• Market Tumult and the Marginal Productivity Trap

    productivity1By Craig Hanson

    The most disruptive aspect of capital market shifts isn’t simply that financing your business becomes easier or harder. It’s that the underlying math the market uses to value your company fundamentally changes. Public markets, venture capitalists and even employees evaluate you through a different framework. These shifts can be dramatic, with severe consequences for those still adhering to the prior paradigm. The market is reminding us of the potential for one of these systemic shifts now.

    For the past couple years, investors of all stages have been chasing furiously after high-growth companies, and rewarding them with valuation multiples exponentially higher than the difference in their growth rate would otherwise imply. An almost single-minded obsession on growth rates has understandably driven companies to dramatically increase their sales and marketing spending, faster than historical norms, fueled by round sizes larger than historical norms.

    The constraint, however – the gravitational impact of expansion economics – is that as more sales and marketing budget is spent in a period of time, the efficiency of that spend (in terms of qualified leads, sales prospects, sales, etc) naturally declines. This law of diminishing marginal productivity makes sense when you stop to think about it. When you move from the top 10 ROI marketing programs to the next 20 down the list, you’re investing in lower return programs. If you see 50 sales rep candidates in a quarter, and move from hiring the top 5 to hiring the top 20, you’re going to get lower productivity reps (assuming the manager is good at picking reps in the first place).

    Despite this, in the recent environment, CEO’s have felt immense pressure, and a bit of economic rationale, in increasing sales and marketing spending even as the productivity of those dollars declines. In other words, even as it drives productivity and efficiency metrics down, some CEOs keep stepping on the gas. Why? There are 2 reasons: one bad and one (temporarily) good.

    First the bad reason. Foremost, as some investors are pumping up round sizes, at all stages, much higher than normal, CEOs given this largesse naturally feel immense pressure to spend it. In too many cases, they have to increase spending dramatically in order to have any hope of reaching the herculean growth rates needed to justify the lofty valuation they just received. Shooting the moon is the only play in the book which has hope.

    There is a second reason, which has slightly more economic rationale, but only temporarily. CEOs may calculate the exponential increase in valuation multiple they receive for an extra 10% of annual growth, relative to the diminishing marginal impact of the sales and marketing money they’re spending. In essence, even though that next dollar spent on sales and marketing is getting you less and less revenue impact, that little bit of revenue impact is still getting you up the exponentially-increasing valuation multiple curve, enough to still justify it.

    The problem with this calculus is this: The diminishing marginal productivity curve is fairly constant, and only increases or decreases over time with the structural effectiveness and size of your programs. This takes time and concerted effort to change. The valuation reward curve, however, is entirely market dependent, and can fluctuate on a dime. In other words, the extra premium you think the market will give you for all of that extra sales and marketing spend can go away. With the recent market drops, this is a shocking wake up call for some CEOs who thought the valuation-for-growth math was a constant.

    Historically, this is exactly what happens to companies when market preferences shift. Those of us who’ve been through a couple cycles remember this full well, but many CEOs and even VCs today weren’t around the last time the math changed unexpectedly.

    In most market stages, public and private market investors care about both growth and the cost of that growth. The metrics of your company’s growth tell the story of its effectiveness, and thus of its sustainability. It’s not just about the growth – it’s how you get there that matters in the long run.

    By taking on mega-rounds, CEO’s should know that they’re doing three things: (1) narrowing their range of operational plan options, as going for broke is the only thing that can work; (2) putting increased pressure on their company to perform to match those expectations, because anything less will eventually create a negative spiral of down-rounds, underwater employee options, and employee defections; and (3) having to hit these high performance standards while slipping lower and lower down the marginal productivity curve.

    Screen Shot 2015-08-28 at 6.47.41 AM

    Worse yet, we see a lot of companies approach us looking for a round much larger than normal as a means to jack up the growth rate and improve the metrics. These are the companies I run from. It shows CEOs who don’t yet have the model working well, have usually achieved good but not exceptional growth, and yet want to spend their way even further down the marginal productivity curve.

    In my view, there can be a place for large financing rounds. But that time is once you have the metrics humming, a well-returning place on the productivity curve, and the discipline to spend at a pace the company can soundly keep up with.

    How are we handling this at our venture capital firm? Admittedly, as expansion stage investors (typically Series B,C,D), we get to rigorously analyze early performance of the company’s model. We pay attention to the productivity and efficiency, and then work our fingers to the bone helping CEOs improve this further as they ramp up the growth curve and move the marginal productivity curve forward over time. We respectfully pass on companies where the model isn’t working or where the CEO doesn’t know what has to be done to build a well-oiled model. Those CEOs who know how to read the metrics of their business and have an astute sense of how to turn it into a powerful platform as they ascend up the expansion stage have our respect and loyalty.

    In most market environments, and perhaps now once again, markets care about both your growth and how you get there. CEOs who pay attention to the fundamental strength of their operating model will guide their companies well no matter what the macro markets do. They know that metrics matter.

    As markets have reminded companies before and now once again, those who sacrifice metrics for growth shall eventually have neither.

    Craig Hanson is the cofounder of Next World Capital, a San Francisco-based expansion-stage venture firm.

  • A Silicon Valley Firm for Startups Eyeing Europe

    craig hansonMost Bay Area venture firms don’t pay much attention to Europe. That’s just fine with Next World Capital, a four-year-old, expansion-stage firm backed by the European clients of Next World Group, an affiliated investment advisory firm with offices in Paris and Brussels.

    Though Next World’s cofounder Craig Hanson tells me these ties are a small part of the firm’s value to entrepreneurs, he admits that it’s a point of intrigue for at least 80 percent of the startups he meets with – a much higher percentage than he’d anticipated when endeavoring to start the firm. We talked recently in the firm’s airy office building in San Francisco (atop which sits one exceedingly nice roof deck). Our conversation has been edited for length.

    You’ve kept your profile somewhat low until recently. Why?

    We’ve been building the organization; we wanted to establish a reputation with entrepreneurs first. Now, we’re hiring and staffing up, and we’re in a good place to tell the story of who we are for the first time.

    You’ve been investing a $200 million debut fund, writing initial checks of between $7 million and $12 million. How many companies have you funded so far, and have you had any early exits?

    We’ve funded 10 companies and had two fantastic exits so far. We invested in [the private cloud management software company] DynamicOps [which sold in 2012 to VMWare for an undisclosed amount, after raising $16.3 million]. A year later, NexGen Storage, a flash storage system company that we’d gotten involved with [leading its Series B round] was approached by Fusio.io. [It acquired NexGen, which had raised $10 million from investors, for roughly $120 million.]

    How did you break into deals as a new fund in the Valley?

    We did it by going directly to companies rather than rely on investor relationships. Once we had the meeting with the CEO…we were able to have in-depth conversations right off the bat. It wasn’t, “Give us your PowerPoint.” We’d say, “We’ve talked with 20 vendors, experts, and customers in the space and we’d love to trade notes.” At that first meeting, we were having second- or third-meeting [types] of conversations.

    How strongly do you pitch CEOs on your European ties, including a Paris-based partner? Is your ability to help abroad a big or small selling point?

    We thought it’d be useful in niche cases. We found instead that it’s a core, strategic priority for most companies, and that it’s happening much faster in their development than it used to. Particularly for cloud-based, SaaS companies, and mobile companies, they’re getting pulled to expand internationally much faster than companies used to.

    What are early considerations these CEOs need to make as they look to Europe?

    Well, among other things, you need to consider when to enter the European market, where specifically you go, and how you orient your positioning around the product, which, in a lot of cases, is slightly different than how you’d approach the U.S. market.

    If you had to generalize, what are some of the distinctions between regions that U.S. entrepreneurs should know?

    Germany is a very large and sophisticated market, for example, so you have to have credibility there, either by investing in employees and resources there, and/or having strong partnerships with credible local firms. If you’re trying to sell a sophisticated infrastructure software product or enterprise app into that market, trying to do that by just flying people out occasionally from a London hub isn’t going to be as effective. There’s a similar dynamic in France.

    The Benelux countries or Nordic countries are more open and used to vendors not having a specific office in their country; they’re used to looking at vendors and relationships and partners across Europe.

    It’s interesting. We tend to hear so much about the importance of expanding into Asia Pacific.

    There’s more cultural and business familiarity in working with European markets. They’re very large economies, and in term of enterprise IT spend, it’s the next largest market to go after [following the U.S.].

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  • Zuora: The Hottest Company You Don’t Know

    images (1)Zuora isn’t a household name, but the six-year-old is becoming kind of a big deal as private companies go. Its high-touch subscription-billing platform already counts as customers dozens of established corporate giants (HP, Dell, News Corp), newer corporate giants (Box, Docusign, ZenDesk), and up-and-comers (Dollar Shave Club) for whom its technology handles everything from pricing to order management.

    Unsurprisingly, investors love the 300-person company. Zuora has raised $128 million to date, including from Benchmark, Index Ventures, Vulcan Ventures, and Marc Benioff of Salesforce.com, where Zuora’s cofounder and CEO, Tien Tzuo, was employee number 10.

    Still, Zuora isn’t planning to go public any time soon, say Tzuo. We talked about why earlier this week.

    You’ve said that you’d like at least another year or two before tapping the public markets, but it seems like you’d get a warm reception right now.

    The private markets are assigning valuations that are as strong if not stronger than pubic markets; there isn’t a lot of inherent value right now to going public. Staying private also allows us to work more on ourselves and to make big bets.

    Do you mean acquisitions?

    We haven’t made any acquisitions but our private valuation is getting to the size now where it’s starting [to make sense]. I suspect [we’d look at] more adjacent areas, as technology tuck-ins. It’s not a strategy of ours, but staying private gives us more flexibility.

    So what kind of big bets are you making?

    We’re kind of in a land grab [having recently opened offices in London and Australia, with plans to move into Asia-Pacific]. If we can raise money and focus on [expanding], then it just makes more sense to do that. Our big challenge is evangelizing the shift from a product to a subscription-based economy.

    Meaning the renting versus buying economy?

    Right. Eighty or 90 percent of companies getting funded now have a subscription model because of [cloud-based servers and other things]. Medical device companies that [used to spend a fortune on equipment] now use services hosted at Amazon and pay as they go for processing power.

    Everyone will wake up across the world and realize their business is a subscription-based model. Product-driven society, where you ship as many cars, pens, and computers, is no longer sustainable.

    Assuming that’s true, you’re probably as aware as anyone of the types of subscription-based companies that VCs are funding. What are you seeing?

    I’m seeing massive niches. Take GoodMouth, which sells toothbrushes. It’s kind of a no-brainer. You’re supposed to change your toothbrush every month or two; GoodMouth sends them to you. With the Internet, you can pick something that has traditionally been too small and scale it to the whole country.

    Another example is point-of-sale systems. It might seem like Square has the point-of-sale market locked up, but that’s not so. There are half a dozen companies focused on point-of-sale systems: there’s one that’s focused on grocery stores, another focused on dry cleaners. Very specific vendors can scale to a very large size today, unlike five to ten years ago, and smart VCs know it. Peter Fenton [of Benchmark, who sits on Zuora’s board], has a company in his portfolio called Revinate. It does hotel management systems. That can’t be further afield from the masses, but it’s a multibillion-dollar vertical.

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