An entrepreneur recently asked me why startups fail. Startups fail because they run out of money. You’re probably thinking, “Tell me something I don’t already know!” Read on and you’ll see that statement is deceptive in its simplicity

This post is based both on my experience as an investor and as entrepreneur (when I’ve boot-strapped and venture-funded).

They spend too much on sales and marketing before they’re ready. Many venture companies move to a high burn rate too quickly and it’s hard to go back. Sometimes even a frugal entrepreneur winds up spending too much either because he doesn’t manage the money or is tempted by having money in the bank. This often happens when a startup raises too much money too early.

Other times, this occurs with entrepreneurs who are accustomed to having lots of resources. They ramp up sales before the product is ready. Of course, there’s a lot of work required to get sales early on. But a product with a truly great value proposition that delivers in a measurable way will practically sell itself. Companies that ramp sales and marketing too soon waste a lot of money.

Sometimes even when the product is great, the sales process itself isn’t understood to a point where it can be scaled: who are you selling to, how much will they really spend, and what profile of sales person does the company need to hire who will succeed at selling that particular product. All of this has to be understood before sales can efficiently scale.

Spending on the sales and marketing operations means there is no return if customers don’t bite. When you spend money on the product that work can be leveraged in future versions. (In fact, the key to effective product delivery is to try a lot of things and see what sticks.) For every venture dollar invested, I estimate that more than two-thirds go into sales costs and only a third into product development. Once you up the burn rate, there’s no easy way back.

The market outpaces the startup’s ability to execute. When you’re in a race, the only thing that matters is winning. To win a race, you have to be the fastest.

In the case of the startup in a hot sector that means how fast do you make critical decisions, hire key personnel, and manage limited resources. If, on average, you’re slower or less efficient than your competitors, you’re very likely burning more cash than they are as well. The chief executive sets the pace. If the CEO dithers on important decisions – let’s say making key hires – it slows the whole operation.

Take Company X (a composite). Entrepreneur X caught a case of what I call “analysis paralysis.” He took 14 months to hire for a key position. At Stanford, my professors would ask: “Would you choose X or Y, or do you need more data?” Students often wanted more data. The professors would chuckle and call them on it: “There is no more data.” A simple, but valuable lesson: In the real world, you rarely have a complete picture. You have to work your hunches, draw on past experience and the available information. Unlike solving engineering problems, there is no perfect answer when it comes to hiring – you need to get all the data you can through references, interactions, and simulated projects, but ultimately it’s very subjective.

There is no Entrepreneur. I know what you’re thinking, “Every startup has an entrepreneur.” What I mean is an entrepreneur with a capital “E.” Let me explain: A lot people have good ideas and some are even able to execute on them. But rare is the man or woman who can take an idea and transform it into a sharply defined product and then sell it to top-level prospective hires, investors and customers. An Entrepreneur as opposed to his lower-case counterpart is a product picker and a market visionary.

Company Y (a composite) was a startup with near-flawless execution but no clear vision. CEO Y tried his last company’s strategy and when it failed found himself at a loss for what to do. The company ran out of money and was forced to sell out for a pittance. Meanwhile, CEO Y’s main competitor was more nimble. He reacted quickly to market changes with a viable contingency plan and as a result sold his startup for many times that sum.

Without strong product and market vision, a startup will burn through cash as its team collectively struggles to define its position.

The market takes too long to develop. Often, entrepreneurs are ahead of their time. Customers are not ready to spend money on or change habits for unproven benefits. The company runs out of money waiting for the market to develop or it tries to start over, but it’s too late.

Company Z (a composite) had a compelling concept, but customers weren’t ready to buy in. CEO Z proposed a restart: Rather than sell to the market segment he was in, he would target a different market segment. As a result, he would significantly reduce Company’s Z’s sales and marketing expenses. Company Z was mildly successful with its new plan, but burned through lots of cash before it re-configured. My guess is that it will be bought for little more than the amount that’s been invested.

Risky Business
VC’s play a high-risk game. We have to identify opportunity and risk and then accept that a certain amount of that risk will result in failure. Venture capitalists lump failures into one of two categories.

A failure like Company Z’s: A startup that struggles for reasons beyond the entrepreneur’s control. Things look good, but ultimately mainstream customers or a large volume of users were unwilling to take a chance on a new concept. Skilled execution and a reasonable backup plan won’t compensate for a market that fails to develop as quickly as originally anticipated. Some entrepreneurs are able to switch markets completely early on – if they haven’t raised and spent too much cash. But in this scenario, all companies in the given market flounder or fail. It isn’t a desired outcome but it’s not for lack of trying.

The painful failures – those that keep me and other VCs I know up at night - are the investments that fail due to self-inflicted wounds. A competitor winds up owning what turns out to be a very large market. The other company simply moved faster and out-executed.

It’s not just how fast you run the race that matters. It’s how fast the race is run. When it comes to startups, speed wins. But if you’re still early, don’t increase your burn and overspend on sales and marketing before you’re ready. Sometimes you have to slow down to speed up.

If Steve Jobs didn’t invent the term OOBE – out of box experience – he certainly set the expectation. Only a handful of tech products have made the general public sit up and take notice. And with few exceptions those products have come from Jobs’ fertile mind. It pains me, a Microsoft alum, to say it, but Jobs, first with the Mac and now with the iPod, has set the standard for how tech gear should be packaged and operate.

The reason Infusion’s user group meeting this spring was such a pleasure to attend was that it was packed with satisfied customers using its product in a myriad of different ways.

Like Jobs, the team at Infusion doesn’t seek attention. They grab it. While the rest of us sent out one-page press releases to announce new products, Jobs rented auditoriums and put on a show. While we advertised our gear in the trade pubs, Jobs ran commercials during the Super Bowl.

You should think twice before spending your hard won VC dollars on a Super Bowl ad, but there are some incredible lessons to be learned from masters like Jobs when it comes to delivering an unparalleled customer experience.

OOBE For The Rest of Us

In the early days of the PC industry, the customer was typically a geek who became something of an extension to the company’s engineering team. He tinkered with buggy products until they worked. But Jobs aspired to bring the miracle of computing to Joe Q. Public. To pull it off, he had to make good on the hype, a tall order for an industry where bugs were the norm. Jobs didn’t just set the expectation - he delivered on the promise.

At Microsoft, when those of us on the Windows team realized our customers had trouble getting their PCs up and running we blamed it on the difficulties of marrying disparate hardware and software. In those days, I spent a lot of time talking to frustrated Windows users.

There are three simple things you need to do to deliver a great OOBE.

• Designate a user-experience manager, one person responsible for all aspects of the product that impact its ease-of-use
• Require people in your company to set up the new product without any assistance from the developers
• Observe customers set up your product, over and over again

Without being aware of it, product designers adjust their own behavior to accommodate product flaws. As a result, it’s important to bring customers who come to the product with a fresh eye and without pre-ordained behaviors.

To get funding for my OOBE group at Microsoft, I videotaped a whole bunch of people - from our top user interface designers to marketing managers - setting up a new computer. Features that today we take for granted - like color-coded cables and ports – came out of those early observations.

Great Experience = Happy Customers

To state the obvious, the computer industry has matured and with maturity has come higher expectations. Few customers have patience for products that don’t work straight out of the box. Only a few companies are so entrenched that customers have no choice but to suffer until the supplier gets its act together.

In most cases, the customer has other credible options. Blow it once and it’s unlikely they’ll give you a second chance. That holds true in even the most technical of vertical markets. Deliver a great OOBE and you too, can preside over a packed room of happy customers.

Entrepreneurs often ask us to shed light on what venture capitalists look for in a prospective investment. The truth, as you’ve probably guessed, is it’s subjective, dependent on the philosophy of an individual VC and his firm. That said, I have noticed strong similarities among the winners that are more often than not absent in losers.

At the risk of dispelling our mystique, I’d thought I’d remove a bit of the mystery of VC investing. Something I wish someone had done for me back when I drained my bank account for my first startup.

Keep in mind that I invest primarily in consumer and business Internet companies.

I look for startups led by an entrepreneur with extraordinary market insight and the leadership, stubbornness, and passion to render his instincts into reality – in the form of a product or a service. I don’t mean a technologist in any traditional sense, but someone with true vision – a word that’s often overused.

How do I know when faced with the real thing versus a poseur? These entrepreneurs often start their pitch out by describing a critical change in market or technology that has happened or is about to happen. They see big waves ahead of others and capitalize on them. Or they are building a product for themselves, which is the root of their incredible passion. They simplify: they take things that are complex and simplify them so they can raise money, recruit people, and get users or customers.

Steve Jobs is the textbook example. I doubt that Jobs has ever spent much – if any - time coding or on CAD. And yet, his background and experience led him to be the driver behind many of the PC technologies we now take for granted. He popularized the graphical interface. (Yes, he “borrowed” it from Xerox PARC, but it was Jobs - not Xerox - who understood its potential and ran with it.) The advanced multimedia in the Next machine is standard in today’s PCs and Macs. Jobs’ products are sometimes like concept cars; it can take years before the rest of the industry catches up to him.

That brings me to a second key ingredient in any good deal – early market validation. Yahoo and Google already had very significant user bases when their VC’s invested. Calculated risks like Yahoo! and Google are popular these days with VCs, many of whom - dare I say it - were responsible for their share of “irrational exuberance” during the boom and then lived to regret it.

I like entrepreneurs who do a lot with a little. It’s a bias formed when I was forced to make do with the little that I had in my bank account. Take hi5, an online social network with 80 million registered users. Hi5 scaled to 25 million users on a relative pittance - $250,000. We were the first institutional money in. Another MDV investment, Infusion Software posted incredible revenue growth last year (I can’t disclose their numbers) with only minimal investment and a bit of debt prior to our investment. You can test the market for software with - at most - millions of dollars. It still costs tens of millions of dollars to scale up; otherwise VCs would be cut out of the software business.

Why is early market validation so important? Because it’s a good indicator of an entrepreneur who’s not only not afraid to test out his product in the market but also of one who has insight into efficient user acquisition. The world of software today is often much more about cracking this problem – user or customer acquisition – than about the technology itself.

This leads me to the final key ingredient: efficient customer acquisition and retention. For $100,000 a month, anyone can corral a herd of users to sample a hosted business application or a Web site, but few are able to convert them into loyal customers without spending a prohibitive sum on sales and marketing.

Companies like hi5 have perfected what I call “Zero-Cost User Acquisition.” Business Internet companies like Genius, Infusion, and Ironkey spend more to acquire customers, but they also collect more revenue per user. PBWiki, meanwhile, spends next to nothing on marketing and leverages their incredible brand with consumers into paying customers on the business side. Their consumer wikis get rave reviews, and more importantly, generate leads that they efficiently and for little additional investment convert into paying customers for their business Internet product.

Now the hard question, which is the most important of the three ingredients? Having both the visionary and early market validation is ideal. Of course, there are a number of incredible entrepreneurs worth funding just at the vision stage. The hard part for any VC is realizing when you’re looking at the real thing.

The secret ingredient is luck. Because luck is unpredictable and hard to come by, few entrepreneurs replicate success. But that’s a topic for a future blog entry.

Last week I attended the Infusion Software user group conference in Scottsdale, Arizona. It was like being transported by time machine to my first user group conference - a Boston Computer Society gathering way back in 1991.

Of course, those were the middle ages of computing. (No, I’m not a geezer; I was just another kid peddling Shareware programs.) For you youngsters out there, yes, we were connected, but it was via archane transports like CompuServe, BIX, and home grown BBS’s. E-mail was in its infancy.

User group conferences are still one of the best ways to talk to customers away from the many distractions and inhibitions of the typical office environment. I’ve found customers are franker when freed from the confines of their offices. (A note: my MDV colleague Nancy Schoendorf and I invested in Infusion, an eMarketing SaaS company, last year.)

That Boston Computer Society meeting had piqued my interest. The guest speaker was traveling from Seattle to flog a new software platform. Yes, the company was Microsoft and the software platform was Windows. With Windows, Microsoft wrested control of the PC industry from then-mighty IBM.

I saw the advantages of Windows early: it was easy to use, easy to develop for, and there was an incredibly strong outreach to the developer community. For several years, I had been writing and selling Shareware for Windows. Now, I – a 16-year-old entrepreneur – would have a chance to talk to someone at Microsoft.

The room was packed. Brian Moran, today an old friend, gave a demo of Windows 3.0. I mustered up all my courage to introduce myself and slip him a disk with my software. On Brian’s recommendation, a recruiter called and invited me to Seattle for an interview.

Fast forward to 2008. This time I’m on stage with Clate Mask, the chief executive of Infusion. The room is filled to capacity with Internet entrepreneurs. (A few minutes earlier, Clate had asked me to tell the audience why MDV invested in Infusion.) Later, it was my turn to listen. Infusion’s customers described how they are using the product – the variety of ways in which they were implementing it was impressive. Because Infusion’s customers are small businesses, every person I spoke with was an entrepreneur. I was right at home.

Put on a user group conference for your startup and I suspect that you, too, will be surprised to learn just how customers are applying your products. You’ll be able to use that information as inspiration for many new features. And, you may even find a great employee or two in the process.

Almost a year ago, I wrote about how the iPhone Changes Everything. Response to my blog post varied from vehement agreement to passionate disagreement. Now it’s clear that Apple really is changing the game, with the release of the iPhone SDK.

Until now, the deck has been the be all end all point of control for phones and the carriers who provide the underlying network access. The availability of the iPhone SDK means that any developer can now create an interesting application for the iPhone, and can do so outside of carrier control.

Apple provides tools, a platform, a way to monetize, and distribution. That’s not only an interesting technology change, but a pivotal business model change as well.

On a side note, while IT executives may be skeptical of the iPhone’s corporate e-mail support and Blackberry’s still have the best keyboards, I suspect that more than a few corporate types will be sporting iPhones by this time next year. Consumers have always brought technology into the companies they work for. Apple will be no exception.

It’s that time of year again. No, I’m not talking about spring cleaning. No, not taxes either. It’s the time of year when every MBA student thinks about his or her career plan. Today I had the privilege of meeting with one of Stanford GSB’s finest scholars. His number one question: should I get into venture capital?

While I won’t answer that question in this blog entry, I will talk about one of the items we discussed at length. Here’s what I like about SaaS companies:

• Recurring revenue model. One of the most compelling aspects of any SaaS company is its revenue stream. Although it takes some time to develop, once a SaaS company has a customer base and has reached a steady churn rate, it has a predictable, repeatable revenue stream. Then it all comes down to continuing to acquire customers while reducing churn.

• Low cost of sales. Another incredibly compelling aspect of the SaaS model is the low total cost of sales associated with these companies. The product is available for demonstration, evaluation, and long-term use right over the web. While some customer accounts may still require in-person sales, the vast majority can at least get up and running without an on-site customer visit. As a result, a great SaaS company can be very successful at a “land and expand” strategy.

• Ease of delivery. Unlike the old installed software model, SaaS companies, like Consumer Internet companies, get to deliver updates when they want to. Customers lose some control in this model – whereas they used to be able to decide when they would roll out software updates, now the company delivering the software decides that for them. But companies benefit immensely because they get the most up to date capabilities without the overhead associated with traditional software delivery and maintenance. Companies can also deliver these releases more quickly and more efficiently than before.
  
  
• Stickiness. Most if not all SaaS offerings require that the customer input or import data into the service. For example, a human resources management offering would likely require a customer to import its organizational data. Having the customer complete the initial work is critical, and sometimes challenging. But once the customer does this, they are likely to stick as long as they are getting some value from the product. Having gone through the process once, they are not likely to switch to another system. Moreover, extracting and exporting data from service based offerings is harder than it was with installed software.
  
  
• Measurable growth. Finally, with SaaS business model, a company can really measure its performance. Once the revenue stream is established, a company can focus on a few key metrics. Monthly Recurring Revenue (MRR) indicates how much recurring (vs. new) revenue a company has each month from its customer base. Companies can track their customer Payback Time to see how long it takes to recoup the cost of acquiring a customer and getting that customer up and running. Then companies can focus on reducing this time.

It’s always fun meeting with the next great MBA graduates. Thank you to the student who came by today for the thought-provoking discussion.

When Sun began using the slogan “the network is the computer,” it was about selling more hardware. But to mix metaphors, this is not your father’s compute cloud.

Today’s cloud is about delivering business critical services over the Internet. As a result, if there’s one thing to be learned from Amazon’s outage, it’s that operational excellence really matters.

Gorillas such as Amazon and Salesforce rely on their existing infrastructure to leverage cost and operating efficiencies. Outside of differentiating in what promises to be a crowded space, the real challenge for startups will be delivering on their operational promises.

Both DIY and partnering have their challenges. With DIY, a company has to build out the infrastructure and operate it, even before it reaches customer scale. But it has as much control as possible. Partnering means significantly lower cost up front, but also lower control and potentially lower margins at very high scale. A hybrid model may make sense – some companies delivering cloud computing services fail over to Amazon or other underlying providers.

Especially when critical business infrastructure is outsourced, transparency is key. One thing both Amazon and Joyent seem to have had in common was a lack of communication. Customers had no idea whether the problem was with the hosting provider, the network, or something else, nor when the problem would be solved.

As with many markets, there are two classes of startups entering the fray, those with a vertical approach and those with a horizontal one.

• Vertical players typically focus on a particular technology as their point of differentiation. They may enhance the underlying platform by making it more scalable or more reliable. On the plus side, they can be more nimble in the short-term due to their focus. But technologies come and go quickly, especially on the Web. It seems like just yesterday that PHP was the new wave… or was it Java?
  
  
• Horizontal players are building out a wide variety of services. In the short term, it’s more difficult for them to execute as quickly. But as we have seen with Amazon, if a large enough community evolves, the community itself may lead the way in asking for and ultimately delivering the most leading edge services on top of cloud platforms.

Regardless of which approach succeeds, and there may be room for both, one thing is certain. No, it’s not that you should think twice about hosting in the same place that Twitter does (although that may very well be a good idea).

It’s that while cloud computing services are delivered virtually, customer expectations are very real indeed. Fail to deliver on those expectations – or worse yet, fail to communicate with your customers about what is going on and why – and face the consequences at your own risk.

“While announcing disappointing fourth-quarter earnings Thursday, Google executives said the company was having a harder time than it expected generating ad revenue on social-networking sites and figuring out the best ad formats for its YouTube video-sharing service,” the Wall Street Journal reported last week.

But the truth is, this really isn’t surprising. Eyeball aggregators like the large social networks have cracked the efficient user adoption code, but they’ve also known for years the simple truth that when you show billions of impressions, users will get burned out on them. Low CPMs are the well-known norm; they make it up in volume.

When it comes to video, there’s no surprise there either. Extracting enough contextual information from short video clips to present relevant ads in an automated way is incredibly difficult. Moreover, the correct video advertising user experience is still under development. After all, consumers just got used to skipping over ads on their televisions using Tivo. Plus, the necessary analytics and measurement for online rich media is just now being put in place by companies like Visible Measures.

There are several parts to a successful monetization strategy:

• Advertising. Clearly this is the core way to generate revenue. While users suffer from seeing too much of the same thing, the fact remains that when you’re at huge scale, big brand advertisers can’t get enough of you. Soft drink companies, wireless carriers, car companies, and the like spend billions promoting their brands. Many sites simply aren’t at a large enough scale to gain the interest of these advertisers, but the large social networks are. Different forms of advertising are beginning to appear as well: digital coupons and product offerings that are contextually targeted provide the potential for monetization lift.
  
  
• Payments for digital items. One behavior that has been widely established on virtual worlds sites is the willingness of users to pay for digital goods. These include items like clothes and property. In the social networking world, this translates into special badges, gifts, and other forms of “currency” that enhance a user’s status or allows them to interact with their friends in a unique way. As in the offline world, establishing the value of authenticity is critical. If a third party’s free gifts, for example, become seen as an equal to site provided gifts, the site’s gifts may become devalued. But users also value scarcity – items that can only be purchased in limited quantities, or are only available on certain dates, for example. Thus sites are beginning to drive very real revenue from digital items.
  
  
• Mobile. Mobile is yet another interesting source of revenue for social networks. This is because mobile networks provide a built in way to monetize since a billing relationship has already been established with the user. SMS messages and digital downloads offer a vast monetization opportunity.

Social networks like hi5 have the eyeballs. Where there are eyeballs, there are advertisers. Computers are great at determining context when large amounts of differentiated, long-tail text are involved. Videos and eyeball aggregators, however, are different.

It was years after Internet search was widely available that text-based contextual advertising became the de facto way to monetize it. Untargeted banner ads were the norm. Without user specified search for context, it should come as no surprise then that high value monetization is harder. The only real surprise is that Google thought it would be easier than it is.

But if there’s a silver lining in this cloud, it’s this: Internet entrepreneurs are hard at work delivering solutions to this monetization challenge. Digital goods payments, mobile solutions, and new targeting technologies are just the beginning of a new wave of monetization innovation. The surprise won’t last long.

Measurement and analytics have always been critical in any medium where advertising is the primary revenue driver. That’s because measurement – an online currency used to value media space – creates the financial relationship between advertisers and media networks, e.g. publishers, web site developers, TV networks, digital billboard companies, and others who carry advertisements.

Analytics also help both publishers and advertisers understand their audiences. They answer the question of who is reading or watching, what categories they fall into, how much money they spend, and on what. As each new medium has come into being, new forms of measurement and analytics have emerged to provide demographic insight and determine value.

One of the most recent and exciting spaces is online video. Already, some 63% of the US Internet population consumes video on the Internet. Today we see that in the consumption of user generated content on sites like YouTube as well as on sites operated by large media companies such as MTV and others. We know this shift to online viewing is happening because “Did you see Seinfeld last night?” has been replaced by water cooler discussion about specific clips.

What does all this mean?

• Consuming video on the Internet is now a mainstream consumer activity
  
  
• Content producers, publishers, and advertisers are struggling to figure out how to finance and monetize online video
  
  
• Confusion persists about how to track, measure, and analyze viewer behavior patterns

Check out two companies helping to solve these problems: Visible Measures and Fliqz.

Almost two decades ago, Bill Davidow, one of the founders of MDV, authored Total Customer Service: The Ultimate Weapon. Lane Becker and Thor Muller at Get Satisfaction are now taking it one step further with their declaration that Customer Service is the New Marketing. They’re putting on a one-day summit to bring together the best minds to talk about it. We’re excited to be sponsoring the event’s lunch with round-table workshops on February 4 in San Francisco. 

Demand generation the old way was a well-understood activity. Companies allocated a given budget. They then spent these dollars at conferences and events that people attended in-person, in print-magazines, and in getting placement of articles and quotes in trade journals and with leading analysts. Their customers called them or went to a store, bought the product, and everyone lived happily ever after. Except that customers were dissatisfied and disconnected from the companies whose products they bought.

The Internet and web marketing changed all that. A giant shift occurred, from product to customers. Today it’s not sufficient to build a great product. Getting product to market is like getting to the starting line. Building your community and interacting with your users and customers is where the real race occurs.

With Genius.com, we’ve seen first-hand how companies are marketing online. What started as a multi-step process – advertise in a search engine, drive traffic to a landing page, put the lead into a database, and then have a sales person follow up – has turned into an immediate interaction. With Genius, sales and marketing reps can now tell if a customer or potential customer is on a company’s web site and interact immediately, online. 

Web based forums, wiki’s, blogs, and other online collaboration and discussion mechanisms are providing a new way to interact with customers. Rather than trying to manage the infrastructure for their online communities themselves, as with so many other areas of IT, companies are turning to hosted software like PBWiki and Thor and Lane’s Get Satisfaction offering. By using these collaborative and open mechanisms, companies are turning what could be a support burden into an incredible asset, with users helping users. A loyal customer base is the result.

On the consumer side, individuals of every age are now managing their own online communities. Hi5, Facebook, Linkedin, MySpace, and other large social networks are a few leading examples. With hundreds of millions of users in aggregate, these networks illustrate just how important the ability to define and interact with your online community has become.

Bill Davidow was right: Total Customer Service is the ultimate weapon. Head over to the Customer Service is the New Marketing conference on February 4 to find out how to put that weapon to work for you.