Milestone Group Quarterly: January 2007
Articles
Investment Viewpoint:
David Skok of Matrix Partners
Milestone: Tell us about Matrix Partners.
Skok: It’s a firm that was started about 30 years ago with offices in Boston and Silicon Valley. We are ten partners focused on early stage investing in the technology sector. We like to be the first institutional money into a deal, and generally always lead the deals we are involved in. Frequently entrepreneurs approach us as they are evolving the idea, and we are very happy to work with them to help evolve and shape the idea to give it the greatest chance of success.
Matrix was involved in backing companies such as Veritas, Tivoli, Clarify, Phone.com (the first browser on cell phones). In the hardware space, we backed Apple Computer, Apollo, Stratus and Sandisk. And in the communications space, we’ve invested in companies like Cascade Communications, Sycamore, Alteon, Arrowpoint and Sonus. More recently, Starent, Airvana, Aruba and Netezza are hot companies that we have backed that are currently contemplating IPOs.
One of the other things that has made Matrix Partners very well known is that there have been some reports on VC firms rate of returns and in those reports we have consistently emerged as the VC firm with the highest rate of return in our last two funds of any firm worldwide. Our rate of return was 513% on a compound annualized basis, which was close to double the nearest other VC fund. We have created over $100B of market value with our investments over the years. Based on the data that we have been able to find, we have found that we have a considerably lower failure rate compared to other firms on the East Coast, despite the fact that we take really big risks.
Milestone: You are quite hands-on with the companies in which you invest. Why is that? Isn’t that a time drain, particularly with the early stage companies?
Skok: We do have a very high level of hands-on, active involvement in our companies. We believe the value that we are able to add to our portfolio companies is one of the reasons why we have such a low failure rate and high rate of return. The biggest single area that we add value in is helping them to build their management teams. We meet and interview a very large number of CEO and VP level candidates, which helps us identify the best talent. Matrix's track record helps small startups attract the very best talent out of safe jobs.
Beyond hiring, we find that companies want our help in a variety of different areas. These include advice on company building, strategy, sales and marketing, M&A, introductions to strategic partners (such as IBM, HP, Oracle, Microsoft), and customers, etc. I’ve found that because I was an entrepreneur for 25 years before becoming a venture capitalist, I have experienced much of what these entrepreneurs are going through, and that has been useful in many different ways.
As one example, I’ve spent a lot of my career focusing on the science of sales and marketing, and developed a methodology that I call ‘Building a Sales and Marketing Machine’. In this case the term 'machine' refers to the idea of a highly automated and scaleable process that can be ramped up easily, and that is well instrumented, and predictable. JBoss was one example of a portfolio company that took this idea, and implemented it, and then enhanced it, with great results.
Milestone: What did you see early on in those companies, say a company like Veritas, that makes it an attractive investment opportunity?
Skok: I will give you my own criteria on this. Our initial focus is on the entrepreneur and any parts of the management team that may exist at that time. We look for entrepreneurs that have a unique insight into the problem or market that they are addressing, and are also very strongly focused on the quality of the team.
After that, the starting point for me is to focus on the customer for the product or service that a company plans to sell to. I like to ask the question: 'Is there extreme pain being felt by that customer?' If so, is that individual or the group inside the customer actually in a position to spend money to solve the pain? And then when I look at the number of people that have that pain, is that a large enough market size to build a large business? I have learned from experience that this concept of extreme pain is really crucial, particularly if you are dealing with an enterprise. I’ve discovered that there are lots of really interesting technologies that could work and do interesting things for them, but they don’t have the bandwidth to tackle more than 3-4 projects at a time. So if you are going to get on that list of things that they are going to do, you have to solve a problem that is causing them extreme pain.
The next thing I look at is the product. Does it have long term, sustainable differentiation and barriers to entry. In many cases, we have major competitors like IBM whose size, distribution or customer base would give them an immediate advantage if they decided to go into competition, even with an inferior product. For a startup, it is important to have some significant differentiation and barriers of entry in order to keep yourself ahead.
A new focus of mine is on the business model, particularly around the cost of sales. I see a large number of startups fail because their distribution models (e.g., direct sales) end up costing far more than they are able to make from the sale. So I am interested in knowing if there is a cost effective way to sell this product (e.g., OEMs, channel partners, Web, tele-sales, etc.). If the strategy requires a direct sales force, then these days that is something of a red flag. Direct sales forces are very expensive, and take a long time to become productive. Only a few startups are finding them to be successful these days. (Netezza is one example where a direct sales force has worked well, due to the very high price points of their data warehouse appliance.)
Milestone: It seems that a VC firm’s brand is a key driver of its repeatable success. Do you agree with that? If yes, how do you achieve that leading brand status and how do you keep it?
Skok: I do agree with that, very strongly. Matrix's success has been very strongly based on the idea that people come to us because of our reputation for being one of the very best firms for helping entrepreneurs become successful, which we believe is the defining character of our brand. We show prospective investors and entrepreneurs our family tree, which shows how an investment in one company has led to many other investments as the entrepreneurs come back to Matrix time after time. For example, a long time back we invested in Bytex, which led to Cascade Communications, followed by Sycamore, Redstone, Arrowpoint, etc. In many ways the best test of whether a business is doing well is to find out whether their customers come back to them over time, and history shows that our entrepreneurs keep coming back to Matrix.
I think that the important thing worth stating here is that brand is not built by marketing. Brand is built by the quality of the experience that the entrepreneurs have when they are working with Matrix. I can personally relate to that because I was an entrepreneur in five different companies before becoming a VC and the last two companies were backed by Matrix. When I started my fifth company - SilverStream Software - I had worked with15 different VC firms, but Matrix was the only one that I wanted to work with again. I had made enough money not to need VCs by that stage, but I still invited them to invest alongside of me because of their immense value-add.
I can give you a series of concrete things where Matrix stood out from other investors. One good example was at Watermark Software. We were approached by FileNet to sell the company to them. At that time the company was doing well, and we were not sure if we really wanted to sell or continue on to an IPO. As a result, we did not want to hire an investment banker because they only make money if they actually sell the company and that would have motivated them to push us to sell. Paul Ferry of Matrix offered to act as our investment banker and during the discussions with Filenet we got into several places where the agreement around how investors should be treated (versus the management and employees) could have easily been interpreted by him as a way to make more money for the preferred shareholders. In every case where that came up, he consistently said to the Filenet people, “No we don’t want to do it that way. We want to work in a way which is going to maximize the return and be fair to the common shareholders.”
Matrix just earned their stripes with us in many situations like that. To me, that is what the Matrix brand is about. It’s not about how many times your name appears in the press. It’s far more about the fact that entrepreneurs trust the partnership, and that kind of trust gets built up over a long period of time.
Milestone: In many startups, the time to market pressures have abbreviated proper business process discipline in building their firms. Would firms be able to create more value if they were to take more time to build their firms and processes from the bottom up? What are the trade offs if they do?
Skok: Yes, they would be able to create more value if they could take more time. The thing that we always try to encourage is to do things around the concept of building customer value. The compromise that is the wrong one to take is to build a company for an exit. If an entrepreneur walks in here and says, 'we think we can exit by selling to so and so' and the presentation is principally focused on exit, I get quite turned off.
I am not interested in building companies around exits. I may be the only VC out there that thinks this way. My thinking is strongly focused on the customer, and creating high amounts of value for that customer. Then focus on building a great organization with high quality employees that are happy and motivated. If you do that, my belief is that you will end up getting an exit. It will most often happen at a time that you are aren’t expecting and will come from a direction you don’t expect, but buyers will always be interested in companies that know how to create value for customers. We saw many badly created companies during the bubble, where the focus was on making money, and not on building customer value.
Milestone: Generally speaking, VC firms with early investment focus tend to outperform other firms, why do you believe that?
Skok: It is probably only true that the leading VC firms that are at the top of the pyramid are making lots more money. If you look carefully at the venture business, what you will discover is that there are something like 10-15 firms that make something like 80% or 75% of the return in the venture world.
Early stage investors take a significantly greater risk than other investors because they get involved so early and consequently they get to buy a large ownership position at a low price, reflecting that risk. However that strategy only translates into good returns if you can have low failure rates, and consistently get a significant number of your companies to exits that are in the multi-hundred million dollar to several billion dollar range.
The crux of why top-tier versus the mid, second or third tier firms are making the money is because they have figured out how to hit those high valuations and do so more regularly than others. It’s really an incredibly marked drop off as you go from the top tier to the second tier in terms of the rate of return.
Milestone: In the Silicon Valley, Google and Yahoo are offering attractive exit paths for early stage companies, siphoning off many of the good deals that would have otherwise percolated through the angel and VC investment communities. Do you notice a difference in the amount of good quality deal flow? Would you attribute it to that or something else?
Skok: Actually what Google and Yahoo are doing is very good for the VC world in that they are creating all sorts of opportunities for new companies and many of those require venture funding to get to the stage where Google or Yahoo would buy them.
Right now we are seeing very good deal flow, although the quality bar for what will create a successful company in today’s environment needs to be very high.
Milestone: Which sectors and company types are you anticipating will be receiving the most VC investment in the coming year?
Skok: In the venture world, we are often turned to as though we have some crystal ball. I am willing to speculate on that, but I will tell you that the smart players in the investment world know that our job is to wait for the entrepreneurs to show up with the good ideas. By the time most venture capitalists have predicted something is going to be hot, it’s probably already too late to invest in that sector. I will give you some idea of what people are talking about these days. One thing that I think is really interesting, and that has changed in a big way, is that consumers are driving much more of innovation and exciting areas than enterprises. As an example, consumers looking to view all sorts of video in HiDef. As well, time-shifting and place-shifting, are driving major advances in networking, storage, compression, chips, and other home devices. A great example of a Matrix company in the consumer electronics space is Ambarella. Their system-on-a-chip allows makers of compact digital cameras to film very high quality HiDef video at 1080i resolution, and compress it using MPEG 4/H.264 to files that are then stored on flash memory cards. That will save us taking two cameras with us, one for still photos, and one for video.
The other area where I think is a huge amount of innovation taking place is the online area, where we are continuing to see innovative new online services for consumers and business. Even though we had Bubble 1.0 and now we might (by valuation terms) be in the middle of Bubble 2.0, there is still a lot of potential for interesting new businesses to be built around new capabilities found with the Web. As one example of these new enablers, in the past if you were a startup Web company that wanted to get your name known, you would have bought a Super Bowl ad at vast expense. Today the means of customer acquisition has become Search, and Paid Search. Startups today pay a ton of attention to getting their search terms to work, or work on cost-effectively buying the appropriate search words. This gives them a very low and predictable cost of customer acquisition that can drive a whole bunch of new business models that were not possible prior to the Google era.
I still think wireless is incredibly important. Both mobile applications and services as well as the underlying infrastructure. The new Wimax technology that will be coming out next year is a great example. Remember how Intel made Wifi happen by building Wifi chips into notebooks? Well starting about the middle of next year you will see most notebooks with Intel chips also having Wimax built in. That is going to lead to ubiquitous, low cost, mobile broadband. As one side effect, that will be tremendously disruptive to the cell phone industry, as customers will be able to use that always-on IP connection to make free Skype voice and video calls. Lots of other exciting new services will become possible as WiMax becomes ubiquitous.
Open Source software and Software as a Service (SaaS) are other interesting areas. One of my investments in this area that is really fascinating is Digium. They have produced a product called Asterisk that is the leading Open Source PBX/telephony product. If you think about it, almost every company in the world uses a telephones as a key part of their business, and VoIP is a major disruption that allows for free or far lower cost calling, and interesting integration of telephone with important business applications. Over time, VoIP will cause every company to throw out their current phone system and replace it with a VoIP-based system. Based on current downloads it looks like Asterisk will be used in more than 35% of those situations.
Milestone: Which dominant exit paths are you seeing for 2007? Which industries offer the most attractive acquisition opportunities?
Skok: There is no question that getting acquired is more attractive than going IPO. The costs of doing an IPO are very high, and the costs of being a public company take away from earnings, and therefore impact valuations. The compliance issues involved with being a public company take away a lot of the focus that one could have spent running the business and bog management down in tremendous levels of complexity that weren’t there before. Doing an IPO requires a company that really has the staying power to continue growing over a long period of time.
Despite that tough set of requirements, we are seeing a resurgence in IPO’s and it looks like four companies from the Matrix portfolio have a good opportunity to go public during 2007 if all continues to go well.
But the majority of exits will continue to be acquisitions. The acquisition candidates are pretty clear. You only have to look at who has been making acquisitions. IBM has been very aggressive in this area, Google, Yahoo, Microsoft, EMC, Cisco, it’s all the big named companies. In the tech space, the big companies know it’s very hard for them to innovate from the inside, so the smart way to deal with this is to go buy startups that are doing that innovation for them off balance sheet.
Milestone: Has outsourcing run its course? Does the availability of cheap development resources abroad reduce the amount of money needed for startups to develop a given amount of functionality?
Skok: I’m going to lump together outsourcing and off-shoring. This trend has definitely not run its course and continues to be a very important technique being used by most of our start-ups. The key to success is managing this well, and that appears to take experience. I have seen a lot of badly managed projects that have not saved money and have really caused problems. If it is well managed, it can reduce the cost of development significantly.
Milestone: Is there a deal you passed on that you now regret?
Skok: There are none that come to mind.
David Skok joined Matrix Partners as a General Partner in May 2001. He has a wealth of experience running companies. David started his first company in 1977 at age 22. Since then David has founded a total of four separate companies and performed one turn around. Three of these companies went public. He joined Matrix from SilverStream Software, which he founded in June 1996. Prior to its July 2002 acquisition by Novell, SilverStream was a public company that had reached a revenue run rate in excess of $100m, with approximately 800 employees and offices in more than 20 countries around the world.
David's work as a value added investor is best known for helping JBoss take their Open Source business to a successful exit with their sale to Red Hat, and for helping AppIQ from its inception to their sale to HP. David serves on the boards of Digium (makers of the very popular Asterisk Open Source PBX/telephony software), Diligent Technologies, OpenSpan, Solidworks, Tabblo and Virtual Iron Software.
He holds a B.SC Honours Degree in Computer Science from the University of Sussex, England.
In addition to his broad focus on enterprise software, David has specific focus on the areas of Open Source software, Software as a Service, and utility computing products for the data center. |
