Milestone Group Quarterly: July 2005
Articles
Investment Viewpoint:
Dixon Doll, Cofounder and Managing General Partner, Doll Capital Management
Milestone: What are Doll Capital Management’s defining principles that characterize how you invest and think?
Doll: We like to look for market opportunities where some unique technology helps a company create barriers to entry and proprietary advantage. We specifically want to see a software product, a system or software as a service model where there is some unique value delivered by that capability. This model has the characteristic that if competitors come in and try to clone the company’s product or lower the prices dramatically, our value proposition in our company will stand tall and not be subject to customers defecting just because other folks are offering lower functionality at a lower price. Many times we characterize the most exciting opportunities that we invest in as non-conventional or “outside the box” opportunities. This means that we go out of our way to avoid the herd mentality. We don’t want to fund the companies that are the third, fourth, eighth, tenth player in a particular space because Silicon Valley is littered with the remains of the “me too” companies that got funded to go off and pursue an investment fad. We want to avoid those like the plague.
Milestone: You have had some great press regarding your China strategy. Where is your focus with China?
Doll: We are concentrating our efforts in China in pretty much the same segments of the market that we emphasize here in Silicon Valley, namely the early stage end of the business. In China, many things are fairly different than in the U.S.. One of the most important aspects of China is the relative number of dollars required to develop a portfolio company product in China versus here in the U.S. Depending on the particular situation, I think a number that you see kicked around is roughly 3x.. To put it another way, if you are going to do a development project on a new piece of software or hardware device, or a similar product, and build a company around it, it is generally our belief that you can get a company over there through a cash flow/breakeven from a development point of view on about a third of the dollars. That’s just directly attributable to the wages, productivity and the work habits of the engineering and technical people in the Chinese marketplace. I think as far as the industries that we invest in, it’s a fairly similar spectrum of opportunities to the ones we invest in here; broadly defined as IT, including software, communications, wireless, security and semiconductors. The two companies that are probably farthest along in our China portfolio have both gone public. One of them is SMIC, which is in semiconductors and the other one is 51job, which my partner David Chao saw an opportunity to go and create in the China marketplace. It’s a company similar to one he had worked with in Japan, called Recruit. His idea there was that China is a very young and emerging economy. The Chinese economy needs a company that is focused on helping connect employers with employees and employees with employers and given the nascent state of the Internet in China, that we should combine the strategies of a web services model with a hard copy distribution model. 51job has a large amount of its business deriving from printed publications that are distributed extensively in many of the major cities in China.
Milestone: Worksoft is a fairly recent investment. Is there anything different about their outsourcing model or is this what we would call a “meat and potatoes” investment in a strong management team?
Doll: There are some elements of it that would fall into the “meat and potatoes” category. There are a lot of examples that we can go back and cite here and in the olden days of U.S. IT industry, where outsourcing software development organizations like EDS, CSC and people like that built very successful businesses. Worksoft is a group of excellent developers and systems integration people that are effectively helping a lot of multi-national corporations set up their applications in the China environment. We felt that there was a very fundamental demand and need for this and Worksoft was a top notch group focused on meeting this opportunity. We think, that if they can continue to execute superbly, they will go down a similar success path. I think their main challenge will be not that different than a lot of other Chinese companies. That is, finding good, experienced project managers and middle-management people to keep the troops organized, managed, and motivated, while making sure that the economics of the deals that they cut with their customers allow them to achieve the desired profit margins. So far so good, but that was the investment thesis.
Milestone: One publicized VC strategy is combing through dot com wreckages looking for good ideas that ran out of money. Smart idea or knucklehead idea?
Doll: I think it might be a smart idea for some firms - it is sort of a personal value choice for a firm. There are lots of opportunities out there. I think DCM, by and large, would tend to focus on new ideas, new companies and companies not encumbered with a lot of baggage that needs to be cleaned up. I am not criticizing the strategy at all; I am just saying it is one that, by and large, we have probably not engaged in very much. We would tend to rather spend all of our energy and capital building a new company, starting with a clean sheet of paper rather than having to spend cycles and dollars having to clean up any wreckage or broken glass.
Milestone: There are guys who are looking for ideas that are dead; the company is gone. Let’s assume there is not an idea issue, same answer?
Doll: Yes. If the company did not screw up, the product was not broken and it just ran out of money and needs to get restarted, I suspect that is something we would consider but it is still a bit of an unnatural act for DCM. It’s a personal style. Our people are more comfortable meeting a great entrepreneur that has a really optimistic view that is soundly based and working with them to spend 150% of their time taking something up and to the right. It doesn’t have any of the blemishes that could be associated with a prior failure.
Milestone: On demand software seems to be a trend with staying power. What spaces make sense and what don’t?
Doll: I am a huge fan of the on-demand software business model. I think the on-demand model is a very disruptive force in the world that is going to really wreak havoc on quite a host of vertical markets where it becomes available. I think that the segments where it makes the most sense are ones where the software running as a service can be pretty much made to be transparent toward a conventional implementation of an application where there is not a lot of customization, hand holding, or fine tuning that is required. There are clearly issues with certain applications in which critical data security, and access control must be loaded in by the customer, so these may not work in an on-demand model for compliance reasons, for homeland security reasons, for phishing, or identify fraud reasons. So I think that whenever phishing, identify theft and financial security matters are of concern to an application, I think those applications will either be more difficult to do in an on-demand environment. What I suspect might actually happen in those cases is more of a hybrid model where the software is operated on a dedicated server inside the firewalls. In that case it would be under the complete control of the customer, but the pricing arrangements, the usage arrangements and the business model that governs the relationship between the software vendor and the customer might have the properties of on-demand. I have talked to a lot really good software people here in the Valley. Many of them say that the conventional big software license or lease model is dead and it has given way to the on-demand model. I am fundamentally a believer in this mega-trend. I think it is a really big deal. It is a disruptive business model as opposed to a disruptive technology.
Milestone: Speaking of death, our audience is mostly software, yet enterprise software is not so lucrative these days. M&A exits in enterprise software average 2-3x, depending on who you listen to, outside of security. What is your firm’s approach in this market?
Doll: I think we try to be grounded in reality more than anything else. You’re always looking at the macro factors that are affecting any segment you invest in. Enterprise software is clearly not a hot space, as you correctly point out. I think it has to do a lot with the maturity of the software industry as well. The whole ERP space is now consolidating substantially, and I think the place where there continues to be opportunity is in the area of innovative enterprise applications. Those tend to be associated with specific vertical markets. So one of the concerns that the venture industry has is whenever you have a product that is tied to a particular vertical, there are always questions about the size of the market. The big markets are ones that we would classify as horizontal so that the application functionality has value whether you are in transportation or in financial services or telecommunications or whatever. An awful lot of those applications have already been fairly well developed. Some of the ones that do hold promise are like our company Vendavo, which has completely changed its original business model. Their original business model was not working. We went in and said, “O.K., we have a great team here. Let’s go look at some new application areas where we think we can develop products that have a lot of value.” So we went into pricing optimization and management. The company has done a remarkable transformation and has numerous Fortune 1000 companies that it is now serving. In the world that we live in today, you have to find applications where the underlying proprietary algorithms produce sufficiently high value to the customer that they are willing to pay prices high enough to allow a venture capitalist and investors to make good returns. They are just harder to find because of the fairly crowded and maturing nature of the software industry.
Milestone: One solution to investing in software is more mature investing, consolidation, take privates, turn arounds and such. What is your view of that?
Doll: I actually think that those techniques, roll ups, consolidations, etc. make sense for the industry and make sense for certain kinds of investors that are more financially-engineering oriented. At our firm, we view ourselves as business builders and we don’t have a long history of doing lots of roll ups or consolidation plays, but I think for the right kind of firm, the culture and mentality of their people will be able to make money. The main reaction that I have to your question is that talk is cheap in this area and a lot of people come around and think that they can go and come up with consolidation, or roll up plans. The devil is totally in the details here and these plans can look really interesting and really viable on paper, but in terms of whether they can actually be done, that is all about getting the deals, or getting the confidence of the people that are going to participate in the roll up or consolidation.. If you don’t have the cash, the stock, the currency or the persuasive powers to get the first company to agree to play at the center of the consolidation, you will never get off the ground. It has a lot to do with the profile of the venture firm, some of the software companies that they have backed, entrepreneur perceptions of their resources and so on.
Milestone: Take the consolidation part out. Take privates, turn around. No combinations. Just fixing mature companies.
Doll: Again, I think I would give you much the same answer. That’s not the kind of opportunity we would focus on. My own personal appetite is to go develop some innovative on-demand implementations. Here’s why. There are not many comparables out there that people really understand, but Salesforce.com really did put a stake in the ground with their business model and if you take two companies that have roughly the same revenues, the same growth rates and the same margins, the on-demand software company will command a much higher multiple of revenue or profit because of the built in existence of the backlog and the stream of future cash flows that an investor can discount. It takes the volatility out of the revenues. One of the most famous things that have happened in the last few years is some software company announcing on the last day of the quarter that they missed their numbers because they could not close one big deal. That’s another appeal to the demand model. I think there is a massive change going on in that regard and that is certainly one of the things that we are most intrigued by.
Milestone: Ray Lane told the Milestone Group Quarterly in 2004 that most CIO’s are disappointed with the return on their IT investment. He blames the proprietary nature of software companies and poor integration. What do you think?
Doll: I think that poor integration is clearly a major factor in the disappointments. I think the number one thing that causes this frustration to occur is improper expectation setting by the CIO’s, with respect to the end users and the line of business executives. They come in and sell a project that is going to cost X and will produce the following returns. Many software projects, even to this day, have a very consistent pattern of coming in dramatically ahead of budget from an expense point of view. So there is a lot of cynicism out there. I think the integration issue is very clearly a major factor in that. Proprietary software I think is less of a reason but you cannot say it is not a factor at all.
Milestone: From 2001 to 2003 and perhaps 2004 we saw IT budget limitations trump most software ROI. How do you help your portfolio grapple with the real value proposition?
Doll: I don’t think there is any secret sauce or black magic in this, but we try to interact with typical customers. We go to conferences, we go to seminars, we sit down and we are always looking for new lists of CIO priorities and projects. During 2001 and 2002 when the IT budgets were severely contracting, the only way you could get a sale at all was if you had a product that solved a pain point or one of these issues in what we call in the critical “must have” category. Compliance and the financial services markets are other examples, but if it is in the “nice to have” category, in those years that you mentioned, frequently it just did not make the cut. Businesses are run to produce a return on investment for their shareholders. There are always lots of projects out there that the business just plain and simply cannot afford to invest in especially, in a period when budgets are being contracted severely. I think it is a pragmatic decision. We still try and do that, even today. You want to go look at the places where the end user is experiencing pain and has a critical problem to solve. Pain killers sell better than vitamins, we like to say.
Milestone: If you were an LP and had $10 million to invest in a competitor’s fund, who would it be and why?
Doll: I’d much prefer to invest it with our own firm where I know so much more about what’s actually going on.
Dixon Doll, Co Founder and Managing General Partner, Doll Capital Management
For more than 30 years, Dixon has influenced and guided entrepreneurs, investors and executives. In recognition of his accomplishments in the communications and venture capital industries, Dixon has been named by Forbes Magazine as one of the top 50 venture investors on the 2003 and 2004 Midas lists, as well as "one of the top 100 personalities involved in creating the information highway" by Upside Magazine and Micro Times. Prior to founding DCM, Dixon spent eight years at Accel Partners where he co-founded the venture capital industry's first telecom-focused fund. The companies that Dixon has helped build include Network Equipment Technologies (NYSE: NWK), Centillion Networks (acquired by Bay Networks, now part of Nortel), Alantec (acquired by Fore Systems, now part of Marconi), Bridge Communications (acquired by 3Com), ZeitNet (acquired by Cabletron), and Optilink (acquired by DSC Communications, now part of Alcatel). Originally from Texas, Dixon grew up in Kansas. His football career at KSU cut short by injury, Dixon re-channeled his energies into the pursuit of graduate engineering degrees. Still an avid fan of Michigan Wolverine athletics, Dixon currently lives with his wife, Carol, in San Francisco; his three sons all live in the Bay area and are pursuing their own entrepreneurial dreams.
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