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Recently, most of Europe
's technology-oriented venture capital leaders gathered
in Athens along with their U.S. and Asian counterparts
and the heads of top global technology companies at
the European Technology Roundtable Exhibition (ETRE).
The year's most successful
European venture-backed exit, Skype, was most likely
a hot topic of discussion, with its co-founder and
CEO Niklas Zennstrom making a keynote.
Stop Press. European
VCs should be discussing Europe 's most successful
exit? Correction – European VCs should be discussing
Silicon Valley 's most successful exit.
The reason for the rectification
is quite simple. It was the Draper juggernaut under
Tim Draper and Howard Hartenbaum that made Skype a
phenomenal VC investment. This was classic venture
investing that's made Silicon Valley the mecca of
venture capital today.
This is not to take away
the critical participation of European VC firms like
Danny Rimer's Index Ventures and Mark Tluszcz's Mangrove
Capital Partners or a pivotal role we played at Ariadne
Capital in its early days. But I also give credit
where it's due – if it weren't for all-singing and
dancing Tim Draper who put Skype's intrinsic disruptive
technology on steroids, Skype would have been a “nice,
interesting – and small - European company proving
that it make early, if only small, profit.”
When I first met Niklas
Zennstrom on Day 2 of his arrival in London in the
fall of 2003 following an introduction by Howard,
we discussed the self-defeating process of most European
VC analysis.
The calculation they
made followed a method similar to the two highlighted
below:
- Calculate a value
for the company today based on a 5-year discounted
cash flow analysis with a 25% discount rate. Do
a Net Present Value and Terminal Value calculation
and see if you can get the IRR on an investment
our Fund promised to our LPs ; or
- Rate the company from
1-5 for each of the following: management team,
market opportunity, technology robustness, defensibility
and intellectual property, sales and growth strategy,
profit horizon, etc. If it gets a median score above
3.5, take another look at it.
There's nothing inherently
wrong with either analysis – but they remain a sub-set
of what's required to evaluate an early stage deal
for its true future value. If early-stage technology
investments were so predictable for their returns,
they would be an asset class indeed.
In “Beyond the J-Curve,”
Thomas Meyer and Pierre-Yves Mathonet state that an
asset class is a group of investments where they have
similar risk and return but are different from those
of other asset classes. Skype failed the narrow tests
indicated above used by most European VCs. Its P2P
technology was deemed not robust enough and the founders'
Kazaa past was seen negatively. And they questioned
whether it would ever make money. Yet, Niklas's (and
co-founder Janus Friis's) return to investors has
been way out of the league of all early stage 2003
investments worldwide.
Skype is a thunderous
reminder to European VCs of the beta value of VC returns
when compared with a basket of European VC investments.
The historic share price of UK VC firm 3i's public
stock perhaps serves as the best benchmark against
which to measure a European venture investment return.
Be my guest, go ahead and do a calculation!
The reminder here --
it's time for us to be in the Venture business, not
just the Fund management business.
European VCs might want
to sit down and analyse why it took a Silicon Valley
VC to spot and deliver on that opportunity in their
own backyard.
A few European VCs did
have a chance to see Skype in its embryonic form.
Their decision not to invest came down to a fundamentally
different approach to investing. In contrast to Niklas's
experience in Europe , his dealings with Silicon Valley
VCs (and those with offices in Europe such as Accel
and Benchmark) were remarkably different.
They generally follow
three logically inductive phases of thinking:
Phase I of Thinking
Does the company have
a simple, easy-to-use product that can be easily adopted
by consumers? Can this product be marketed directly
to consumers so that its channel to market is not
dependent on clunky corporates? Does the product fulfil
a basic modern human need that users get excited about
and tell others about and therefore, create a “viral”
effect? If the technical, product development and
market strategy are executed well such that it achieves
scale and mass adoption, can it make lots of money
through “economies of scale” once a “purchase price/revenue-profit
model” switch is flicked on?
An introduction by me
between Niklas and Sabeer Bhatia, an investor in Ariadne
Capital and another example of an entrepreneur backed
by the Draper juggernaut and vision of “viral marketing”
leading to its Hotmail success, led to a fascinating
meeting between Sabeer, Niklas and myself in the spring
of 2004. While the contents of that conversation remain
confidential, it confirmed that Niklas had gotten
the right investor DNA on board.
Phase II of Thinking
What's the cost of carrying
the company until the point that the “switch is flicked
on?” Do we, i.e. the VC, have the pockets to support
it, the vision to encourage it and the networks to
propagate it? Will the company's product be so disruptive
that its true value might be a calculation of money
saved at the bottom line for doing the same utility
using today's technology rather than just money made
at the top line at some point in the future?
I can hear Niklas's voice
telling me how Tim pushed them toward viral adoption
and minutes of voice traffic rather than a false economy
of early profit.
Phase III of
Thinking
Do we, i.e. the VC, have
the networks among decision makers in large acquisitive
corporations that will value the company by calculating
how its own cost of building the start-up's new product,
acquiring its customer base, scale, reach (particularly
in new markets and demographs), traffic and brand
will vastly outweigh the price of purchasing the start-up
today. And that upon acquiring the start-up, can it
flick on its own “much bigger switch” (i.e. revenue
model) and see a much greater generation of revenue
and profit? That's the trade-sale argument to be made
and won. And that will give a start-up today a multi-billion
valuation tomorrow rather than just one worth tens
of millions.
The proof of that lies
in the spectacular $2.5 billion-$4.1 billion exit
of Skype to eBay.
Many European VCs like
to believe that they do operate and “think” this way.
Evidence suggests otherwise. Not counting U.S. VC
firms in Europe , very few actually do. Maisy Ng of
Add Partners, Ajay Chowdhury of IDG Ventures and Richard
Irving of Pond Ventures come to mind, among others
such as Index and Mangrove.
In Skype's case, European
VCs did bring value. Index brought in a critical Cisco
relationship and Mangrove did critical early due diligence
that led to an investment. Working with Skype from
its early days, we at Ariadne Capital did some of
its critical early business development deals that
led to its software being bundled with headsets and
carrier agreements with PSTN operators that allowed
for Skype In and Skype Out to materialise. We also
placed four key individuals in an early team.
But we followed the Silicon
Valley VC lead. By the time Draper invested, almost
every European VC wanted to put their money in too.
Why did Europe 's VC's not take the lead in the first
place? This was after all, Europe 's biggest venture-backed
exit, right?
• Bundeep Singh
Rangar, Board Member, IndusView LLP ( www.indusview.com
) & Senior Advisor and Co-Founder, Ariadne
Capital ( www.ariadnecapital.com
)
• Bundeep.Rangar@IndusView.com
• India@ariadnecapital.com
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Ariadne
Capital Journal - Through the Maze Volume
5, Edition 3
