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Pay for Performance
That suits businesses just fine. With a high cost of capital, the market is hungry for performance and metrics. What you measure, you can pay. What you deliver, you can better. Head-hunters make fees when the head is on the plate, not for hunting in a jungle where the game is plenty. While IT spending remains low, companies in the TMT industries face a simple message: Deliver or Die.
One of the first industries to be hit in the downturn was the online advertising one. Not surprisingly, it’s been one of the first to emerge revamped. As CPM rates plummeted and the market punished banner servers 24/7 Real Media, Inc. and Double Click Inc., a new generation of companies surfaced to set a recession-busting trend for online advertising. Taking a cue from the sales world, they modified the online ad model into a pay-per-click one, whereby advertisers paid when their links or banners were clicked upon rather than served. These firms identified their customers as the advertisers rather than owners of websites the ads occupied. In doing so, they made online advertising more accountable to advertisers willing to pay for clicks valued somewhere between an audited ad and a sales lead. The results are now clear. While top online media property AOL Time Warner, Inc.’s online ad revenue is expected to drop 35% to $1.55 billion this year, the U.S. pay-per-click leader Overture Inc.’s revenue in the first quarter of 2003 alone rose 200% to $143 million. Google, with its sponsored search service, is projecting $750 million in 2003 revenue. It is touted to be one of the biggest IPOs in the waiting. Starting bravely a full six months after NASDAQ peaked, Espotting began Europe's first such service. Unlike U.S. companies, Espotting built its system to cater for multiple territories and languages. It can roll out a new territory footprint in fewer than eight weeks. That’s one reason it's Europe’s top player serving 10 countries with 15,000 advertisers. It’s also on track to generate $100 million in revenue this year. And did I mention - it’s profitable. All this amidst the worst slump in advertising history. As the shakedown moves upstream from advertising to telecoms to software to financiers, perhaps venture capitalists ought to retool their own model to a pay-for-performance one. The classic VC model is to take a 2.5 % management fee on the value of raised funds and a 20% carried interest from the upside created for its limited partners. That makes VCs more like fund managers than risk-taking venture enablers. Sure when there’s an exit, everyone might win. But the chances of a proper exit in most markets, never mind the current one, are slim. What are the incentives to build value along the way? I remain unconvinced by VCs who shrug when speaking about their underperforming portfolios and say, “market conditions.” The whole point is that as a VC you’re supposed to have an unfair advantage and do better than the market. If your success is tied to the market, then something is fundamentally wrong. Or you are simply, average. Venture Capital is a service industry. Yet it’s dominated by people who don’t want to believe that. They confuse their customer: the entrepreneur/ management team with their supplier of capital, the institutional fund. Walmart wouldn’t be Walmart if it confused its customers and suppliers. VCs should heed their call for “Success Fees Only” and apply it to themselves. They should have a base for subsistence and a commission for solving the pain-points of their portfolio. Instead, when London’s top three property leases are still held by private equity houses, it’s not difficult to see the fat in the system. The current VC model is becoming as obsolete as Anderson, Enron and the NASDAQ at 5,048.62. VCs could take a 1% management fee to cover overheads and a success fee each time they delivered value to their investments. For each investor they secured for their portfolio company, they could take a finance fee; for every talented individual they attracted, they’d earn a placement fee; and each time they delivered a customer account, they’d get a good old-fashioned sales commission. That would generate a healthy portfolio: the best ROI for the limited partners. And if they performed well, they might “earn” more than the 2.5% management fee. That’s what I’d call the next generation pay-for-performance VC. |
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© Ariadne Capital Ltd. 2003 |
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