure services company, and then a venture partner at Seattle-based Ignition Partners, to look elsewhere for his $1 billion payoff. "One of the frustrations I had as a venture capitalist in the technology business was venture capital and technology are so efficient with so many people innovating, the only niches you can identify are piss-ass things," he says.
After funding anti-spam startup Cloudmark Inc. and taking a seat on its board, he was frustrated that within a short period, there were 15 venture-backed anti-spam companies. "There's so much capital and so many people focused on those areas that every niche gets overfunded and overexploited."
His breaking point came during a partners meeting at Ignition's Seattle headquarters as he listened to another pitch from another entrepreneur that he thought would be lucky to end up as a $50 million acquisition by Cisco. So he went searching for a market that was neither overfunded nor hyperefficient.
He landed in the fuel and energy markets. Tobias invested his own money into Seattle Biodiesel LLC, an alternative-energy biodiesel company headed by John Plaza. While the cleaner biodiesel represents only $300 million of the $155 billion diesel market, Tobias is excited by the fact that less than 1% of venture capital raised when he launched was directed toward the energy sector, though that percentage has climbed to 5% since.
Earlier this year, he raised $9.5 million in a first round of venture funding led by San Francisco-based Nth Power LLC. Tobias believes he can capture a significant chunk of the growing biodiesel market through innovation. "I'm looking for a technology edge that makes biodiesel better, faster and cheaper than anybody else while the current oil and gas investors are flushing out all the risk from their investment," he says. "I'm focusing on research and development and tech investments while the big companies are building industrial facilities like they've been built over and over before."
Mobio Networks' Bhasin, however, hasn't given up on information technology. He believes the consumer mobile software startup he founded at Storm Ventures' offices last year can be the next great billion-dollar startup. Storm incubated and provided seed funding in 2001 to Airespace Inc., a wireless switchmaker that Cisco purchased last year for $450 million in what was the largest trade sale exit by a venture-backed U.S. technology startup in 2005.
Ryan Floyd, a partner at Storm, agrees that the entrepreneur-in-residence path can help a startup get bigger, faster. "Venture capitalists are in the business of creating big companies, and entrepreneurs are in the business of trying to create products," he says. "So we try to drive them towards a swing-for-the-fence attitude."
— additional reporting by David Shabelman |
