Replaying the "Greater Fool" theory 15 years later

From the “Heard on the Street” section of this morning’s Wall Street Journal:

Testing Silicon Valley’s Greater-Fool Strategy Lofty valuations for venture-backed companies like Uber and Snapchat depend on the stock-market off-ramp staying open
By JUSTIN LAHART
…
There are 65 venture-capital backed companies in the U.S. valued at $1 billion or more, by The Wall Street Journal and Dow Jones VentureSource’s latest count. That is more than half again as many of these so-called unicorns as a year ago.

Even by the standards of rapidly growing companies aiming to go public, they are hardly cheap. Uber tops the list with a valuation of $41.2 billion, and that looks like it is heading higher. … In second, at $16 billion, is Snapchat, which has only recently begun generating revenue. …

Overall, private valuations are about as high now as during the dot-com bubble, according to research firm Sand Hill Econometrics. One reason valuations are so lofty: In an era when generating outsize returns has been extremely difficult, big investors who previously would have tended to take a position in a company on its IPO are instead jumping into late private-funding rounds.
…
[T]he list of tech companies with deep pockets and a desire for acquisitions is pretty short, and the fit needs to be right. So for most big venture-backed companies an IPO is a likelier exit. But the public market’s ability to absorb those companies may be limited.

Sand Hill estimates the total value of U.S. venture-backed companies came to about $750 billion at the end of 2014. That is equal to 2.5% of the total market capitalization of U.S. public companies, according to Federal Reserve data. The only other time venture-backed companies were valued that highly relative to the stock market was in the second quarter of 2000, when the dot-com bubble began to rapidly deflate.

Indeed, one pin in that bubble was the flow of shares of speculative companies into the market. Until late 1999, the availability of dot-com shares was limited, with many held off the market by insiders subject to lockup agreements.

From November 1999 to April 2000, though, the amount of unlocked shares rose to $270 billion from $70 billion, as economists Eli Ofek and Matthew Richardson documented [in their 2003 Journal of Finance article]. This increased the float in dot-com companies to the point there weren’t enough investors willing to pay up for them.

This is interesting on two levels. First, the Web 2.0 stock bubble is now shaping up to burst like the one 15 years later. A crash in valuations will be bad for entrepreneurs seeking funding in the next 3-5 years. As my business plan students (at both KGI and UCI) could explain, potential exit valuations influence (if not determine) the valuation for even the earliest seed stage or Series A round.

However, this time the question is whether the bubble will burst before or after the companies go public. The VCs and investment bankers — as well as the founder and employees of these overvalued companies — would clearly prefer to IPO in hopes of finding a “greater fool.” The buyers of these frothy shares would be betting that they’re not the fool, but instead they can sell to one.

The “greater fool” theory is not new. While Wikipedia (that fount of all truth and wisdom) is not much help, Investopedia helpfully provides a definition for that term:

Greater Fool Theory

DEFINITION OF 'GREATER FOOL THEORY'
A theory that states it is possible to make money by buying securities, whether overvalued or not, and later selling them at a profit because there will always be someone (a bigger or greater fool) who is willing to pay the higher price.

INVESTOPEDIA EXPLAINS 'GREATER FOOL THEORY'
When acting in accordance with the greater fool theory, an investor buys questionable securities without any regard to their quality, but with the hope of quickly selling them off to another investor (the greater fool), who might also be hoping to flip them quickly. Unfortunately, speculative bubbles always burst eventually, leading to a rapid depreciation in share price due to the selloff.

As an entrepreneur, I always had trouble with this approach by other entrepreneurs — and even more so, by the financial professionals who prepare these stock offerings. I realize the stakes are high for the founders and investors holding this illiquid shares — particularly at the tail end of a surge in valuations — but doesn’t excuse succumbing to the corrupting influence of this pressure. Caveat emptor doesn’t isn’t enough to excuse offering shares with no financial basis for their valuation other than market mania.

A bird in the hand...

The morning paper reported that Snapchat CEO Evan Spiegel turned down an (all cash) purchase offer from Facebook for approximately $3 billion.

My Snapchat-addicted teenager was relieved, saying "that means we're probably not going to get ads". (I had to break it to her that ads are inevitable, no matter who owns the company).

There is an interesting comparison to other pre-revenue startups

• Snapchat, two years old, refused $3 billion offer from Facebook
• Instagram, two years old, $1 billion purchase in 2012 by Facebook
• YouTube, 18 months old, $1.65 billion purchase in 2006 by Google
• Pinterest, valued at $3.8 billion in last month’s VC round
• WhatsApp turned down $1 billion from Google in April, and one analyst Wednesday estimated its value at $11 billion (based on Twitter’s $24b market cap after last week’s IPO)

Obviously, these are exceptional exit opportunities, but still there are lessons for other firms considering the timing of their exit.

The New York Times suggests that its offer for Snapchat suggests desperation by Facebook:

Facebook’s Snapchat bid shows triple the desperation. The social network paid $1 billion for no-revenue Instagram a little over a year ago. Now, it’s said to be dangling as much as $3 billion to lure a mobile app that sends self-destructing digital images. Facebook’s apparently escalating need to buy off marauders at its moat suggests its defenses may be scalable.

Coming just months before its initial public offering, Facebook had obvious reasons to buy Instagram. Consumers were spending more time on mobile devices, instead of desktop computers. This was listed as a “risk factor” in its prospectus for its initial public offering as the social network still hadn’t figured out how to make money on mobile advertising. More important, it faced the risk that users might migrate to a rival optimized for smartphone usage.
…

Snapchat has similarly astounding growth. In September, its users were sending 350 million photos a day, up from 200 million in June. …

Still, there’s a disquieting element about a company spending billions for a simple application it could almost certainly have replicated for next to nothing. Facebook’s acknowledgment that teenagers are using its service less on a daily basis may signify the social network is losing its edge among the ranks of new technology adapters. That it is also now willing to shell out $3 billion to snuff out a rival in its infancy brings with it a whiff of desperation.

Writing on Sunday, Blogger Ben Evans asked where Facebook should draw the line:

Is FB going to buy Whatsapp, Snapchat, Line, Kakao and the next ten that emerge as well? Sure, some of those will disappear, but it doesn't look like FB will crush the competitors the way it did on the desktop. On mobile, FB will be just one of many.

From the standpoint of the entrepreneurs, Business Insider reports on those claiming that Instagram sold too early and too cheap:

Now, 18 months later, industry people are starting to believe that [CEO Kevin] Systrom was wrong to accept that deal. They believe that if Instagram had stayed an independent company, it could be worth between $5 billion and $15 billion today.

This morning, activist investor Eric Jackson tweeted: "Systrom has to be feeling like he totally missed this wave. Instagram likely worth $15B today minimum." Jackson told us he came up with that valuation figure by looking at Instagram's total active users, about 150 million, and Twitter's, around 236 million. Assuming that Instagram's user base is more U.S.-weighted, and therefore more valuable, he figures Instagram's market cap as an independent company would be at least half of Twitter's $30 billion.

To me, this is the question of the value of a bird in the hand. Instagram’s continuing success is not guaranteed. Like any stock, the value could go down, not up. (NB: Digg, MySpace, AOL). Since they’re pre-revenue (let alone having positive cash flow), no one has any idea what these companies will be worth.

It seems unlikely that Spiegel (or Systrom) will have another comparable exit opportunity. If (as Wikipedia says) Systrom owned 40% of Instagram, 40% of $5b-1b is $1.6b (pretax) left on the table. For the founders, it’s the difference between never having to work again, and having enough pocket cash to change the world, whether by buying/selling companies or eradicating malaria.

Mark Zuckerberg refused a Yahoo purchase offer and delayed his IPO, and now is #20 on the list of US billionaires with a worth of $19 billion, the richest American under 40 years old. Timing is everything: Zuckerberg is worth far more than the widow of Steve Jobs, who accomplished far more over a longer period (but IPO’d early and sold his Apple founder’s shares in the 1980s).

Key employees with stock options will be similarly conflicted. With another 5x rise in valuation, some may never work again. On the other hand, some have enough money to buy a house (even in Los Angeles) today, and they won’t if the company never concludes a successful exit. The more sophisticated realize they, too, may not have another opportunity: a childhood friend had stock options from seven Silicon Valley companies, and none ever produced a sizable ($100K+) return.

The existence of a Chinese VC valuing Snapchat at $4b is giving Spiegel a concrete reason to turn down the Facebook offer. Still, new capital is not liquidity. Also, as Tech Crunch notes for Pinterest, the ever-increasing valuation may make it impossible late investors to profit from acquisition — making the exit IPO or nothing.

So does turning down a $3 billion exit mean a $10 or $15 billion one? Or a $500 million one? Spiegel isn’t panicking, but instead is leaving all his chip on the roulette wheel for one more spin.

Buy, don't start a company

In doing research for my first (journal) article on 3D printing, I found an interesting article that suggests young entrepreneurs should consider buying a small growth business rather than start one from scratch.

The story (from the October 28 dead tree edition of Forbes) is about Stanford alumnus Rob Cherun and a course he took that changed his career goals from McKinsey consultant to one-man LBO artist:

Cherun’s inspiration was a little-known but increasingly popular course at Stanford called “Strategy 543: Entrepreneurial Acquisition.” This second-year elective is a fast-paced, two-week primer on how to become a one-person version of KKR or Blackstone Group, carrying out your own tiny takeover and installing yourself as chief executive officer. …

Every year second-year Stanford students like Cherun stampede into S-543 to learn the essentials of raising money, finding an acquisition target and closing the deal. Instructors Peter Kelly and David Dodson–two longtime entrepreneurs and investors themselves–take only 40 students per session, and that doesn’t come close to satisfying demand. Months before this autumn’s class began, every slot was claimed, and another 26 students hovered on the waiting list. Frustrated aspirants will get a second shot in the spring, thanks to a new scheduling expansion.

Columnist George Anders cites a study of “search funds” that concluded that the occasional home run (100:1 return) produces a pretax IRR of 34%, even allowing for a 50% failure rate.

In Cherun’s case, money was the easy part: after four Stanford instructors ponied up, Cherun and a partner raised more than $500k for their search and a promises of equity funding for an actual deal.

The entrepreneurs bought 90% of a Canadian company that monitors construction sites for thefts. The 35-year-old founder remained as a minority partner and got to spend more time with his wife and kids without having to travel across the country. The new owners have doubled revenues to $10m (loonies?) annually.

However, these Stanford students face a sizable opportunity cost. In almost the same issue, Forbes proclaimed Stanford the “best” US business school, based on the difference between pre-MBA salary ($80k) and post-MBA ($221k) salaries that (net of tuition and lost wages) left them on average $100k richer after five years. The generous salaries for the elite graduates of the Stanford class of 2008 were aided by placements at Apple, Google and the top consulting firms (Bain, BCG, McKinsey); these were 5 of the 6 employers most preferred by MBA students (#4 on the list is Amazon).

Three other schools (Chicago, Harvard, Wharton) also had $200k post-graduation salaries. My undergrad school, MIT, ranked 12th -- just ahead of UCLA, Berkeley and Virginia; my grad school, UCI, ranked #62 (up from #69 in the last ranking).

It takes great confidence to walk away from the certain cash to run a small company. (Stanford students are nothing if not confident.) The risk is probably lower if (as in Cherun’s case) the company has a track record and (as recommended by Stanford) can be bought for 6x EBITDA.

Except for the last point, this looks like a win-win, providing a liquidity opportunity for entrepreneurs who can’t take the company to the next level. Still, having a residual equity stake (and a meaningful management role) makes it a lot more attractive for founders who might have trouble letting go of their baby.

Zipcar: it's hard to create a stand-alone business

Zipcar sold itself Wednesday to Avis for a half a billion dollars. While that's a hefty premium over final close last week, Dennis Berman of the Wall Street Journal notes that it’s only about half of what the company was worth two years ago at its IPO. The company has $55 million in cumulative losses, but was unable to cost-effectively acquire new customers.

With its greater scale, scope and buying power, Avis hopes to succeed where Zipcar failed. Avis-Budget-Zipcar will be competing with the two other major rental car conglomerates, Hertz-Dollar-Thrifty and Enterprise-National-Alamo-Vanguard-Tilden.

In other words, while Zipcar invented a new business model, it didn’t invent a new industry. It was a failure for public investors and as a stand-alone company. Even several of its venture investors — whether seeking a bigger pop or perhaps having some shred of ethics — hung in with the public investors, hoping for a turnaround that never came.

I think this is symptomatic of a larger problem, which is the difficulty in creating new stand-alone companies that will last. Facebook (and Amazon and Google) will survive, but will LinkedIn and Twitter and Yahoo?

Dan Henninger in the WSJ this morning suggests that the hostile business climate of the past four years is contributing to the problem, but my sense is that it’s hurting low margin businesses — ones that have little margin to spare when faced with higher taxes or regulation. I suspect that the high margin home-run companies work whether the top personal and Subchapter S marginal tax rate is 35% of 2012, 41% in 2013 or 54% now in California).

Instead, I think the issue is whether firms can create new industries, like personal computers, networking, e-commerce, Internet services, social media, biotechnology and the like. The PC and Internet services seemed to catch the incumbents sleeping, and the nature of the e-commerce transformation is overwhelming the incumbent industry more quickly than it could have imagined.

However, Google is meeting the social media challenge more quickly and vigorously than most incumbents. Meanwhile, the long lead times (and huge risks and capital requirements) of the pharma industry have made it difficult for new biotechnology companies to enter without competing with existing biotech or finding Big Pharma is now demanding a high price for access to its channel.

Overall, exit by acquisition rather than IPO is the norm — one more data point that the go-go 1990s were an aberration. Even for companies that do IPO, many of them (like Zipcar) will find their real growth in the bowels of a large, bureaucratic, cash-flow positive enterprise.

Selling out without "selling out"

In June, I heard Panos Desyllas present a conference talk (which I then blogged) on how UK biotech startups got killed after they were acquired. Today, his co-author Marcela Miozzo of Manchester Business School presented the paper here at KGI to a student audience.

To recap, the authors concluded that the acquired firm could be complementary or competing on two dimensions: technology and capabilities. If the firm is complementary on both dimensions, the odds are good it will survive; if they are competing on both dimensions, the odds are the company’s assets will be stripped and everyone “made redundant” (as they say in England).

One question I asked today was: did the entrepreneurs see this coming? Marcela made it sound like they didn’t explicitly look for this, but it sounded like they tended to be surprised.

In particular, she said the scientists were shocked or disappointed to find that their research wouldn’t be continued, and their prospective cure for a particular condition (e.g. Hepatitis) would die with the company. I think this is an area where human health research is different from other technical entrepreneurship — both the central role of scientists, but more particularly the idea of saving lives (or not, if corporate imperatives intervene).

It might be nice to say that the entrepreneurs should know better — that selling their company to certain firms would cause it to be killed — and thus when they exit, they should avoid "selling out." However, as Marcela noted, the entrepreneurs "knew that there were only 4 or 5 companies in the world that could acquire them.”

So in this constrained optimization of exit strategy — in many cases, for startup firms that have to be sold soon before they run out of money — such buy-and-kill outcome may be unavoidable. Perhaps the only bright spot is if the entrepreneurial climate is fertile enough that (in a Schumpeterian sense) the remnants of the former company can be recombined to make a new startup.

IPOs dying again

I got an email from one of my former students this week who works with startup companies trying to IPO:

It's a brutal market out there! … Many companies were looking to go public in late Q3/early Q4, however, the continued demise of the stock market has many folks running from the idea of an IPO.

Her remarks brought home a nasty side-effect of this month’s stock collapse. And sure enough, MarketWatch and USA Today later reported that at least 8 announced IPOs have been deferred due to “current market conditions.”

PWC (as reported by Business Insider) notes that 2011 was shaping up to be a much better year for IPOs than 2010. Now that trend is in doubt.

As I’ve been saying for years, I think entrepreneurs should look at it the other way: the normal exit will be by acquisition, because only during certain rare (and frothy or bubble-y) periods will an IPO be available. Perhaps the IPO window will open again, but (as has been true since the dot-com crash) the opening will only be temporary.

The problem of being acquired

(Cross posted to the Bio Business blog.)

At #IndustryStudies2011 this week in Pittsburgh, I heard an interesting talk about what happens to biotech startups after they are acquired. Panos Desyllas of the University of Manchester presented his study (with two Manchester co-authors) of UK biotech firms acquired 2006-2010 by non-UK companies.

The team studied in depth six acquisitions, interviewing executives from both sides of each transaction and also analyzing five years of trailing patent data. They also traced what happened to the key scientists after the merger by noting their affiliations in subsequent patents.

From this data, they came up with a simple (but useful) 2x2 typology: are the two firms similar in technology and are they similar in capabilities?

The firms might be exploring different technological frontiers. Or the acquired firm might have something that the acquirer does not — or vice versa — whether it be UK marketing by the acquired firm or global marketing by the acquirer. The (plausible) intuition is that complementary acquisition is more likely to create ongoing value than a more directly competing one.

The typology worked as predicted. In the case of acquisitions where both the technology and capabilities overlapped, the buyer closed the acquired company, keeping only an IP expert or two as a temporary consultant to transfer the tacit knowledge.

In discussion during and after the session, we discussed the case where the buyer bought a rival with the sole purpose of killing it. This happens all the time, and in some ways it seems like a special case with an utterly predictable outcome.

The other case I brought up was when the acquisition starts out as being complementary — but the acquired firm gets killed anyway.

In April, Cisco killed the Flip camera line that it bought for $590 million in 2009. Pure Digital founder Jonathan Kaplan was sorry to see Cisco knife his baby rather than put it up for adoption, particularly when it remained profitable.

The other example (from the life sciences industry) was Biogen Idec, billed in 2003 as a merger of equals between two biotech startups, Boston-based Biogen and San Diego-based Idec Pharmaceuticals. However, the failed merger brought the closure of the former Idec operations in San Diego last November, and the layoff of some 300 employees (including a close personal friend).

During Desyllas’ session, we discussed whether the closure was a good thing or a bad thing for the local economy. In true Schumpeterian fashion, the creative destruction makes available skilled talent to the local economy for other ventures. On the other hand, some off the displaced workers may never have a similar opportunity again.

But in the end, we agreed that the pattern proved a familiar point: companies get sold when the owners want to sell — usually when they want liquidity for an illiquid investment. Whether the founder (such as Kaplan) or the venture investors, once the company is sold all bets are off.

Cleantech entrepreneurs: life without VC?

Cross-posted to Cleantech Business.

Statistics released Friday by the Cleantech Group say that “cleantech” VC investments in 2010 hit a record $7.8 billion, up 28% from the $6.1 billion in 2009 for North America, Europe and Chindia. The N.A. data was even more impressive, up 45% to $5.28 billion. Worldwide, solar continued to account for the largest share of the investments, up 52% from 2009 to $1.83 billion.

Although this sounds encouraging, Iris Kuo of VentureBeat had a different take. First, cleantech VC investment has been declining for the past two quarters. Instead, the capital-intensive have been going to government sources, including BrightSource, Solyndra and Tesla.

However, analysts are just beginning to realize that cleantech businesses may be fundamentally unsuitable for VC investment. A series of clues have emerged in the past 6 months.

Exhibit A was the whole debate started by VC Fred Wilson and his “two venture capital industries” thesis:

The first VC industry is investing in software based businesses. The software VC business has been fundamentally altered by the massive decrease in the cost of building and launching a software based business.…

The second VC industry is investing in cleantech, biotech and other capital intensive tech businesses that have economic models that have not been fundamentally altered. This VC industry operates largely the same way it has operated for the past twenty or thirty years.

The statistics were supported by TechCrunch data from the first 8 months of 2010: an average of $5m for web/ecommerce vs. $31m for cleantech.

Exhibit B was the decision of Kleiner Perkins to pull back from cleantech investing and go back to its roots in IT. Of all the major Silicon Valley VCs, KPCB had made the most aggressive bet on cleantech — particularly green energy. This is the firm that in 2007 made a partner out of a former presidential candidate and Nobel Prize winner.

Exhibit C are the observations of one of the most respected IT industry executives, analysts, inventor and entrepreneurs: Bob Metcalfe (MIT ’69), inventor of Ethernet and founder of 3Com. Having finished a decade as a venture general partner, last month Metcalfe said that the VC model (so far) does not fit cleantech:

Q: What did you learn from your investing in clean-tech, or as you call it, enertech?

A: I’m still in the process of learning – this is complicated stuff. But I learned that the innovation environment in the energy space is not there yet. The problems we see are a mismatch between the asset class called venture capital and the innovation opportunities in energy – it takes too much capital and it takes too much time. But I claim that’s only because the innovation environment in energy hasn’t developed, say, the way it has in pharma. Drugs take a lot of money and a long time, but there’s a lot of venture capital activity in drug discovery. That’s because the drug-discovery business has grown into being able to exploit the venture capital model. The partnerships that big pharma has with drug companies in stage one, stage two, stage three [clinical trials] allow venture capitalists to do what they do and get the returns that they need. The energy space has not quite developed, but it will.

This entire debate was anticipated by Prof. Martin Kenney of UC Davis, the editor of Understanding Silicon Valley — perhaps the leading academic expert on Silicon Valley and a longtime expert on hightech VC.

In July 2009, Kenney wrote a book chapter entitled “Venture Capital Investment in the Greentech Industries: A Provocative Essay” that will be published in the Handbook of Research on Energy Entrepreneurship. He notes a number of warning signs:

1. investors have been pouring money into green energy without being able to get it back from IPOs;
2. market growth may be slow, since “clean” technologies are competing with established (and cheaper or better) incumbents;
3. the cleantech bubble investing bubble parallels the Internet bubble;
4. thus far, the most successful cleantech businesses have been self-funded: either bootstrapped (e.g. Danish wind turbines) or internal green ventures from existing multinationals like Siemens and Sanyo.

Kenney tries to offer a positive scenario, suggesting that VCs could learn and adapt like they have in biotech. However, in the past 18 months have been signs that biotech VC may be facing similar problems (if the returns to pharma R&D are becoming less certain).

While the scale of investment in energy is enormous, the VCs have various reasons to actually favor larger deals (and often pension funds throwing money at them to invest). While VC worked great during the 1990s with relatively small investments followed by quick exits via IPO or acquisition, but both are much harder in renewable energy.

The first problem is the time scale. If (as Zider’s 1998 classic HBR article suggests) VCs seek a 10x liquidity event after 5 years (to cover their losers), then doubling the delay to 10 years cuts the IRR by more than half (and the NPV even more than that). For a 10 year exit — and ignoring the increased risk of failure — the same IRR would require a 100x return.

The other problem is that the size of the investment reduces (if not eliminates) the opportunity to exit via acquisition. A 10x return via acquisition was common for $50m dot-com investments, but such exits are going to be much rarer with $500m invested; a 100x return is going to be out of the question.

If VC can’t find a way to make money off cleantech investments, then cleantech entrepreneurs are going to have a hard time bringing their businesses to scale. Without VC, new businesses will have a hard time competing with self-funded multinational incumbents — or government-funded enterprises in large centrally-planned economies.

Flipping is not a business model

I’m getting ready to grade the final projects for my tech strategy MBA class. One of the projects is about a Web 2.0 company seeking a business model — a common problem.

Near the end of the presentation, one slide summarized the revenue model options:

1. keyword advertising
2. promotional services
3. freemium
4. sell the company

With the last point, I hit the roof. (Figuratively — I tried to be patient with students no matter what they say.) This is wrong, wrong, wrong!.

Sure, it’s wrong conceptually, theoretically, legally. Getting an investment is not the same as generating income.

But it’s also wrong from a business standpoint. Yes, the founders and VCs get what they want — but the founders have failed to solve the fundamental problem of their business.

Perhaps someday Google will be able to monetize the $1.7 billion they paid for YouTube; there are certainly going to be cases where the acquiring company has economies of scope (or distribution channels or negotiating leverage) to pull off business models that wouldn’t work for a stand-alone company.

But for every YouTube, there’s a MySpace (bought by Fox), Bebo (AOL), or Skype (eBay).

On the one hand, it’s hard for stand-alone tech companies to get established and compete against diversified and integrated tech giants — whether Apple, Cisco or Nokia. On the other hand, the idea that entrepreneurs should seek an exit prior to creating something of lasting value is part of the “born to flip” mentality that was briefly in vogue during the past decade.

So I think there are a few students in one MBA course at one university who are getting the message. Let’s hope that others do, too.

Timing is everything

Over the weekend, Apple bought music streaming company Lala for an unspecified price. The most authoritative report comes from blogger/reporter Peter Kafka:

Apple ended up paying around $80 million for the company, according to multiple sources. That’s less than half what investors valued the company at in 2008, but it’s more than the $35 million the company raised throughout its life. Which means that some investors could get their money back and more.

But not all of Lala’s investors. Warner Music Group (WMG), for one, ended up getting back about half the $20 million it put into Lala, I’ve confirmed with people familiar the company.

This account and others make it clear that Lala is being purchased for the knowledge of its staff and its technology. One thing it never did was create a viable revenue model, despite multiple iterations and support from both VCs and record labels.

This seems to be a common problem in Web 2.0 startups. The Dot-Com II era has not been creating viable stand-alone companies, but instead technology sandboxes that have to be bailed out by a good fit to a rich incumbent. In this case, Lala’s service nicely complements the market-leading iTunes. But relying on acquisition for exit has always been a small-numbers problem, particularly when the big boys have gobbled up your competitors (leaving you without a dance partner).

As it was, it sounds like the Lala investors (or founders) got a little greedy. Kafka notes that the investors thought the company was worth $200m at its peak. It‘s not clear if there was a willing buyer that was turned away. But if the owners were holding out for more, they clearly gambled big and lost big. As Charlie Jackson used to tell me, “I’d rather be lucky than good” — an admonishment that timing is everything.

Instead, timing is against the entire categlry. A lot of people thought digital technologies would transform the music industry, and thus garnered piles of VC in hopes of realizing that vision. As Kafka notes, the track record is not great:

The last big exit for a digital music company happened way back in the spring of 2007, when CBS (CBS) paid $280 million for Last.fm. But no one has gotten anything close to that for digital music since then. Imeem is being sold for spare parts, and News Corp. also bought iLike at a steep discount. Spiralfrog filed for Chapter 11 after burning through its cash.

Still, somehow Pandora raised another $35 million. Between the economy, the capital markets, the cratering of its sector and its similar lack of a business model, the wildly popular service with innovative technology has been darn lucky to survive multiple brushes with death. If I were CEO, I’d be looking to negotiate any exit ASAP.

Update Wednesday 9am: Other estimates put Lala's purchase price at $17 million — and a net price of $3m after allowing for cash on hand. Meanwhile, MySpace bought another music service with $24m of VC for “less than $1 million” according to various accounts.

Killing a business

Friday’s paper brought news of the planned liquidation of the Smith & Hawken, the premium garden store founded in 1979 in Marin County. Although I’ve never visited one of their stores, it was nonetheless sad news, because the company provided important inspiration for my early days as a tech entrepreneur.

When we founded our company in July 1987, my partner Neil Rhodes and I were intentionally (and ultimately unsuccessfully) emulating Hewlett & Packard. Like Bill & Dave, we started in a garage, and we deliberately emulated certain elements of the HP culture (which also became our biggest customer).

However, it was Smith & Hawken that provided explicit validation for some of our ideas about what a business was and could be. A year after we launched, in 1988 we read Paul Hawken’s Growing a Business; this was decades before the two comparable HP histories, The HP Way and Biil & Dave.

In his book, Hawken talked about issues that resonated closely with us, things like how to treat employees and the meaning of business. Although it’s been 20 years since I opened the book, I recall his view as being that creating and growing a business was more than just about money, and that founders could and should shape the firm to reflect what they believed important.

Although his industry was very different, this was a view quite consonant with tech startups of the 1980s, back when people tried to build a business for the long haul and before IBM and HP layoffs changed forever the idea that somehow tech companies were different.

Perhaps Smith and Hawken weren’t different, either. Hawken used the success of the book and the company to branch out into other things, leaving the company in 1992, which was then sold in 1993 for $15 million to the parent of NordicTrack. Some of the experiments by the founders (losses on an unsuccessful clothing line) were seen as contributing to the company’s need to be acquired

Since 1993, Smith & Hawken has had three corporate parents. The last owner was Scotts Miracle-Gro, which bought the company in 2004 and has been unable to find a buyer for the firm. Some of the turnaround moves sounded plausible, but nothing worked.

The two founders showed none of the remorse one might expect of a parent outliving its child:

"Scotts couldn't have been a worse corporate owner," said Hawken, who lives in Mill Valley. "Smith & Hawken had become just a ghost of itself."

[David] Smith, who lives in Mendocino County and owns Mulligan Books in Ukiah, said he had gone so far as to ask friends not to shop there.

"When Scotts bought it and Smith & Hawken was owned by the largest pesticide seller in the U.S., I suggested people boycott it," he said. "It had completely lost its roots."
…
Hawken, chairman and CEO of engineering company Pax Group, used the occasion of the closing to host a party Wednesday night. "I couldn't be happier to see my name come down," he said.

What’s the moral of the story? Perhaps that nothing lives forever. Certainly that (as my mentor Charlie Jackson advised me 15+ years ago) once you sell a company, you have to let go and accept what happens. Also, people change — even visionary founders — and their passions will also change.

Most of all, I think it says that even with a unique business concept and vision, firms need to have the management depth and the dispersed leadership and the culture to continue on after their founder is gone. This is certainly a crucial issue for Apple to deal with, more than a decade after Steve Jobs undid the terrible damage done by his three CEO predecessors, and nearly five years after his initial cancer surgery.

VCs vs. entrepreneurs

To be successful, any sort of business deal must align conflicting interests. In thinking about venture capital, the decision of entrepreneurs to seek (and accept) VC investments assumes that both parties want the company to succeed, and the only conflict is over the terms of the investment (particularly the dilution).

However, a couple of recent blog posts highlight a second, equally important category of conflicting interests: control over the timing of exit.

On AngelBlog, Basil Peters recounts an example of a tech startup with a chance to exit via acquisition, one that would produce a 3x return for VCs, and perhaps 10x for the angels and 100x for entrepreneurs. The problem is that the VC needs a bigger return (the home run) from its winners to cover its losers. This is consistent with the story of VC investment math told by Bob Zider a decade ago in his HBR article, “How Venture Capital Works.”

Of course, such an early offer may mark a peak in the company’s valuation — in an increasingly competitive segment (as in the Peters example), the total return will only go down. Once faced with an obviously worsening situation — whether firm-specific problems or an increasingly unprofitable industry — VC are known to pull the plug prematurely, saving management attention for the likely winners rather than spending more time salvaging a “dog.” In my SD Telecom study, we had to interview one founder in the final few days before the VCs closed the door forever.

The other point is that, come hell or high water, the VCs will liquidate their investment before their investment fund matures and must return capital (and earnings) to its principals. As VCs freely admit, this means they seek a quick exit — ideally 3-5 years, with 7 years at the outside. Blogger Sigurd Rinde of Germany notes the disconnect between achieving VC objectives, and the goal of many tech entrepreneurs of creating long-term value.

I had a slow growth, bootstrap startup, which never sought (nor was suitable) for VC. This had its pluses and minuses, but it’s clear (as I used to say back then) that taking VC is like starting a time bomb: you have to come up with an answer before it goes off, or you’re dead.