Milestone Group Quarterly: July 2006
Articles
Investment Viewpoint:
Promod Haque, Managing Partner, Norwest Venture Partners (NVP)
July Newsletter
Milestone: Tell us about Norwest Venture Partners.
Haque: We are a global VC firm with a long history, having started back in 1961 and in that time having funded nearly 400 companies. Based in Palo Alto, we have eight investment partners managing about $2.5 billion in venture capital. Our current fund, which we announced earlier this year, is a $650 million fund. Our focus (as you might expect with our length of history), has varied over the years. During the last seven to eight years, we have focused exclusively on the IT industry. We focus, for example, on broad sectors, such as semiconductors and components; and on what we call systems, where hardware and software are combined.
We do a lot of work in the software arena, both in the infrastructure and application space. We also make investments in services, including companies that are providing advanced data services and VPN's. The last area of interest for our firm is consumer and Internet technologies: digital media, consumer Internet and the like.
In terms of our strategy, we are by and large early stage investors. We are fond of doing Series A and Series B deals. Occasionally, we will make later stage investments if we know someone, we know the company or one of our venture capital friends might introduce us. There are also special situations where we do leverage buyouts in areas that we have a lot of expertise or with smaller companies where we have synergy.
Milestone: Where does the 45-year staying power come from?
Haque: As a firm, we have built deep relationships over the years. It has been a good business; the returns have been strong, so raising money at any time in a cycle has not been an issue. We benefit from having been in business through multiple cycles: up, down, boom, and bust. That legacy is useful because it breeds a discipline that is instilled in us from one generation of partners to another. It results in not getting scared when the cycle is down, knowing what to do and what not to do.
Milestone: Based on that long view, what piece of advice do you give would-be entrepreneurs?
Haque: First, is to find balance by bringing people in that complement the skills of the founders. If the founders are all engineers, they need to find people who are skilled in marketing or sales, for instance.
I also tell entrepreneurs to sharpen their communication skills. They need to be able to articulate their vision; not just to investors, but also to employees and customers. You might have a good idea, but if you cannot communicate this idea to your key audiences, you are going to have a problem. Which gets us back to complementary skills among the founders.
It’s also the case that they need to understand their limitations, and to be willingly accountable to a board of directors. We’ve all seen the entrepreneur who is cocky and arrogant – the founder who does not want to listen to anyone. At the same time, though, they need to be focused and avoid jumping from one idea to another.
In terms of scaling up their business, it is important for them to realize that they are going to have to enlarge the inner circle. A lot of times we see these founders or founder not wanting to share authority and power. They hire lieutenants, they hire senior guys but they don’t want to empower them, and they want to make all the decisions themselves. Usually that is the kiss of death when it comes to scaling the business.
Milestone: Do you see us cycling into another growth cycle? What will prevent us from making the mistakes of the past?
Haque: I think we are cycling into another growth phase. What we need to do when we enter it – or while we are in it – is to avoid the mistakes that were made in the past. And these mistakes were not made by entrepreneurs, but also by venture capitalists. Looking back at the last growth cycle, I think there’s plenty of blame to go around for the bust (and the boom) and the chaos that resulted. I think entrepreneurs are wiser (the ones that have been through the cycle, are at least).
One of the things, though, is capital efficiency has become pretty core, at least for now. A lot of VCs and entrepreneurs alike have realized that gone are the days when you can sell a half-baked company. Now, good companies with good exits, companies that have achieved a lot of traction, might sell for $200 million or so.
As a venture capitalist, if the good ones are selling for $200-$300 million, you can’t be in a situation where you only make one or two times your money. Our rule of thumb is that you should be able to get a company to cash flow break even, if it is a software company for about $25 million dollars worth of capital—inception to cash flow break even. If you are a hardware company or systems company, you may need a bit more—probably $35 million.
This as well as globalization make capital efficiency a pretty big deal, especially here in the Valley where costs are fairly high. This has led to a lot of development work, not the initial architectural work, but some of the development work going offshore to cheaper cost centers. That is why you see a lot of interest in terms of outsourcing to places such as India, Eastern Europe, and China.
I think what you are starting to see – even though we are entering into a growth phase and there is a lot of money available out there – are firms saying, ‘We know how bad things can get, so let’s manage this.’ There is more discipline today than what I believe existed in the 1998-1999 timeframe.
Milestone: You hear a lot of elevator pitches, how many do you think you hear a week?
Haque: We do hear a lot, though it’s difficult to put a number on it. We have eight investment partners and a few associates. We all hear at least two to three a day. We get emails from people, phone calls, voicemails and the like. We receive less actual business plans sometimes than years back. Most early pitches come through email, introductions from our network of contacts, or in hallway conversations.
Milestone: What would you hear from someone that would make you want to spend time with them? Is there any one thing, or is it situational?
Haque: To some extent it is situational, but there are three or four things that usually grab attention.
First, what is the credibility factor of the person pitching? Usually VC’s will ask about a person’s background to determine whether they have a frame of reference to validate some of these ideas. Obviously, if they are from the domain from which they plan to operate their new business, we are more interested because this is an informed, credible entrepreneur. They need to show that they understand the ‘pain point’ their solution is solving and how this compares to other solutions in the marketplace.
As I pointed out before, it often comes down to capital efficiency. If you ask them how much money it’s going to take to get to cash flow break even and where they are going to locate their workforce, those are usually pretty good indicators of whether they really understand the challenges of building a business.
So, there are four or five parameters we always look at when evaluating companies: Are they capital efficient? Is the technology unique? Is the market large enough? Have they validated this pain point or problem that they are trying to solve? Do they have enough potential customers to make a business?
Milestone: Let’s move to outsourcing. The strategy, of course, is to take costs out without sacrificing quality. How does someone look at the quality side of that, is there a benchmark? Is it regional, or structural?
Haque: Whether you outsource or not, quality consciousness has to be first in mind, especially for a VP of Engineering. The challenge with quality is this: it’s a process, a process that is disciplined, meticulous, and often considered to be ‘ho-hum’ type of work. The fact of the matter is that sharp, creative engineers, innovators if you will, don’t like doing work that requires them to check and re-check everything.
There is a school of thought – especially in software – that says it is more difficult to get high quality work out of so-called creative people. They’ll come up with a breakthrough idea, but when it comes to getting it ready for production, or time to make sure that the program has had the living daylights tested out of it, they’re not interested. It does not matter where they live, either here in the Silicon Valley, Bangalore or Europe. What you really have to do (this goes back to hiring the right kind of team) is have the right balance of skill sets in place.
Say you hire five sharp architects – the brightest and best people working for you. It doesn’t mean you’ll get a product out. And even if you do, it may not pass the quality test because these are people not turned on by quality. By definition you need a different set of skill sets in the company whether you are running it here or in Bangalore, China or Eastern Europe. And you need a process. It all comes down to understanding the mindset, the skill sets and the process involved.
Milestone: What about the outsourcing providers? What is going on in that business from your perspective if any and how do these folks needs to differentiate themselves?
Haque: There’s a sort of myth that has been established that outsourcing is a new thing. But companies, GE for instance, were doing this at least 20 years before Silicon Valley figured it out. Tech companies – Intel and IBM – set up offshore, not because of cost pressures, but because they needed to be close to their customers.
Remember, a lot of the big system integrators in India (Wipro and Infosys) started up to handle a fair amount of Y2K work. At that time there were two big agenda items on any CIO’s mind. One, in order to solve their Y2K problem they needed people to rewrite code written over 20 years ago, many in archaic languages like Cobol and Fortran. Second, the Internet was staring them in the face. The CEO is saying, “what are we going to do with this Internet, are we going to have an online channel?”
So guess what all the bright and creative engineers wanted to do here in the Valley? They had a choice between working on programs written in 1968, or working on Internet projects. The work that went overseas was Y2K related. The offshore engineers did an excellent job on Y2K, and obviously made a lot of money doing it. But they also became quite familiar with Corporate America and Corporate America became quite familiar with them.
Then came the recession in 2001. All of a sudden, revenues at US companies started going down. The way to respond is by reducing head count, and one of the first things cut back on was IT and engineering. But IT Directors and CIO’s had to keep their businesses running. All of a sudden they started to lean back and say, ‘Gosh, a lot of these guys from Wipro and Infosys and 20 other firms did a great job for me in Y2K. Maybe I can have them take care of my Peoplesoft implementation?’
You saw the growth of these companies during that timeframe. Mostly because larger companies, not the ones that already had experimented with outsourcing, but companies such as Oracle even IBM, Cisco, Juniper, Lucent, Nortel, saw the benefits of outsourcing.
What really drove this to the next level, which is where startups come in, is the use of outsourcing to achieve capital efficiency. I can still remember – it was in 2000 – when it dawned on us that an engineer in Bangalore can build a better product, at one-fifth the cost. One of our companies did that, a start up. At that time we were not even aware of the cost—we were doing it because we just wanted to hire more engineers and we couldn’t find enough of them. Then we learned about the whole capital efficiency factor, and now it is very much a part of any start-up’s strategy.
Serving start-ups is a new opportunity for offshore services companies. Companies like Wipro don’t cater that much to the needs of smaller companies. They want to do work for the Cisco’s, the Oracles and the IBM’s of the world.
If you are a $100M company and you want 50 people to do some product development work for you, chances are you are not going to get the attention of a Wipro. Persistent Systems, for example, now offers product development services to start-ups, as well as mid-tier and large companies.
Milestone: The way to differentiate then is to understand who is going to come looking and what their needs are going to be? They are heavily weighted around service and this goes back to the process. Is that right?
Haque: Exactly. For example if you are a smaller company, the way you compete with a larger company like Cisco or Oracle, is that you get the job done in six or nine months rather than take two years to design a new product. These companies have to do the same. These companies, like Persistent Systems, are going to be responsive to the needs of smaller companies. They need to be quicker; they need to be nimble and fast, just like smaller companies in the Valley compete with larger companies.
Milestone: Any thoughts on international trends, China, India? What is shaping up there?
Haque: There are two things happening. We have spent time in both China and India and, of course, are active in India on the investment side. I think when you look at China and India what you see are local economies growing at some pretty astounding rates, 9, 10, up to 12% per year. But remember, the base is small – 10% of $600 billion is still only $60 billion in annual growth. Now, if you have a trillion dollar economy, 5% growth is still pretty large in absolute numbers. So, while growth rates are important, they alone do not make a strong economy.
The story in these emerging markets is consumer Internet and wireless. Theses countries have large populations, and as these wireless devices and handsets continue to become cheaper, pretty large markets are emerging. There is a vibrant local investment market with businesses that cater to the needs of the local population. So, normal consumer Internet deals are doing well. We have invested in a few in India; we have looked at a few in China.
What about the local market beyond just consumer or mobile Internet? What about equipment for enterprises and businesses, hi-tech equipment? While that sector is growing nicely, it is still a small market. In spite of all we hear about India, only $500 million of IBM’s $80 billion in revenue comes from India. If you look at IT spending in general, and this includes a lot of different things beyond equipment and people, US spending is somewhere around $400 billion a year. In both China and India, it hovers around $20 billion.
The fact is that the technology markets are the U.S., Europe and Japan. It’s where the purchasing power is. If you are a startup that is going to sell advanced technology, let me tell you the markets are here. When I say the market, I am talking about technology products. Developing countries are tremendous consumers of steel and concrete, because they are building their infrastructures. Those are some pretty heavy duty, highly intensive, capital intensive businesses that get funded very differently, usually done by joint ventures between larger companies.
Milestone: Do you think the transition is complete from ASP over to software as a service? What are the market barriers you see right now?
Haque: I think SaaS is a pretty big deal because most businesses, especially small and medium ones, would rather buy on a monthly recurring basis without having to make up front capital expenses. This is unlikely the case for larger entities, such as IBM, Cisco, FedEx, Goldman Sachs, or Fidelity. These guys realize if they like something, they will keep it, and don’t want to pay lots of money for it over a long period of time. Larger companies have capital expenditure and budgets and are pretty savvy – they run their cost analyses and often find that they are better off to license. Medium enterprises are where the big market is for SaaS.
From a vendor perspective, SaaS is a bit of a dilemma. A start-up looks at this and says, ‘I am going to sell this customer a service, or whatever I am selling. I can only get $2000 a month versus getting $100,000 up front. I have some cash needs, I have some cash flow issues and capital constraints.’
It then comes down to the cost of customer acquisition. If the company needs to put a direct sales force together they look at the revenue stream and see only $2 thousand per month versus a $100,000 sale. They may need more capital over a four to six year period before they get to cash flow break even. Once that happens, though, they have a recurring revenue business, which tends to be more predictable in revenue flows.
Milestone: What about Web 2.0?
Haque: Obviously, Web 2.0 is all about collaboration and communities; it’s the way we live in general. I think Web 2.0 is real. The biggest concern I have with Web 2.0 is that there’s far too much money creating Web 2.0 companies and we may be setting up a repeat of the dot com cycle a few years back. Once you get too many people trying to do the same thing and not enough differentiation and then you sit there (3-4 years after you have sunk lots of money into a company) and say, ‘Gosh there are ten companies out there doing the same thing and I don’t know how to differentiate myself from the other nine and neither does the consumer. There are going to be some categories within Web 2.0 that get established. There are going to be early movers who will have an advantage, but you will also have a lot of "me too" kinds of companies that are going to struggle.
Milestone: VoIP? Where do you see that going?
Haque: VOIP is real; we actually have companies in this space, providing infrastructure not necessarily the service. I think what is happening in general on the Telco side is that the Telco business model is changing. What the Telco’s are starting to realize is that the needs of the customer are very different today than they were 10 years ago. Even though voice today is still a significant contributor to revenue, the Telco’s are discovering new sources of revenue in data services, or what is now called value-added services. These services are going to provide a higher revenue stream and a better margin than voice does today.
The Telco’s have to realize that voice is a commodity – everyone has it. If you look at rate cards today, whether it is voice or wireline, it’s so much cheaper today than it used to be five years ago and it is headed nowhere but down. So, new features that combine data services with voice become important. You are starting to see more than just VoIP come out in terms of advanced data services. You are seeing the cell phone becoming a pretty powerful device with more and more capabilities. Wireless is growing dramatically and value added services are growing very nicely and that is where all the margins are. I think we’ll see smaller companies, not lots of them, but select companies, created to provide some pretty innovative services. They’ll set the trend and either be acquired or become larger independent companies.
Milestone: Any deal you can think of, any regrets, any company you passed on?
Haque: One comes to mind. I would not say that we passed on it, but we just weren’t aggressive enough. And that is Juniper Networks. Maybe the valuation at that time scared us and we thought it didn’t make sense. When I looked at it, the valuation was up to $100 million. At that time, we had a company called Verio that was an early beta site for Juniper. Verio was a roll up of ISPs and eventually hosting, which we took public and then sold to NTT. We had caught wind of what Juniper was doing, but I remember inquiring and finding out that the valuation was $100 million and decided not to pursue it. Today, it’s worth $6-8 billion.
Promod Haque is managing partner at Norwest Venture Partners. He has been ranked as a top dealmaker on the annual Forbes Midas List for the past five years. In 2004, Forbes named him as the #1 venture capitalist based on performance over the last decade. In 2006, Promod was presented with a Global Leadership award from NASSCOM.
Promod focuses on investments in semiconductor and components, systems, software and services. He was an early investor and a board member of Cerent (acquired by Cisco), Siara Systems (acquired by Redback Networks), OnDisplay (acquired by Vignette), Winphoria Networks (acquired by Motorola) and Extreme Networks.
His current investments include AmberPoint, Cast Iron Systems, FireEye, Open-Silicon, Persistent Systems, Sonoa Systems, Veraz Networks, Veveo, Virtela Communications and Yipes Enterprise Services. Other notable investments and previous board seats include Tivoli Systems (acquired by IBM), Forte Software (acquired by Sun Microsystems), Kiva Software (acquired by Netscape), Information Advantage (acquired by Sterling Software), Arbortext (acquired by PTC), Resonext Communications (acquired by RF Micro Devices), Showcase (acquired by SPSS) and ZettaCom (acquired by IDT).
Prior to Norwest Venture Partners, Promod spent 18 years in various operational roles ranging from product development, marketing, Chief Operating Officer and Chief Executive Officer at various public and private companies - Siemens International, Thorn EMI, Emergent Technologies and Dimensional Medicine, Inc.
He received a bachelor of science in electrical engineering from the University of Delhi, India. He holds a Ph.D. in electrical engineering from Northwestern University and an MBA from Northwestern's Kellogg Graduate School of Management, where he serves on the advisory board.
|
