Tech, Startups, Capital, Ideas.

Sometimes entrepreneurs come in with a pitch to take money and give it to someone else instead of investing it in themselves or their product. Here’s why that’s a tough pitch.

There are a few large players out there who are gatekeepers and at some point will require that you pay them money if you’re going to swim in their pond. These include the big software companies, the wireless carriers, the music industry, and I predict, the large social networks. This is reality.

• Microsoft charges customers for Client Access Licenses, or CALs, which associate customer payments with computers or users accessing Windows.
• Google effectively charges customers a percent of revenue via a split of Google Adsense revenues or through the cost of advertising via Google Adwords.

• Wireless carriers control the wireless pipes, and therefore they ultimately take a piece of money that is charged for content that passes over these pipes, or charge for access such as short-codes. In terms of startup pitches, this appears in the form of shared startup/carrier revenue. The good news is that there is a model for charging for content; the bad news for a startup is that some of that revenue must be shared with the wireless partner.

• The music industry charges royalties on music, obviously! This can come in the form of payments as you go, or as a large up front payment, or both.

• Most social networks don’t charge for access today. They primarily collect money from non-users in the form of advertising. Some are starting to collect money from their users in the form of paid online classifieds and virtual currency. In the future, I predict that at least one of the large social networks will implement a revenue sharing mechanism with its ecosystem partners, enabling them to make some money, but keeping them relatively weak. (See: top of list.)

Once in a while these companies will require large up front payments, but typically they are open to negotiation.

From an investor point of view, it’s hard to get comfortable with investing money into a company and having that money go out the door the next day, especially when there’s a lot of consumer-behavior risk involved once the product gets to market.

There are a few exceptions to this rule, of course:

• Founders taking money off the table once their business has reached some scale.
• Buying an expensive, exclusive license to something very valuable that creates a barrier to entry (such as wireless spectrum, or intellectual property).

But these are the exceptions, not the rule. Put yourself in your potential investors’ shoes: if you’re going to take money to give it away, make sure you have a really great reason for doing so.

Just got email from Zopa saying they are coming to the US - with a national rollout. Originally they said they were going to launch in California and expand. Now they are going broad from the start, as also reported here.

I saw the Zopa interface last summer and it looked very interesting - a lot more financially technical than the Prosper interface. As an active Prosper lender, I’m interested to see how Zopa’s US offering compares.

The email itself started out as follows:

“The pace is really picking up for launching Zopa here in the U.S., and not just because our new CEO rides a motorcycle… Douglas Dolton, our brand new, San Francisco-based, Global CEO.”

Zopa is funded by Benchmark Europe, while Prosper is funded by Benchmark US, as described in this alarm clock post from last spring.

With so many Internet-enabled companies being started, one of the biggest challenges is filtering the massive amount of deal-flow in the space. Here’s one way to think about the opportunities across a range of funding stages.

Pre-Traction There are a lot of these startups, perhaps thousands or even tens of thousands of them (probably an order of magnitude less on the business side than the consumer side). This applies to both Internet-enabled business to business (B2B) and business to consumer (B2C) companies. The reason so many companies are being started is that broadband is, at long last, widespread, there are lots of technology building blocks, and capital is available.

On the consumer side, that makes these companies really hard to invest in, because it is practically impossible to predict consumer behavior, that is, what the result of the actions of millions of different individuals will be.

Just as Supreme Court Justice Potter Stewart once said about pornography, the answer to the question, “if you had to do it over again, how would you replicate viral growth?” is typically, “I couldn’t, but I know it when I see it.”

The value of domain expertise A lot of experimentation goes on during this stage, until some traction is achieved. Successful progress is often made when entrepreneurs focus on something in which they have domain expertise. A lot of people think that only applies to business focused companies, but domain expertise applies equally in the case of consumer entrepreneurs as well, typically in the form of”¦ themselves! (Recall, Time’s 2006 Person of The Year: You.) That is, entrepreneurs who are solving their own problem or working on a problem near and dear to their hearts.

A variety of vehicles have emerged to fund entrepreneurs at this stage, from angel investors to smaller funds; some larger funds also have programs targeted at this stage. The smaller funds and angels can do a significantly larger number of seed deals, because even if the seed deals exit for “relatively” small amounts of money, say in the $5M - $50M range, that is still a great outcome for these investors relative to the amount of money they are working with.

Larger funds, of course, need to return larger amounts of money, and so a limited number of seed deals make sense, combined with working very closely with the network to find companies that are a bit later in the process, namely”¦

Early traction, with un-scaled monetization model These startups have early traction, but only a view toward how they will monetize it. This traction may be the indicator of something great to come, or it may be the indicator of an impending local maximum. It’s hard to tell.

Early traction means different things to different people; what’s important is that it’s a very helpful negative filter: there’s almost no good reason not to be in market today for an Internet-based startup.

For these companies, there is a possible path to revenue in the form of advertising, the sale of virtual goods, or premium up-sell (freemium / subscription model), which is especially common for Internet-based B2B offerings.

The reason to invest here is two-fold:

1) A startup could be in a break-out category. This is a sort of option value in the market with the aspiration that one or more of the companies ends up in a tornado of a market. The phrase, “a rising tide lifts all boats” is highly applicable here ““ if you end up in a great market, you can go a long way. The trick here is either to recognize a tornado market before it happens, or to have sufficient bets at this stage that one or more of them ends up in a tornado market.

As one venture capitalist told me, the other implication of this is that it’s often not the case that repeat entrepreneurs have the level of success that they had the first time around, because even though they’re great entrepreneurs, they may have been in a great market the first time, but not the second or third. As venture partner

Donna Novitsky put it,

“A great market and a bad product is better than a bad market and a great product.”

For an Internet-enabled company at this stage, growth is more important than revenue.

2) The opportunity for 10X ““ 100X returns. The later an investment is made, the less opportunity there is for hugely out-size returns.

Capital efficiency remains highly important, because in terms of Mark Leslie’s Sales Learning Curve (SLC), the company has still not proven scale. Spend too much capital too fast before figuring out how to achieve user or customer adoption, and you’ll need more money too soon.

The easiest way to raise money in the current market is to prove more traction. More traction means a higher valuation. Fail to gain traction and it’s hard to raise money, which is bad news for the entrepreneur and investors. A lot of experimentation still needs to happen.

Late traction, un-scaled monetization model The next stage is “late” (for venture capital ““ I’m not talking about buyouts here), in which the company has traction, but an un-scaled monetization model. Some companies at this stage still have no revenue, nor a vision of how they will ever get any.

In that case, it’s all about growth and timing. They are spending significant amounts of money (because it’s expensive to run at large scale), yet they don’t have revenue and so can’t become stand-alone businesses (unless they can answer the revenue question).

Some of these companies are highly dependent on other companies for their users. This is a dangerous place to be in, whether it’s on the B2B side with users coming from, say, a large CRM platform, or on the B2C side, with users coming from one of the large social networks (without a long-term business relationship in place). Having this dependency is much like having a mobile play that gets traction but goes around the wireless carriers: eventually they’ll want a piece of the pie.

I’d rather have a company that defines the ecosystem and owns the customer (or user) than a company that is part of the ecosystem. That’s not to say that lots of great and valuable companies that are part of an ecosystem won’t be built ” I’d just rather be in pole position.

The struggle with these companies is that one has to be both careful and skeptical about investing in them but also aware that they have the potential to deliver significant returns. They’re momentum plays that are about continuing to scale and then finding a buyer who wants to monetize them or get into the game, before the company runs out of cash. These companies (you know the ones) can, however, produce huge returns.

Late traction, scaled monetization This last category of companies has scale and revenue and is looking to scale further or more rapidly, using capital. The returns do not have as high beta at this stage and investors may not own as much, but the opportunities are incredibly interesting because the companies are already at scale and have meaningful revenue.

Of course, something could happen to the companies at this stage, so there’s still some real risk. A competitor could move in, a source of revenue could dry up, a company could fail to execute, or something might not be what it appeared to be prior to the investment.

Investments come in a variety of forms at this stage, from buying equity, to buying founder equity or providing liquidity for some of the early investors (such as small funds who have more than reached their goal and promise to their limited partners by this stage and would welcome liquidity, even if they don’t achieve maximum return as the company continues to grow).

Conclusion It’s a crazy world out there, with sky-rocketing valuations and dozens of new Internet companies being started every day. The availability of widespread broadband to the home, lots of ways to accelerate initial user and customer adoption, technology building blocks, and early stage capital means that it’s a great time to be in IT. With all these investment stages, it’s easy to get caught up trying to define a great company in a tornado of a market, but like Justice Stewart once said, “I know it when I see it.”

Check out this awesome cartoon from Dawn Douglass and Keefe Chamberlain. Don’t let it stop you from ordering the lobster, of course!

How did this cartoon come about?

Dawn had contacted me about a new site she is launching (I can’t break the news yet). I emailed her back asking her to keep me posted. I also mentioned the web site of a friend of mine, Robert von Goeben, who created a series of cartoons about being a VC during the bubble. A few days later, I had breakfast with Noah Kagan who I told about my three-lunch day. He thought it would make a great blog entry. Then a few days later, I received the amazing and pleasant surprise of this cartoon in my inbox!

To get the cartoon, copy the following code:

<a href=”http://www.vcdave.com” title=”VCDave Blog”><img src=”http://www.vcdave.com/wp-content/vcvsent1.jpg”  alt=”VCDave Blog” />

In case you haven’t seen it - Google launched a FREE 411 service.

To try this service, just dial 1-800-GOOG-411 (1-800-466-4411) from any phone.

It’s true — I had three lunches on the same day. I’ve had two lunches on the same day before, but never three. I didn’t plan it — it just kind of ended up that way.

When I did my startups, we called it the Startup Diet. We spent all our time working. We ordered pizza into the office, stayed till all hours of the night, and if we went out it was for burritos down the street. If you’re an entrepreneur, you’re living this movie right now.

When meetings are your life, however, you spend a lot of time eating out. Tomorrow I have a breakfast, a lunch, and a dinner; Thursday breakfast, lunch and drinks.

Now don’t get me wrong — I love going out to eat. It’s a lot less formal than meeting someone at the office, plus it’s a lot of fun, and I get to buy — something I rarely did as an entrepreneur. But there are three problems.

First, it’s easy to gain weight. Heart disease and diabetes run in my family and I have to watch what I eat. As a marathoner, more weight means a slower time. All in all, it’s bad news.

Second, when I get to the weekend, I’m ruined by the meals I’ve eaten during the week. Kaygetsu? Lunch Thursday. Town Hall? Dinner Tuesday. Buck’s? Breakfast Monday.

Finally, it’s killing my reputation. As an entrepreneur turned VC, I’ve always stuck to my entrepreneur roots. Now I get remarks like, “I see you’re going for the standard VC breakfast of granola, yoghurt, and fruit,” or, worse yet, “Looks like you’re having no problem adjusting to the VC lifestyle.” Any lean and mean entrepreneur will know that these sorts of comments are like daggers through my heart.

Back to my three lunch day. Here’s how it happened. I scheduled lunch with someone I really wanted to meet. I wanted to have lunch because of the less formal setting (plus, I knew I’d be hungry around 11:45). Then there was someone who suggested lunch and I had to meet with that person – so I accepted. The thing I didn’t count on was lunch #3, the surprise lunch.

I intended to meet up with an entrepreneur for coffee after lunches one and two, and, being a little slow due to the two lunches I’d just had, I asked the entrepreneur if he had eaten yet (this was at 2:30 in the afternoon), and he said — no. I admit I didn’t eat a full third lunch — but I did have a few bites — after all, this was someone I respected and I didn’t want him to have to eat alone. But when you’ve already had two lunches, a third one can really cramp your style.

Don’t worry, though. I’ll do my best to live up to your expectations of the VC lifestyle by taking you out to eat at a great restaurant. I do have a weakness for good sushi.

But if you just want a burger, a burrito at some hole in the wall joint, or a beer, count me in. Taco Bell may have coined the term Fourth Meal, but it’s taken on a whole new meaning for me. Just don’t ask me why I’m not eating.

Next time: How to Eat Healthy as a VC.

Here’s a graph of the total value of loans originated on Prosper over the past 6+ months.

I’ve been an active lender for over a year now. The market has become more efficient but it is still relatively inefficient. In the short-term, that’s good for lenders because it causes rates that are higher than they should be. In the long term, of course, the market has to develop further for the loans to get paid back.

What’s interesting is that the trend for loans originated seems to be improving.

10/25 - $20M in loans
1/10 - $30M (granted, some of the slowness could be due to the holiday season)
2/27 - $40M
4/3 (estimated) - $50M

Is There an Emotional Attachment on Prosper?
When I first started out, I looked at every loan. Now I have standing orders and barely look at any of the loans.

Prosper has been called the eBay of loans, but standing orders make Prosper very different from eBay in a fundamental way. With eBay buyers are typically looking at items individually. When you’re buying a computer, or a GPS or something like that, there’s little emotional attachment. But when you’re buying a photograph or an antique, there’s a very real emotional connection between buyers and the item in question. Buyers look at each item individually. On Prosper, for the vast majority of lenders, I suspect it’s purely about return. But that difference might not matter; where there are lenders and borrowers, there’s a market. And in this case, it seems to be one that is rapidly getting more liquid.

Lots of sites have built hacks to split revenue with the authors of user-generated content. Now Google had introduced an effective new way to share revenue with your users. It’s the Google Adsense API.

Anyone who does a lot of keyword buying is familiar with the Adwords API. This API lets you programmatically control your ads on Google. Now individual users can associate ads with the content they publish on your site. Sites traditionally have done this by inserting an author’s publisher ID for some part of the ads that are displayed next to an author’s content, and then inserting the site owner’s own publisher ID for the rest of the time. This provides a revenue split between the site owner and the content creator. But now this can be done via the Adsense API.

This will further cement Adsense into publishers’ sites.

In case you haven’t seen it, Google has a great April Fool’s Joke…

I had the chance to catch up on a little light reading over the last week: Founders at Work and Mr. China. Here’s what I learned. Founders at Work is inspiring reading about some incredible founders from the past few years and the past few decades. Key takeaways are that it’s people first, ideas second; and that whatever the original idea for a company, success will likely be the result of a much different idea.

Successful entrepreneurs have known for a long time that the best way to start a company is to find some good people to work with and then just to start working. The “right” idea often comes about as the result of working on one thing and then solving another problem in the process, or of being in the right general area and nimble enough to switch courses when a new path presents itself.

The trick for investors, of course, is to invest after a few of the experiments have been run but before the successful experiment plays itself out. The great entrepreneurs in Founders at Work were able to run lean and mean while they were in experiment mode and then used capital to move their business forward more aggressively.

Everyone has been talking about Mr. China and it is a great read. It’s the story of a former Andersen consultant who moves to China to enter the new world of business there in the 1990’s. He teams up with an investment banker and together they invest (and lose) hundreds of millions of dollars. I loved the book but wondered why it took them eight years to learn the lesson, “when in Rome, do like the Romans.”

It was also notable that the author was as surprised as he was by the actions of some of the people he invested in, who then set up next-generation, competitive shops right next door or mis-used their investors’ money. The entrepreneurs profiled in the book were extremely aggressive, yet they didn’t seem that much different from, say, the Intel founders setting up shop after Fairchild, or the Enron execs mis-allocating money from their stock holders and pensioners.

The author comments at the end on how in fighting the day to day battles he became out of touch with the overall evolution of the country. The fact that in the midst of the action it’s easy to lose sight of the big picture is, in and of itself, a great takeaway. Moreover, there will always be someone else who neglects the importance of really understanding the local environment and wants to become the next “Mr. China.” The author has done all businesspeople a service by sharing the story of his life in China - it’s a funny and very worthwhile read.