Milestone Group Quarterly: October 2008
Articles
Investment Viewpoint:
Michael Kim, Partner, Rustic Canyon Partners
Milestone: Tell us about Rustic Canyon Partners.
Kim: Rustic Canyon is an early stage venture investment firm. We have offices in Santa Monica, Redwood Shores and a presence in Seattle. We started at the end of 1999 with a first fund of $500 million. In 2003, we raised a $185 million fund, which is now fully invested. We’re investing currently from our third fund, which is approximately $200 million. Typically, we invest in the first or second institutional round. Our average pre-money has been in the $8 million range, and our typical ownership at the time of investment has been in the 22 percent range. We like to invest anywhere from $2-5 million initially, and in the range of $8-12 million over the life of an investment. We either lead or co-lead, and we have specific areas of interest that play to the strength of our partnership.
These specific areas of interest are: consumer Internet & digital media, clean technology, business process outsourcing, information services, wireless & wireline broadband. We are not active in healthcare, biomedical, or biotech, and we don’t really focus on companies where we don’t have a strong domain expertise. I have six other partners, and most of them came from the media world.
We have multiple partners working on each portfolio company in order to bring a large set of experience to bear. We are proactive in working at the board level and on a one-to-one basis with the CEO. And, we use our networks to help our companies, whether in building management teams advisors, customers or partnerships. I think our strategic advice and perspectives on partnerships and acquisition strategy add a unique dimension to the type of discussions we have with our portfolio CEOs.
Milestone: How does all of this show up for a company you invest in?
Kim: We are thesis-driven in our investment approach. While media is a particular strength, our effort in clean technology is a good example of this approach. In 2001, we took an interest in clean technology and renewable energy, and brought on a partner, Lee Bailey, to examine the space. He helped start what became US Renewables Group – a separate investment partnership focused on cash flow-based project financing opportunities in renewable energy. They have approximately 20 investment professionals in Los Angeles and New York, and have raised two funds totaling $575 million. Because of this relationship, we think we have a unique source of deal flow in clean technology, as well as deep resources for diligence.
Milestone: You’ve been an investment banker, and now you are an early stage VC. How do those roles intersect for you?
Kim: The intersections come from the ability to assess market opportunities, the defensible competitive advantages and a strong business model that generates cash. Investment bankers want clients who are growing rapidly and have a large market that they can address. A large and addressable market gives you the opportunity to maneuver. The ability to identify the specific competitive advantages of a company within their market is, obviously, an important skill in both worlds. Finally, having a business model that generates extraordinary large cash margins allows you to have pricing strength as well as the ability to face competition. If a company is going to go public or be acquired, they need the ability to generate cash flow with strong growth prospects. Investment bankers get that. That is a very important dimension in the venture world, as well.
Over the last couple of years we've seen private companies with very strong growth in their user metrics, particularly in the consumer Internet space, but without commensurate growth in monetization. They have been accorded some remarkable valuations but I think we are in a different world now, particularly with an emphasis on cash generation.
Milestone: We are talking about innovation in this issue of the Milestone Group Quarterly. What would you say is the story with innovation today?
Kim: Well, I think the United States, and Silicon Valley in particular, has created an environment where innovation is rewarded. That’s not often found elsewhere, especially without government support. We have a virtuous cycle of educational institutions, private companies and public companies fueling innovation. I think it’s paramount that the United States, through different public policy efforts in education or the tax code, enable and encourage innovation.
The ability to create and to innovate is something that the US really must safeguard and enhance. One of the competitive strengths of the United States is an ability to innovate and generate intellectual property for competitive advantage. If you look at China and India, competitive advantage occurs on a different basis—largely based on lower cost—the cost of software developers of the cost of manufacturing.
Today, innovation is as strong as ever it was. The areas that are most promising are actually in the clean technology space. With clean technology, human resources and capital are deployed in order to come up with a new way of providing energy more efficiently and to reduce the impact of traditional energy sources. I think a lot of those companies will fail, but the fundamental building blocks arising out of optical, semiconductor and material sciences will remain and they will allow true innovation in clean technology, which obviously benefits the entire world.
Milestone: Among your portfolio set, is there a representative company which is responding to those innovation imperatives?
Kim: Sure, I can talk about two of them. In the building material space, Serious Materials has developed a way of producing drywall in a significantly more efficient manner. Approximately 1 percent of electricity used for industrial production in the United States is used to make drywall. Serious Materials’ production method reduces the energy required by almost 10 times than traditional methods.
Another example is Transonic Combustion, which is working on a new type of fuel injection, with the objective of a 100 mile per gallon combustion engine. The technology is early stage, and hasn’t been deployed commercially, but the progress is there.
Milestone: Thinking about clean tech, as we see investment dollars flowing over the next several months, will we see it more in that direction? Will it be at the expense of other investment types?
Kim: Over the past several years there has been a significant increase in funding for clean technology by the venture community. Certainly, that has been at the expense of traditional industries, particularly optical and semiconductor. From the human resource perspective, a number of people these more traditional industries have moved into under the clean technology rubric. Those are skill sets which I think are applicable to clean technology. While you could argue that traditional industries have seen venture capital dollars flow towards clean technology, you can also see that the technologists are rather flexible in how they apply their domain expertise.
Going forward, I think that it will remain that way because the potential market opportunity appears to be very large. But, these opportunities require vast sums of capital. In a world where capital may not be as readily available, we'll see a number of clean technologies fail because they are unable to raise follow-on capital.
Milestone: Looking at the broad technology market, what are the future events others should be thinking about, events that may lead to significant disruption in industries or markets?
Kim: Today, the driving force in the technology market is demographics. In countries like China or India, large segments of their population have become highly educated and working in technology, creating new wealth. I think that demographic change creates significant new opportunities; not necessarily in technology, but for all business and enterprises.
In terms of Silicon Valley, it’s clear that there has been a large and welcome influx of technologists from countries like China and India. This has only enhanced the market here for innovation and the ability for US-based companies to create new technology.
But as the world’s population increases, the sheer number of people is a major driving force in technology. For example, in China they had very little cell phone users almost ten years ago. Now, it’s the largest market for mobile phones, where I think there are now over 350 million mobile subscribers in China, which is larger than the population of the United States.
Milestone: Thinking about your experience with entrepreneurs, what's the general advice you'd give them when they are about to approach you with?
Kim: Venture capitalists look at a potential investment along three dimensions. Probably the most important is the management team. The management team is such an important element of a successful company. A management team doesn’t necessarily mean the best pedigree, but rather being flexible, being able to react to the market, and being able to execute rapid changes to their plan. Does the management team work well together and have the intangible quality of being proactive--being able to create its own opportunities?
The other two dimensions are ones I mentioned earlier--is there a large market opportunity with a large revenue opportunity and gives them room to operate, and does the company itself have competitive advantages that allow it to generate above average cash margins. In the world today, the ability to generate cash is critical.
Milestone: We always ask this question -- is there a deal you have passed on that you now wish you had a do-over on?
Kim: Yes. There is a company that’s based in China called Oak Pacific Interactive. They have a property called Xiaonei, which is the equivalent of Facebook in China. We had the opportunity to take an early look at it because one of the co-founders works at Rustic Canyon, but because we don’t typically invest internationally, we reacted more slowly than normal. Earlier this year they closed at $400 million around the financing and a $1 billion valuation. We didn’t pass on it, we just didn’t move fast enough because we had issues about the geography. It was an opportunity that we could have gotten into, and I regret that we didn’t.
Michael Kim joined Rustic Canyon from Accelerator Venture Partners, a San Francisco-based partnership investing in early-stage technology companies (including two companies that went public: Evolve Software and Shopping.com). Formerly an investment banker, Michael was with Morgan Stanley's Technology Merger & Acquisitions Group in Menlo Park. While there, he was directly involved with 27 announced transactions worth over $77 billion. Prior to joining Morgan Stanley, Michael was an associate at The Chase Manhattan Bank in New York City and also worked at IBM in Armonk, NY. He graduated with honors from Cornell University, received an M.S. from Georgetown University's School of Foreign Service and received an M.B.A. from the Wharton School of Business.
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