PRINT THIS PAGE Internet investing: the same, but different
30/01/2008. Source:IVCJ (Israel Venture Capital & Private Equity Journal). Jonathan Saacks, Gil Dibner, Genesis Partners
In many respects, venture capital investing in internet companies is no different from investing in other sectors. But there are definite differences too. In this IVCJ article, Jonathan Saacks, partner, and Gil Dibner, principal, at Genesis Partners explain. On the surface, Internet investing is not significantly different from investing in any other market. We at Genesis Partners look for the same combination of factors in an Internet company – a large, attractive market, barriers to entry, skilled management, the potential to be global leaders – as we do in any other company. Just like in other sectors, deal selection is the single most important factor in VC performance, and we choose to invest in companies that have the potential to be global leaders in large markets and that we believe can achieve large exits. As in every other area of VC investment, risk and uncertainty levels are high, since not all investments will convert into significant exits.
There are some ways in which Internet VC investments differ from those in other technology areas, and we’ll try to highlight some of them here. Our focus in this article is consumer-oriented Internet businesses.
Business models. The Internet is a very efficient platform for delivering services to people, and that is what makes it such an interesting space for VC investors. Internet companies have the opportunity to scale revenues rapidly by distributing their applications to large numbers of users at very low marginal cost.
Consumer-oriented Internet businesses usually fall into one of three categories: commerce, media or platform. A commerce play (such as eBay, Amazon or Expedia) delivers a product or service directly to the consumer in exchange for cash payment.
A media play (such as Yahoo, Facebook, Metacafe and Yedda) delivers application services, entertainment or both to consumers and generates revenue from advertising or referral fees. The media model has existed for years in the offline world and is now well established online as well.
A platform model provides software infrastructure that helps power media or commerce. Eyeblaster, for example, provides advertising infrastructure. Zlio provides infrastructure for usergenerated commerce sites. Dapper provides infrastructure for the exchange of content between sites.
Some companies span one or more of these categories. Google’s search function, mapping function and YouTube division are media plays in that they create real estate. Google AdSense (like Yahoo’s Overture) is media infrastructure because it helps other sites monetize their real estate. Google Checkout is commerce infrastructure. Both VCs and entrepreneurs must have a clear sense of what model they are pursuing and what it takes to win in that particular business.
Technology. Technological considerations should play a role in Internet investing, but the meaning of "technology" is perhaps somewhat different. Internet platform plays are typically easier for VCs to swallow because they tend to depend on proprietary technology in the traditional sense of software, algorithms and databases. In addition, platform companies typically have goto- market strategies driven by agreements with eco-system partners. These companies often benefit from barriers to entry to some degree. Internet media investments, however, are particularly challenging to assess because they depend on a different type of technology – the technology of user experience and user interface. Online advertising models are well established, and, consequently, there is no doubt that significant Web traffic can be converted into meaningful revenues. The challenge, however, is that attracting, engaging and retaining users is more of an art than a science. The skills required to do so consistently and effectively are tied to understanding human behavior, human psychology and user interface design more so than they are to traditional technological ability. Some media plays, such as Yedda, depend on significant proprietary software technology on the backend that can confer some barriers to entry. But any media company, in order to succeed, must master another type of technology – the technology of architecting a compelling user experience. A typical mistake is to confuse "technologies" such as RSS and tagging for business models. Whether a business is powered by RSS or by simple HTML (or by paper and ink for that matter), a media business is still a media business, and engaging users is the paramount challenge.
Team. At Genesis Partners, we believe that perhaps the single most important factor in the success of a start-up is the strength of the founding team, and this holds true in the Internet space as well. In addition to management skill and technological excellence, an Internet team must bring with it a certain intangible ability to understand the unique dynamics of users and partners. Entrepreneurs who live and breathe by the rules of the Web are more likely to succeed.
Capital Needs. One of the most interesting aspects of Internet investing is the question of capital needs. The proliferation of open-source software, advanced APIs from partners, more efficient programming languages and skilled Web developers means than Internet applications can be authored much faster and at a lower cost than ever before. At the same time, viral models, new distribution platforms (Facebook, Myspace, Google Gadgets) and the growth of the blogosphere mean that distribution for successful Internet applications can often be achieved at very low cost. This has led some VCs to believe that Internet investing can be done on the cheap. Reality, however, is more subtle. At early stages, Internet investments can sometimes require less capital than investments in other areas, such as semiconductors, systems or medical devices. In addition, initial evidence of market traction can be achieved at a similarly low cost. Meaningful growth beyond that phase can often require significant capital for continued development and marketing. The challenge is to keep cash-burn (and investment levels) down until solid evidence of traction emerges and then to decide if raising the cash-burn level is justified by the size of the opportunity.
The acquisitions of Del.icio.us and Flickr by Yahoo are good examples of high-profile but relatively small exits. Larger, more successful Internet companies often require higher levels of expansion capital. Facebook, which has yet to exit but is no doubt a successful company, has raised $37 million. MySpace, which was acquired for $580 million, raised over $65 million. Skype, acquired for $4 billion, raised over $18 million. At Genesis Partners, our strategy is to find opportunities where we can deploy relatively small amounts of capital until traction and/or technology can be demonstrated, but we are ready to make the big bets required to reach the large exits we are seeking.
Evidence of Traction. As in any other sector, VCs must monitor their Internet investments to understand how well they are performing and to determine if further capital should be deployed in support of existing investments. With consumer-oriented Internet companies, however, this monitoring function is more complex. In certain cases, R&D success or the ability to achieve partnerships with leading players can be indicators that an investment is proceeding according to plan. Ultimately, however, VCs and entrepreneurs must look to user behavior to understand how well the business is performing. Our view is that user engagement is more important than absolute numbers of users or page-views, at least in the early stages. We want to see that users who discover a Web site or Web application continue to return and use the application week after week and month after month. It is also critical to start to assess the company’s ability to convert traffic into revenues. We want to see that the typical lifetime value of an individual user is above the average acquisition cost for a given user. Internet companies have a tendency to generate volumes of data about user behavior, but VCs and entrepreneurs must be very careful with how they use and interpret that data. Does the data really show that users are engaged by the application and returning? Or does the data show that users are coming to the Web site in droves, but never returning? VCs must also be patient. It can take time – and a lot of trial and error – for a company to discover the "magic formula" for attracting and retaining users. User interface design is a tricky business, and growth can often appear flat for months as a company continues to experiment and refine its user experience.
Exit Scenarios. Investors should have a clear-headed approach to thinking about exit scenarios for any investment, particularly an Internet investment. Today, we are clearly in a period of somewhat inflated expectations and irrational exuberance regarding Internet businesses. This can clearly be seen in the overall level of VC investment in the space and the types of models that are being funded. The public markets and the M&A environment, however, are a bit more rational.
The corporate development groups at major Internet acquirers, such as Google and Yahoo, have a very rational approach to M&A. They make acquisitions for a combination of four reasons: team, technology, revenue and strategic value.
First, companies can be acquired for their team. Talent is increasingly hard to find, and large companies are often willing to pay several million dollars to add a team of highly talented people to their payroll. This is certainly part of the justification for the acquisitions of Flickr and Del.icio.us.
Second, Internet companies can be acquired for technology. In these cases, the acquirer typically analyzes how much it would cost to build the technology internally and will not pay significantly more than this price. For Internet companies that are light on technology, this exit option typically does not exist. For others, it can lead to an exit in the $5-$40 million range.
The third type of Internet exit is based on revenues. In this case, an Internet company is acquired because it is generating a consistent revenue stream that would be accretive to the acquirer. There are, however, few Internet companies that can achieve revenue levels that are high enough to attract the interest of a major player.
Finally, and most importantly for the VC model, Internet companies can be acquired because they are of deep fundamental strategic value. This is true of all of the major Internet acquisitions in the past few years: Skype, MySpace, YouTube, Last.Fm, Shopping.com, etc. This is the primary type of scenario that should interest a VC investor – and it typically stems from a combination of factors: a large user base, a powerful brand, a secure place in the overall Internet eco-system, and effective (if not unique) technology on the backend. All of these things are hard to achieve, hard to replicate and generate significant value.
At the end of the day, the Internet is not fundamentally different from other areas of VC investment. It is high risk, but it offers the potential for high returns. It is difficult to argue that the Internet is more risky than any other segment in technology today. The Internet does, however, bring with it a unique set of challenges and opportunities. And VCs that clearly understand the unique aspects of Internet investing are best positioned to succeed in this growing and promising market.
This article first appeared in the Israel Venture Capital & Private Equity Journal (IVCJ). IVC Research Center publishes the Israel Venture Capital & Private Equity Journal, a quarterly review of trends and developments in the Israeli-related venture capital industry. IVCJ, distributed worldwide, is dedicated to provide wide-range coverage of Israel's venture capital industry. For more information please visit www.ivc-online.com
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