Lewis Gersh's Blog

Thoughts on Venture Capital, Digital Media and Transaction Processing.

At a recent Chango board meeting, we were discussing recent hires (Dax Hamman as Chief Revenue Officer and Chris Dingle as COO) and the launch of the highly complex advertising platform.  One board member pointed out that “NASA accomplished many great inventions and successful achievements on the way to the Moon…do we need to accomplish everything for the platform launch?”  The immediate response from CEO Chris Sukornyk was, “Dude, the rocket ship’s packed.”

Well now it’s fueled too.

Today our Toronto-based portfolio company Chango announced it has raised a $4.25M Series B financing.  The investment was led by Rho Canada, a division of NY-based Rho Capital Partners, and included participation from previous investors Metamorphic Ventures, iNovia Capital, Extreme Venture Partners and 24/7 Media co-founder, Geoff Judge.  Our colleague from Rho, Roger Chabra, will join the board of directors.

Search Retargeting is a very interesting solution to a very large pain point in advertising.  When people conduct a search, it provides an extremely relevant place to run texts ads.  There is an extremely high demand for these search driven text ads, driving the price extremely (prohibitively) high for many search terms.  Conversely, display ads are not nearly as relevant by themselves, have virtually endless inventory and much lower demand, driving the price extremely low.  Chango’s platform targets display ads based on searches, taking the best part of advertising on search and expanding it to display.

How does it work?  When a user conducts a search on Google, Yahoo! or Bing and clicks through on a natural or paid search result, the site they visit captures the referrer data which includes the keywords of the search.  Chango aggregates this search data in large volume (now more search queries than Yahoo! or Bing) and each action of referrer data is matched to an anonymous cookie.  This allows the platform to retarget advertisements based on any search action.  The model greatly increases the ability of advertisers to reach their target customers they were unable to reach on the search engines.

Performance has proven itself, solving the pain on both sides of the equation.  Publishers are seeing much higher yield for their less relevant display inventory while advertisers are finding new customers and achieving a significant return on investment.  We are very excited about the trajectory for both Search Retargeting and Chango.

Today our portfolio company Encoding.com announced the beta launch of Vid.ly, a service that solves the problem “how can I make my videos available to everyone on any device.”  They put together a fantastic demo video you can watch here: http://vid.ly/5u4h3e.

This is a very large pain point for businesses that want their videos to play properly.  It is estimated that up to 30% of videos called do not load and play successfully.  The reason is mainly due to a fracturing of formats in the market, each with its own set of rules to allow videos to play.  Think of all the different operating systems, browsers, mobile devices, screen sizes and shapes, and so on.  If the video file’s encoding is not comprehensive or current, or the format is not properly detected, the video may not load and play.  This results in a negative customer experience for the potential viewer, lost revenue for the business, and so on. In fact, it was in discussion with many of the 1,400+ customers that have done millions of encodes with Encoding.com that gave rise to the concept for this service.

Now, with Vid.ly, a publisher of a video can upload the file to vid.ly and have it encoded for all formats, keep current with encoding requirements, hosted in the cloud, receive URL shortening and tracking, and format detection for so the video will play successfully when accessed by any user, any format, any device, anywhere and anytime.  One video, all formats.

Vid.ly is starting as a free service today, following with a premium professional service in a few months.  The premium service will include API access, adaptive bit rate streaming for Apple devices (HTTP Live Streaming), ability to customize the 14 profiles, no source file size restrictions and premium CDN access or choose your own.  If you are interested in participating in the beta launch free service, here is your invite code: HNY2011.

Two years ago Encoding.com launched as the first cloud-based encoding service provider and has quickly grown to become the largest encoding service on the Web.  We are really excited about Vid.ly and the next two years.  Congratulations to Greg and Jeff and the team.

I have been discussing a concept called “The Velocity of Obsolescence” periodically over the last year in our partner meetings and with venture colleagues and was asked to share it for discussion. Essentially the concept speaks to the rate of speed that an innovation and/or the competitive advantage of an innovation will lose its value. Innovations may be in technology, product, sales, marketing, and so on.  Ventures typically have many innovations they rely on at any one given time and each has a “shelf life” from its inception.

I believe the Velocity of Obsolescence has been accelerating dramatically in early stage ventures of web enabled services and this has significant ramifications for venture funds and portfolio companies.

Obsolescence is accelerating for a variety of reasons. Web infrastructure “plumbing” is now stable, enabling companies to launch with greater capital efficiency. Underlying business models have been proven so that we now see exciting new versions or extensions of them. Data has never been more easily available, especially with the growth of APIs, to leverage for value. The web has become ubiquitous, thanks in large part to broadband, wireless and the current shift to mobile. Time to market has accelerated greatly and large companies are willing to be beta-test customers for start-ups. It has never been faster and cheaper to start a web services company. There are a multitude of professional funding sources for start-ups. Start-ups can become large companies in a very short period of time. And so on.

In a very real sense, due in great part to the factors above, the velocity of innovation has increased dramatically which is itself a key variable in the velocity of obsolescence. Moore’s Law states that the number of transistors that can be placed on an integrated circuit will double every 24 months. Stein’s Law states that if something cannot go on forever, it will stop. What is the law for The Velocity of Obsolescence and are we in an acceleration mode?

An early stage web services company has a set amount of time to execute on its innovations (build, go to market and start to scale to gain defensible market share) before forces such as competition, market developments, technology advances, etc. render some portion or all of the initial innovations obsolete.  The venture must continually innovate upon their initial innovations to stay ahead of the incessant waves of obsolescence approaching from all sides.

Web enabled services only really got going about fifteen years ago.  In my experiences as an entrepreneur and a VC across that time, I think fifteen years ago a venture with innovations had about forty-eight months. That means if a good venture did not innovate upon its good initial innovations, on average after forty-eight months the venture and/or its innovation(s) would be obsolete.  I think ten years ago it was probably thirty-six months.  I think five years ago it was probably twenty-four months.  I think today we are at about eighteen months.  Interestingly time-to-obsolescence has probably been occurring faster as time itself progresses.  This is the Velocity of Obsolescence and it has been accelerating. Time-to-obsolescence for a good innovation can never achieve zero and eventually the curve should flatten out, but we are not there yet in early stage web enabled services.

This affects our fund strategy and probably other funds in a number of ways. Entrepreneurs will require greater experience in the sector to be able to build quickly and innovate constantly. Venture funds are better being focused so they can add-value and help accelerate their companies as opposed to being generalists who police them. Valuations are best set to keep options open for future financings and/or exits so the venture can make fast choices and not be hamstrung into a forced binary path of success or failure.  These are just some of the strategies to deal with a market in which the Velocity of Obsolescence is accelerating.

Do you believe the Velocity of Obsolescence is increasing for early stage ventures in web enabled services?

There have been several great posts recently on the state of current investment activity in early stage venture capital, including Fred Wilson’s post warning of “storm clouds”, then Roger Ehrenberg’s post on the “feeding frenzy”, and Brad Feld’s post on “percentage of 2009 seed deals not raising a next round”. There is something to add to Brad’s post and that is that most seed deals will not raise a next round because there will be a lack in supply of VCs there to meet the demand.  Here’s why.

We have seen two incredible shifts happen in venture capital over the last two years:

First is the dramatic rise of the seed funds, super-angel funds and accelerators/incubators all focused on professionally funding start-up companies.   There were only a handful of seed funds several years ago whereas today there are literally dozens including First Round Capital, I/A Ventures, Blumberg Capital, Zelkova Ventures, SoftTech VC, 500 Start-ups, lowercase capital, etc.  And some larger VC funds have truly developed seed programs (they used to say they would do seed deals, but in truth rarely if ever did them) including Foundry, DFJ, Charles River Ventures, Polaris, FirstMark etc.  There are also accelerators/incubators like TechStars (we are an investor), AngelPad and Y Combinator, etc.  And the angel market has come back strong, both as groups and individuals.  Just check out Angel List for example.

Second is the dramatic decline of the overall quantity of later stage venture funds.  This inevitable contraction actually came from Bubble 1.0 in the 1990s when both the quantity and size of funds exploded at an unnatural rate to take advantage of the quick IPO exit market.  As venture funds are measured on a 10 year return horizon, once the bubble burst in March of 2000, many funds were living off prior exits while ignoring their own equivalent of burn rate and runway – their returns on investment and multiple of capital.  Everyone in the venture industry knew the 10 year returns on average were deteriorating rapidly and would even turn negative at the 2008-2010 timeframe.  As many of these funds over-invested in the next crop of companies anxiously awaiting the next IPO boom that never came, they themselves became sitting ducks for disgruntled LPs as the global economic crisis occurred.

We sat in our partner meeting post-Lehman Brothers market meltdown and hypothesized that as many as two-thirds of all venture funds might cease to exist.  LPs would confront funds with the lack of returns and put them out of business overnight, or they would reduce the available capital to call exclusively for home run follow-on investments, or perhaps just let them finish out the fund with no hope of a next fund.  Many in the industry can confirm these occurrences from the empty offices they encounter every day.  Recently Ernst &Young reported a 47% plunge in active venture funds in the first six months of 2010 compared with the same 2009 period.  Active in the report means one deal per quarter, which is not really very active.  We suspect 47% is low and will grow significantly higher (even with the addition of so many very active seed funds).

So this is the problem. We have a record increase of seed stage investment activity from seed funds, super-angels, angels and accelerators/incubators.  And much of what is funded by this seed fund rise are B2C oriented ventures which by their nature are capital intensive and require significant capital to stay alive through the user growth phase that often far outpaces revenue.  And many of these “sexy” B2C “bright-shiny-object” seed deals have been bid up in valuation with little or no diligence in a seemingly “what’s hot” contest seeking to be named on the investor roster in TechCrunch.  And yet we have a record decrease of later stage venture funds to invest in these companies when they seek larger capital.

Probably starting in the Spring or Summer of 2011 it is going to look like a high school dance with a very lopsided boy-girl ratio.  On one side of the dance floor there will be a record high number of seed funded entrepreneurs with high B2C valuations, corresponding seed investor egos that bid them up, a need for additional capital to survive, angel/seed investors that cannot provide the necessary capital (many don’t plan for or do follow-on investments), and intense competition for larger capital from the oversupply of these deals.  On the other side of the dance floor there is record low number of venture firms with larger-than-seed capital to invest. This will lead to an inevitable scenario where only the hottest girls will find a dance partner and the rest will go home in tears.

A big congratulations to the team at FetchBack for their successful sale to GSI Commerce!  This deal is very special for me and Metamorphic Ventures as it validates and confirms so much of what we are about for our entrepreneurs and investors alike.  Here are some perspectives on this deal.

Our investment strategy is greatly focused on the belief that the primary revenue source on the Web to date, technology driven advertising, is experiencing a long overdue shift  closer towards eCommerce, and likewise we believe that eCommerce is experiencing a long overdue shift towards advertising.  I was fighting for this in my first start-up in partnership with AOL in 1996 when we termed it content-to-commerce, and now this has evolved to what we call Transactional Media.  Online advertising and electronic transaction processing are both rising tide markets and will be for a long time coming, so we focus on B2B monetization services that support this investment thesis.  We have also built a charter towards capital efficient companies that reduce risk while increasing return at low exit burdens, all while being entrepreneur supportive.

It was almost exactly three years ago when Chad Little, Seth Page and I sat down for a lunch in Phoenix to discuss Chad’s new business idea over fajitas and beautiful mountain scenery.  Chad had set his sights that FetchBack was to become a leading provider of retargeting services.  Essentially, when a user visits an eCommerce site, the industry average is about 1% convert to a purchase.  By running ads targeting the other 99% when they are subsequently on other sites, these conversion rates can average 8-10%.  There is a good bit more to it than that, but you get the gist and Chad was planning incredible depth of technology-driven analytics and reporting to increase optimization and yield management.  At the time, Fetchback was also taking advantage of the fall in display ad rates, the incredible infrastructure built by huge capital intensive Web media companies, the precipitous drop in start-up tech costs and the corresponding acceleration to market for new products.  Advertising technology that drives eCommerce transactions with the opportunity for capital efficiency.

This was to be Chad’s third start-up and he wanted a capital efficient approach that gave him flexibility.  Chad and I had both experienced raising large amounts of capital for prior ventures and know the positives and negatives (much debate online these days about lean vs fat start-ups).  Our charter at Metamorphic is designed for lean, capital efficient start-ups.  Chad and I discussed FetchBack raising a $1MM seed round and we quickly agreed on a reasonable valuation and for Metamorphic to lead the round (which included an LLC conversion to Delaware C-Corp).  We introduced Chad to some great co-investors and board members, including Geoff Judge, Erik Matlick, Jeff Stewart and Bill Benedict.  Coincidentally, we were also joined in the round by Bob Ellis who I co-founded my first venture backed start-up with, the second in partnership with AOL, back in 1998.

Chad and his team were all about speed and laser focused execution from day one. Get the product live ASAP so they can get customer #1 live, get revenue in the door, learn and improve.  Repeat and accelerate this process over and over again.  We spent a lot of time discussing strategies and tactical plans together – Chad was driven to take this over the goal line as FetchBack quickly became profitable and cash flow positive without the need for additional capital.  As the market turned from an educational sale to a “why us” sale, FetchBack’s superior analytic and reporting began to shine against the competition, producing exceptional yield management on eCommerce conversions, proven by the 97% renewal rate across 500+ advertisers.  And when Chad told us he thought it was time for FetchBack to partner up (sell the company) to accelerate FetchBack’s position in the market against ever growing competition, we discussed the reasons, the positives and negatives, and then helped him make it happen.  As a capital efficient start-up, FetchBack was able to sell for a reasonable exit valuation and produce it’s investors a 9.7x multiple of capital invested – that could not have happened if Chad had opted to raise large capital.  And GSI Commerce is a fantastic $1B revenue company and fit, where 1 + 1 = far more than 2.  And more so, GSI is founded and run by Michael Rubin, a friend who was an angel investor in my first venture backed start up.  Let me say that if you liked FetchBack before, you are gonna love it now with these complementary forces working together…unless you are the competition.

Thanks Chad and team, we enjoyed working together on this one, learned a lot from it, and look forward to the next one.

We recently invested in Tynt as part of an $8M financing with Panorama Capital, Greycroft Partners, iNovia Capital, Disruptive Ventures, Newport Coast Investments (Chad Steelberg), W Media Ventures (Boris Wertz), Joe Apprendi (Collective Media), Allen Morgan (Mayfield Partners), Erik Matlick (Madison Logic), and Yen Lee (Uptake.com).  It’s  a great team, most of the investors we have known for quite some time and/or co-invested with on a number of ventures.  Here are some insights into why we invested in Tynt.

Many think of Tynt as the “copy-and-paste” company because of their patent pending technology that enables the tracking of copy-and-paste activity on Web sites.  Tynt has discerned there are basically only three reasons users copy-and-paste information from Web sites: (1) to search by pasting it into a search box, (2) to promote the information by pasting it into an email to send to someone else, or (3) to archive it for future reference.  In general, assume the proportions are 45%/45%/10% respectively.  Tynt’s algorithms essentially “know” which is which in real time.  The copied information may be text from an article, a product form an ecommerce site, and so on.

Approximately 87% of Web users copy-and-paste every month and Tynt’s network already has over 450,000 thousand sites, tracking almost 10 billion page views a month (see recent post by Fred Wilson on the 1 billion page view mark, albeit different traffic).  This in turn generates about 200 million copy-and-paste actions, which in turn result in hundreds of millions of search queries and email forwards a month.  And Tynt has another 40 billion or so page views of publisher installs in the works now and an expanding pipeline.  The product is less than one year in market, and monetization services are launching– here are some examples.

If the copy action is for a search, the publisher may use Tynt’s SpeedSearch product, which enables a fade-up window to appear before the paste is made into a search bar.  This is important for a publisher because that activity almost always results in a Google search where the publisher loses its visitors and all chance for monetization of the associated traffic (John Battelle wrote on this attribute).  SpeedSearch serves the publishers site/network search results first, as well as the option for syndicating in paid search and adding display ad units.  This retains and monetizes traffic for publishers, solving a huge pain point.

If the copy action is to promote publisher information via email, when the visitor pastes into any email client, Tynt appends a link back to the source on the publisher site.  Upon clicking the link, the user is taken to the exact location of the page where the copy action happened and the copied information is highlighted in yellow.  These link-backs enhance search engine optimization for publishers, drive valuable traffic (often new users) back to the site, and present the publisher an advertising opportunity below the link in the email.

Perhaps most important in Tynt’s data is the measure of user engagement on a Web site.  Page views and time spent per page have been the typical metrics to date and are fairly blind.  Tynt goes much deeper.  A publisher of a Webs site can now know in real time what the most important information is to users by the copy-and-paste activity – this is a level of engagement and relevancy measurement that previously did not exist.  This allows the site manager to tune its content, headlines, tweets, newsletter subject lines, and so on for far greater efficiency to site visitors and monetization.  This can also be extremely useful for publisher ad targeting as well as third party targeting based on the real time relevancy of the information on a per user basis as well is in the aggregate.

The engagement and relevancy real time data has endless uses.  SpeedSearch is one great example where the product truly displaces a Google search based on the new real time data at the publisher site level of interaction.  We ran a test on how relevant the copy-and-paste data was as a measure of user engagement.  We set up a search engine with algorithms using only this data and ran searches on it and compared the results against Google search results.  The Tynt data produced far more relevant search results, so much so it was truly shocking.

User-driven engagement data is extremely powerful and Tynt has barely begun to tap the opportunities with data mining and licensing, advertising and targeting, search and so on.  Many third party companies are coming up with their own uses, from ad networks to publishers, content and eCommerce sites, portals and search engines.  One thing is becoming obvious from the uses that are already in-market and/or being developed:  This real time data actually quantifies user engagement in a tangible and actionable way, and that engagement data is truly displacing previously real time data into latent data by being a step ahead in the process.

There is a lot of chatter about valuations and round size recently – a sure sign things are getting a bit frothy again.  It’s the entrepreneur’s choice relative to what the market will bear for how much to raise and at what time/valuation. This post is about a cap table limitation in a high valuation and large capital venture round of financing.

Valuations were most recently escalating to higher levels in the first half of 2008.  There were plenty of what I call “beach muscle rounds” of financing being raised – you know the kind where the entrepreneur brags he raised some excessively large amount of venture capital in a diligence-averse short period of time at a startling valuation.  Once Lehman Brothers crashed in September 2008, everything stopped cold.  We saw a high percentage of deal flow evaporate out of the VC system, the vast majority of which were a welcome good riddance to “sub-prime” entrepreneurs who realized they would not be able to raise money and promptly reverse-commuted back to a day job.  Most of the remaining entrepreneurs, many of whom were seasoned vets in venture backed technology companies or truly dedicated up-and-comers, chose to bootstrap the new venture and wait to raise capital.  They realized that very few VCs were funding anything new, and even if they did get a term sheet for their venture, it probably wouldn’t be on terms they would find very attractive – we’ll call that a “sand-kicked-in-your-face” round of financing.

Start-up financing fell to record lows, valuations dropped, and this crop of entrepreneurs became the most capital efficient class by necessity.  These founders narrowed focus, reduced expenses and expedited time to market for revenue generation to offset capital burn.  Deja-vu, it was just like 2002-2003 all over again after the mighty Bubble 1.0 burst.  Key strengths of that 2003 crop of capital efficient companies were that they had lots of options and could operate from a position of strength (low burn, low valuation, revenue producing and often profitable) when deciding to either raise additional capital or sell the company for a valuation that produced an excellent return for shareholders including the entrepreneurs.

A mere 18 months ago everyone saw the Sequoia Capital‘s “R.I.P. Good Times” presentation, a great marketing piece on the sudden push for capital efficiency, especially the part about “plan that you will never raise capital again”.  It was great timing for it, perhaps only better if many funds had promised similar investment strategies when initially raising capital from their LPs.  I remember saying to my partners David and Marc, “You can try to make a company capital efficient, which is operationally difficult enough, but you can’t make a cap table capital efficient” meaning, the investors paid the price they paid upon investing their capital, which is not reversible.  In fact, changing a company from one that has been funded on a capital intensive plan into one that is capital efficient creates a cap table that is suddenly incredibly inefficient and often fatal.  Why?

The company transitioning from capital intensive to capital efficient will reduce its top layers of executives, reduce much of the middle management and admin staff, and generally reduce salaries.  Vendors and 1099 contractors with be terminated or cut back on fees.  The company, with far less resources working for it, must then narrow its product and focus to hone in on producing sales to paying customers quickly, so the company can generate revenue and offset burn.  The original growth projections on which the company raised money get reduced dramatically and most likely stretched out over a much longer time horizon.  This may be more healthy and reasonable for building a business, but the company is still saddled with the original capital intensive aggressive growth valuation.

Worse, that original aggressive growth plan came not only with a correspondingly high valuation but also a VC expectation of a 10x return on that valuation as an investment goal.  Very few companies grow well enough so as to achieve that 10x goal in the first place, so how is one that is now scaled back ever achieve it?  Or more realistically, how will the company ever even attain its post-money valuation in any reasonable period of time?  It probably won’t, which is why in part the Sequoia advice to never expect more capital may be correct even if/as the markets come back – because the cap table itself impedes potential future investment without dramatic restructuring to the company, its key people and all shareholders based upon greatly lowered growth plans and elongated timeframes.  This often makes it virtually impossible to raise more capital and leads to a high mortality rate for such companies, a damaging result for everyone involved.

How many entrepreneurs who once flexed mighty beach muscles are now merely avatars for dead men walking?  How many great entrepreneurs are chasing an exit burden like life after 30 in the carousel of Logan’s Run?  To all entrepreneurs out there raising rounds of financing now as things get frothy again, just say no to the temptation of a beach muscle round of financing as you and everyone who relies on you will have to answer for it.