Where Sand Hill Road Meets Wall Street

This weekend SuccessFactors announced its acquisition by SAP for $40/share in cash, valuing SuccessFactors at approximately $3.4 billion, and representing over a 50% premium to Friday’s closing stock price.  As one of SuccessFactors’ venture capital backers, my partners and I at GGV Capital are extremely proud of our association with Lars Dalgaard, CEO, Bruce Felt, CFO, Aaron Au, CTO, and the rest of the hardworking and talented crew at SuccessFactors.  Congratulations on a great outcome!
 
The announcement of this deal prompted me to recollect the SuccessFactors story.  There are a lot of great lessons here – Lars and his team did a tremendous number of things right.  Here are a few highlights for me:
 
1.       Culture is Key.  From day one, Lars built a culture of customer-focus and the “no jerk” rule.  Putting the customer first above all else gave all SuccessFactors employees a strong compass.  All decisions, large and small, were then executed up and down the employee ladder with this relentlessly in mind.  The no jerk rule held employees accountable and ensured that everyone worked together internally rather than undermining one another as happens so frequently.
 
2.       Great people can accomplish great things.  Over the years, Lars has been relentless in hiring the very best.  People work hard at SuccessFactors.  Those who execute under Lars find themselves with increasing responsibility.  Innovative thinking is prized.  But the “no jerk” rule is key.  The company also eats its own cooking – using its own software to appraise and manage employees.
 
3.       Serve your customers and your roadmap will become apparent.  One of the great benefits of SuccessFactors’ customer focus is that the company has happy customers who increasingly seek more from SuccessFactors’ products.  A majority of the company’s revenue now comes from applications conceived of and created after we invested in 2006.  This is amazing.  It’s as if the company built another company, larger than the original, while it was public.  That’s the key to long term growth.
 
4.       Manage expectations and stay focused on the ultimate goal.  From day one as a public company, Lars and his CFO, Bruce Felt, played a consistent and steady hand.  Even when the stock price slid to the mid single digits in late ’08 / early ’09 and investors panicked, Lars and Bruce continued to message their goals consistently to Wall Street.  No Hail Mary passes.  Rather, like Bill Belichick and the Patriots of the early 2000s, they just executed.  Fast forward to today, the company reported 4+ years of quarterly results on or ahead of guidance.  The net result – a $40/share deal with SAP.
 
In 2006, the year before SuccessFactors went public, the company did just over $30 million in revenue.  Fast forward, SuccessFactors was set to report about $100M in December ‘11 quarterly revenue, or a $400 million run rate.  More than 10x growth in 5 years.  Yes, Lars - truly remarkable!   It’s been a true honor to be a passenger on the journey.

My partners and I hosted our quarterly CEO dinner last night.  It was a great event.  The theme was mobile computing and our two speakers were Tom Conrad from Pandora and Satya Patel from Twitter.  Tom and Satya provided some great insights.  Thanks also to the 60 CEOs who attended and participated in the lively Q&A discussion as well. 

  Below are some of the key themes that emerged from the dinner:
 
1.       In the next 3-4 years, we will see more hybrid experiences on mobile devices: part mobile web-based and part native application.  For example, we may see search, the ultimate web-based application, driving application based results.  We will still be downloading apps but maybe these apps will render from the web to add flexibility – we’re already seeing lots of this in popular apps such Facebook and Twitter.

2.       Android phones will be the feature phones of the future.  Feature phones will get a lot smarter.

3.       With regard to competition, there are two fundamental truths in the consumer internet world: 1, consumers are lazy and, 2, any app that is used at scale has attained this scale by doing one thing really, really well.  It is hard for competitors in other businesses to compete with this focus.   Despite this, saying no is the hardest thing to do as a head product designer – being so focused can get boring, but knowing when to embrace the needs of subsets of your audience and when not to do so, is one of the keys to success.

4.       China will surpass the US as the number one mobile market in terms of application downloads and usage across iOS and Android by the middle of ’12 (courtesy of Flurry CEO, Simon Khalaf)

5.       The size, growth and enthusiasm of the Android user community outweighs the challenges of managing Android development and supporting the myriad combinations of Android builds, phones and carriers.
 
Thanks again to those who participated, and a special shout out of thanks to Tom and Satya for their enlightening comments.

As published in VentureBeat

High-value financings for venture-backed private internet and digital media companies seem to be happening at a rapid pace. Dropbox, Tumblr, AirBnB, Foursquare, and Spotify have all raked in big fundings and attained record valuations in recent months. Meanwhile, public investors are decidedly less sanguine. The Nasdaq Composite index is flat for the year – and the average internet and digital media company is down 50% from 52-week highs.

So why such a disconnect? Will the recent class of high-priced venture rounds produce strong results for entrepreneurs, VCs and LPs? Or, will the public market continue to bump along and provide little opportunity for spectacular exits?

Pondering this conundrum, I stumbled onto a very interesting graphic put together by Jose Cobos and his colleagues over at investment banking firm Cowen & Company.

As you can see from the chart, only six of the 116 publicly-traded internet companies are projected by analysts to achieve over 30% top-line growth in 2011 and 2012 and to achieve 2012 EBITDA margins of at least 30%. That means only 5% of the current crop of public internet companies are in the top echelon in terms of profitability and growth.

Let’s take a further look at these six companies: Baidu, Tencent, Yandex, Mail.ru, Qihoo 360 Technology, and MercadoLibre. What do these companies all have in common?  Most obviously, they all operate outside the U.S. Second, they are being richly rewarded by public investors – all six are presently valued at at least 10x revenue – a very meaningful premium over the group of internet and digital media companies as a whole, where median revenue multiples fall in the 1-3x range, depending on subset.

Relaxing the 30% EBITDA margin constraint, 12 more companies are projected to have at least 30% growth in 2011 and 2012, so the total number of “high-performing” public internet companies is 18. Scanning this group, you’ll see that most of the companies are still highly valued – LinkedIn, Zillow, and Youku, for example, all enjoy very high revenue multiples as well. But, the overall average revenue multiple is lower than the top tier.

Dropping even further, to the 44 companies projected to have at least 30% growth for 2011 alone, the valuation picture is far murkier, with several companies being valued much closer to the 1-3x revenue group median.

For CEOs of high-growth internet companies thinking about IPOs, this chart provides a very clear case for how to ensure success as a public company. The market will reward high growth (30% or more for several years into the future) coupled with high rates of profitability. If you can’t see a way to achieve both growth and profitability, you may not achieve a premium public valuation and should plan accordingly.

And remember, the most interesting common trait of the six companies in the top tier is that they’re non-US businesses based in China, Russia, and Latin America. Producing both growth and profitability is a time-tested winning strategy to attain high public market valuations. Lately, as several foreign economies have been on a rapid growth curve, a crop of non-U.S. startups has been particularly good at producing both. Perhaps U.S. entrepreneurs seeking high growth and high profits would do well to look outside the U.S. — expanding their businesses into high-growth markets.

For venture investors, this chart is also telling. Big fundings for companies that don’t show promise for delivering both high growth and significant profits may produce poor investment returns on the public market. As the chart says, it’s a long climb to the top – and very few internet companies will reach the peak. Unless the percent of companies able to summit goes up substantially over the next few years, many of today’s high-priced venture investments may falter when it’s time for the public to decide their value on the open market.

As published in VentureBeat:

Recent tech IPOs have been anything but predictable.

LinkedIn, which initially filed to price its IPO in the range of $32-$35 before ultimately pricing at $45 per share and is now trading over $100 per share, has rewarded IPO buyers. Meanwhile, Chinese social networking site Renren, which filed its IPO at $9-11 before pricing at $14 per share but is now trading at about $10 per share, has been a loser for buy-and-hold IPO buyers.

This kind of volatility begs the question, how good is Wall Street at predicting longer-term winners at the time of an IPO? Is a “hot IPO” – one that attracts huge investor interest and prices well above its initial filing range – a harbinger for strong stock returns over time?

It turns out Wall Street investors are not very good at predicting longer-term stock price performance at the time of an IPO – in fact, they’re terrible at it.

In the following chart provided by Morgan Stanley, all tech IPOs since 2004 above $30M have been plotted so that the x-axis shows the percent change from the mid-point of the initial filing range to the ultimate IPO price. Hot IPOs are on the right of the chart, while cold IPOs – those that price below the initial filing range mid-point – are, conversely, on the left. The y-axis then plots one-year stock price return from IPO price.

Source: Morgan Stanley

Amazingly, the chart reveals that there is absolutely no correlation between hot IPOs and one-year stock returns (nor cold IPOs and stock returns, for that matter).

Realizing this, all the focus lavished on hot IPOs by the press and the VC community seems misplaced. Remember also that existing investors typically don’t sell much, if any, of their stakes in IPOs and are usually “locked up” – prohibited from selling stock until 180 days after an IPO, making the IPO price even less important to venture investors.

Here are two theories for why IPO demand and longer-term stock price performance are so uncorrelated:

Limited history with public investors. By definition, IPOs represent the starting point of the relationship between a newly public company and public investors. Important factors for investors such as reliability and capability of management, market size and competitive dynamics are difficult to assess with no historical results to lean on, and opinions will vary wildly.

Information scarcity. The SEC forbids companies that have filed for IPOs to communicate publicly about the offering before it takes place. While the information available to prospective investors tends to be thorough, face-to-face time with management is limited during IPO roadshows, so even professional, institutional investors are challenged to put the available information into a usable context.

After several years of near-frozen equity markets, many entrepreneurs are understandably excited about the prospect of going public in the months to come. But knowing that a hot IPO has no impact on a company’s longer-term share price should allow the would-be public company leader to focus on what really matters in an IPO:

The IPO is a financing. My partners and I often remind CEOs considering taking their companies public that an IPO is a financing and not an exit. In that regard, while it might be nice to raise heaps of money via a hot IPO, a high IPO price puts the same pressure on a company as does a high-priced venture round – more expectations and less room for error. This is not to say a cold IPO is desirable, but CEOs who focus on building their IPO syndicate with investors they believe understand the story and are in it for the long term are doing themselves a big favor.

Confidence in the next few years. Too often we see company leaders excited about pursuing an IPO based on strong confidence in the next one or two quarters. This is setting the bar too low; companies should go public only when they’re confident they can deliver on a longer-term growth plan. If a CEO lacks visibility on how to grow the business over the next 2-3 years, the company is not ready to go public.

So what does a hot IPO mean? Hot IPOs may get more press coverage initially, but the data clearly shows that a hot IPO offers no guarantee of future success as a public company. Management teams and investors alike will do better to focus more on the longer-term opportunity. Then, maybe we’ll begin to see more correlation between IPOs and long-term stock performance.

Last night, my partners at GGV Capital and I hosted our Q2 CEO Dinner in SF.  We had a great group of 30 CEOs join us.  Keith Rabois, Bruce Felt and Ted Wang also did a great job as panelists discussing the financing, M&A and IPO landscape.  I’ve outlined some of the compelling insights that came from the lively discussion among Keith, Bruce, Ted and the CEOs in attendance below.  Thanks to all who attended and joined the conversation.

1. Don’t go public until you’re ready.  Being ready isn’t about knowing what next quarter is going to look like.  Rather, its about understanding the outlook for the next few years.
2. Once you’re ready, go public. Most of the commonly voiced concerns over being public are overblown, and the positives of being public outweigh the negatives. (See more from Keith Rabois on the real reasons companies don’t go public and my former blog on the $100M revenue myth.)
3. In terms of hiring, think of three general criteria - values, cultural fit and skill set.  Never compromise on values.  If someone has great skills, especially if they’re unique, you can consider compromising on personality/culture, especially if its employee number 150 vs employee number 15.
4. Secondary sales as part of up round venture financings are here to stay.  Expect it to become very common for a small portion of secondary to adjoin financing rounds for companies where values are going up.
5. Liquidity for existing employees can create problems however.  If people are only in it for the money, they’re probably not the right employees.
6. Take care of your employees.  It can’t all be about the monetary compensation.  Showing them you care can really help with morale and add momentum to recruiting.
7. If you’re going to sell your company, be prepared to see your product trajectory flatten or even stagnate.
8. If you’re going to sell your company, go for the highest price.  Price will always come down once an LOI is signed.
9. Don’t hide the challenges you’re having when in an M&A or financing discussion.
10. The best companies are disciplined enough to focus on what is important, not on what is urgent.  Recruiting in particular is key to a company’s success, but it reduces efficiency in the short run.  You have to be ready for this and stay focused on prioritizing building out a great team.

Much has been made of the recent Groupon S-1 filing.  Many recent thought leaders, worried by the accounting losses and concerned by the scant detail available, warn investors to stay away.  Some of the more thoughtful pieces from folks like Jeff Bussgang (Flybridge Capital) that analyze various subscriber/merchant ratios or the UK Guardian claims that the valuation is just not rational are worth a read.   I’ve seen fewer votes of confidence – but many believe the awe-inspiring growth and market leading position Groupon has taken are reasons to build a position in Groupon, regardless of IPO and aftermarket pricing.  For example, Reed Hoffman and James Slavet make a compelling case for why Greylock invested in the company and a recent blog post from Steve Cheney makes the case for why Groupon is worth $25 billion.

So who is right?

The best way I know to answer this question is to dust off the history books.  After all, Spanish philosopher George Santayana preached: “those who cannot remember the past are condemned to repeat it.”  That is highly apropos in the financial markets, where history often repeats itself.  

 Groupon is an online consumer service.  Groupon spends money to acquire users.  Then it markets to those users and makes money when they buy groupons.  Simple.  Groupon is unique as a consumer service, however, in that it is (1) growing REALLY fast, and (2) it is posting huge accounting losses.   Two other online consumer services who were also growing really fast and losing money at their IPOs within the past 10 years are Netflix and Vonage. 

Netflix, the popular video delivery service, IPO’d in 2002.  At that time, the company was growing its top line by approximately 100% and was losing money.  The stock debuted at approximately $7.50 on a split adjusted basis, representing a $300M market valuation.  Today, Netflix shares trade hands at over $270, representing a $14Bn market valuation.

Vonage, the VOIP residential phone service, IPO’d in 2006.  Similar to Netflix and Groupon, at the time of the IPO, the company was growing its top line by over 100% and was showing large accounting losses.  The stock debuted at $17, representing approximately a $3Bn market valuation.  Today, Vonage shares trade hands between $4 - $5, representing a $1Bn market valuation.

Why has Netflix been a rocket ship while Vonage has been a falling knife?  In my opinion it pretty simply comes down to the fact that Netflix has shown it can continue to acquire lots of new customers at an attractive price relative to the lifetime value of those customers.  Conversely, Vonage had trouble showing it could acquire enough customers to continue to grow rapidly relative to the lifetime value of those customers. 

So will Groupon take after Netflix or Vonage? 

The Case for a Netflix-type Rocketship:

• Very Strong Initial Returns on Marketing Spend.  Groupon reveals in its S-1 that the cohort of subscribers it acquired in Q2 ’10 for $18M has already produced $62M of gross profit through Q1 ’11.  This is fantastic ROI.  It looks as if Groupon’s cost to acquire an active user is trickling up, but as long as these users continue to transact at similar rates to past cohorts, Groupon is planting seeds for years of strong financial returns.

•  Positive Free Cash Flow.  Groupon is showing huge accounting losses, but even as it is spending huge on marketing campaigns, the company is actually generating Free cash flow (cash from operations less capital expenditures).  Groupon collects cash up front when people purchase groupons, but remits to merchants much later.  Hence, the company is actually putting cash on the balance sheet.  This is a big deal – it should help finance growth for the future.  Interestingly, Netflix also was generating cash from operating at its IPO (it had big non-cash expenses, amortizing its DVD library).  Vonage, on the other hand, was burning cash hand over fist.

•  Great Brand & Large Market.  Groupon has quickly become a household brand and the number and breadth of merchants eager to use groupon campaigns is awesome. 

The Case for a Vonage-style Flameout:

•  Decaying Lifetime Value of a Subscriber.  The little cohort and local market data Groupon offers in its S-1 might lead one to conclude that subscriber value is decaying over time.  If this is true, Groupon’s future prosperity is at risk.  Any investor will need to watch these metrics closely.

•   Competition Drives Subscriber Cost Up & Gross Margins Down.  There are several other well capitalized players aiming at Groupon.  From Living Social to Facebook and Google, the competition to acquire subscribers could drive costs up, similar to what happened to Vonage with the cable company, national and local phone providers.  Also, merchants may be able to drive better economics, driving down Groupon’s gross margins.  This would cause the cost of future subscriber cohorts to rise while their lifetime value declines.  Groupon may have to opt to grow much more slowly in that case to reach profitability, as Vonage has done. 

And the winner is…

I think the smart money is with Groupon following in the footsteps of Netflix.  Yes, there will be intense competition and the economics of their business may deteriorate slightly over time.  But, as a category leader in a large market with rapid growth, great subscriber economics and positive free cash flow, the comparison to Netflix seems the right one.  Either way, though, this one will be fun to watch as its handed off from Sand Hill Road (Chicago style) to Wall Street!

Although there have been many huge venture capital returns in the past, one of the great little secrets in technology investing land has been that, for the best companies, more value is created post IPO, rather than pre IPO. As an example, an investment in Cisco at its 1990 IPO price or in Microsoft at its 1986 IPO price would be worth approximately 300x today, even at their currently depressed stock prices. The clear message here – if you pick the real winners, you can make more money investing at the IPO (or even afterward) versus investing when a company is private in one of the venture capital rounds.   I like to call this, “Public Venture Capital.”

The recent rise of the private market secondary share exchanges has helped inspire rapid increases in valuations of the newest private company highfliers such as Facebook, Zynga, Groupon and Twitter.   Shares in each of these companies are trading on private markets at prices that bestow valuations well into the multiple billions.  What does this mean?  Will this trend mark the end of Public Venture Capital opportunities?

A very interesting recent TechCrunch post by William Quigley of Clearstone Venture Partners, “The Next 10 Years Will Be Great For Both Founders and VCs,” argues that the rise in private company valuations will continue, ushering in the what Quigley calls the “real golden age” of venture capital.  He also argues that great returns in Public Venture Capital are gone, and the only way to participate in great wealth creation in this and future tech cycles is to be a “founder, an early employee  or a private investor.”  In fact, Quigley believes that upwards of 50-75% of the terminal values of the best companies will be captured by the folks who did the real work – the founders, employees and private investors.  Quigley’s chart helps summarize his argument.  

While I agree with Quigley that more value is being created pre-IPO in companies like Facebook, I don’t think Public Venture Capital is dead.  Quite the contrary.  Great companies tend to create value at a rapid rate for a long period of time.  Some great companies choose to go public earlier in this value creation curve, and some choose to go public later, such as Facebook.  As proof, Apple has created over 3 times as much value as Facebook since Facebook was founded.  True, Facebook’s growth has been phenomenal, but Apple’s growth has been no less awe inspiring, and public investors in Apple would no doubt argue that Public Venture Capital is alive and well. 

Quigley argues that the next 10 years will be great for founders and VCs.  I agree.  But, I don’t believe this will be because great public returns will die in favor of value being captured when companies are private.  For founders, employees and investors alike, the trick was, is and will always be to hold shares in great companies.  Companies with great management teams that grow fast, operate in very large markets and have competitive advantages that enable the delivery of high margins.  In these great companies, the reward of a high stock price is far more certain than the timing, whether captured privately, at IPO or long after an IPO is completed, of the gain.

A Silicon Alley Insider graphic recently making its way around the Twittersphere caught my attention and deserves a mention. 

It’s a really simple depiction that in my opinion helps further disprove the Myth of the $100M Revenue Milestone I’ve already discussed.  Recall that the $100M Revenue Myth is the oft-quoted maxim that companies need to be on a $100M revenue run rate and be profitable for at least two quarters before going public. 

This chart shows clearly that unprofitable IPOs have actually outperformed profitable IPOs through the first two years of being public. 

How can this be? 

From what I’ve seen, unprofitable companies that have successful IPOs typically capture investor interest based on rapid growth rates and perceived large market opportunities.  Recall that “Underlying Growth & Market Size” is one of the Fab Four.   Although this chart doesn’t incorporate growth rate as an additional dimension, I’d be willing to bet that growth rate correlates much more closely with stock price performance post-IPO. 

Interestingly, the unprofitable curve plummets between 2 and 3 years post IPO.  At some point, investor patience will run out.  Ultimately, public investors expect profits.  Fast growth in a large market is great, but eventually you’ve got to deliver earnings as a public company.  How long do you have?   This chart makes a good case for 2 years.

Dan Primack also tackled this issue recently,noting that in 2011, profitable venture backed IPOs have performed better than unprofitable ones. 

So, the data is mixed.  But, the bell has sounded clearly – unprofitable companies can have successful IPOs.

As a junior banker at Goldman Sachs in the early ‘90s I was weaned on the conventional wisdom that growth companies were ready to go public when they reached the $100M annualized revenue figure (ie, a $25M quarter) and had at least 2 quarters of profitability under their belts.  The “$100M Revenue” theory was based on the idea that a company must be large enough to both (i) withstand competitive pressures and (ii) earn a large enough market capitalization (or market value) to enable the company to sell enough stock to institutional buyers in its IPO without suffering massive dilution in the process. 

This theory makes no sense and, despite the fact that many bankers and VCs still cling to it like religion, there are multiple counter examples debunking the theory. 

In fact, in my opinion there are four factors that far more important when gauging IPO readiness and the likelihood of success than the “$100M Revenue” theory:

• Predictability & Visibility.  If your business is $50M in revenue but you know with high precision what next quarter, or even next year, is going to look like, you pass the test.  On the other hand, even if your business is $200M in revenue, if you can’t reliably predict what is around the corner, watch out.

• Underlying Growth & Market Size.  When CEOs fall into the trap of sketching out for me their plan to ascend to $100M in revenue to “get out” in an IPO, I always ask them the following: “what is your plan to get to $300M in revenue?”  The IPO is not an end game.  A better analogy – the IPO is the second half.  You need to ratchet up your game and be ready.  If you’re growing fast and have a large market in front of you, $300M or more will seem like a breeze and public investors will reward you.  If, on the other hand, you eke out growth to $100M in a small market and go IPO, don’t expect to have a fun run as a public company.

•  Competition.  Strong competition is fine, but the market will most always reward the market leader with a disproportionate share of the market value of a sector.  This is especially true if the leader can show that its extending the lead.  If you have fierce competitors who subject your future to undue risk (ie, a less predictable future), watch out. 

• Management Team.  Time and again, highly skilled teams show more ability to have successful IPOs than poorer teams.  Strong communicators with big visions who don’t surprise negatively, manage expectations well and deliver.  That’s what you need to be successful.  Motherhood and apple pie.

So there you have it, an alternative set of requirements to the $100M Revenue Milestone.  Lets call them the Fab Four.   Hint - look for references to the Fab Four in upcoming posts!