Skype: Reflections for European Venture Capital

In a few days time, most of Europe’s technology-oriented venture capital leaders will be 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, will be high on the agenda with its co-founder and CEO Niklas Zennstrom making a keynote.

Stop Press. European VCs will be discussing Europe’s most successful exit? Correction – European VCs will 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:

1. 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
2. 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?

Perhaps that question ought to be pondered at this year’s ETRE. We might even get an honest answer.

Indian VC Investments Total Record $528 Mln in Q3 2005

India’s venture capital and private equity market hit a record high in the third quarter this year with more than half a billion dollars in new investments, according to information provider Venture Intelligence India. The six times increase over the same quarter last year indicates growing investor interest in the world’s second fastest growing economy.

A total of $528 million was invested in 28 companies during July to Sept. 2005 compared with $90 million in eight companies during the same period last year. Late stage investments dominated, including 15 Private Investments in Public Enterprises (PIPEs). IT and IT-enabled service (ITES) companies won new favor with six investments totaling $55 million. Eighteen companies raised $10 million or more.

With Goldman Sachs predicting India’s economy to become the world’s third largest by 2032 and Deutsche Bank stating that target might be achieved by 2020 if economic reforms were pursued more aggressively, it’s easy to see the attractiveness of the Indian market among venture capitalists. India’s GDP is expected to grow 7.2 percent this year, the second fastest after China that’s expected to grow 8.5 percent, according to the United Nations Economic and Social Commission for Asia and the Pacific (ESCAP).

India’s high growth sectors include the IT and ITES industries predicted to grow 34 percent this year, followed by the automotive industry at 29 percent, telecoms at 22 percent and media at 18 percent, according to New Delhi-based corporate finance advisory firm IndusView Advisors Private Ltd.

“The Indian VC industry is still in its infancy and a lot of growth still lies ahead,” said Saurabh Srivastava, Chairman of the Indian Venture Capital Association (IVCA). “We’re still just making baby noises on the global stage.”

Venture capital and private equity investments represent only 0.15 percent of India’s GDP, compared with 0.28 percent in Europe and 0.54 percent in North America, according to Pricewaterhouse Coopers.

The largest investment during the quarter was $100 million by Newbridge Capital in truck financing company Shriram Holdings based in Chennai. The second largest deal was ICICI Venture’s $59.8 million buyout of Mumbai-based Associated Cement Companies, the first buyout of a publicly-listed manufacturing firm. Two investments of $45 million tied for third place. This included U.K. venture firm 3i’s first Indian investment into Mumbai-based entertainment software firm Nimbus Communications.

VCs also enjoyed 11 exits during this period, including three public listings. Newspaper publisher HT Media’s sold $86 million worth of stock. Its Initial Public Offering, subscribed 18 times available shares, was the largest venture-backed IPO during the quarter. It had raised $45 million in two financing rounds from Henderson and CIFC (Citigroup) in 2003 and 2004. Other IPOs included financial services firm IL&FS Investsmart backed by Japanese VC Softbank and U.S. stock broking firm E*Trade, Inc. and telecom research and development services firm Sasken Communication Technologies that had been invested in by Intel Capital, Nokia Growth Partners, New Enterprise Associates and Nortel Networks.

Mergers and acquisitions were led by Essar Group’s $1.56 billion purchase of mobile phone services company BPL Communications and Oracle Corp.’s $593 million purchase of Citigroup Venture Capital’s (CVC) 41 percent stake in banking software firm i-flex Solutions. CVC had invested just $400,000 in the firm more than a decade ago.

Exits earlier this year of Indiabulls, Yes Bank, Suzlon Energy and Indiagames made Ashish Dhawan’s ChrysCap and Saurabh Srivastava’s Infinity Venture the top two performing vintage 1999-2000 Indian funds. Both have embarked on raising new funds, along with other survivors of the previous boom in venture investment in India in 2000 when almost $1.2 billion was invested.

The raising of new funds seems well timed as investment and exit activities have generated heightened interest in India among potential Limited Partners and VCs alike. Draper Fisher Jurvetson announced a $200 million Indian fund earlier this month joining other Silicon Valley VCs in India such as Sequoia Capital and Bessemer Venture Partners. More than $3 billion in new capital is expected to be committed to Indian venture capital firms this year, according to the IVCA.

Indian funds already closed this year include ILFS’s $125 million Leveraged India Fund, the $200 million Westbridge Capital II, $425 million Actis India II and $150 million GW Capital II funds. These do not include India-specific buyout funds such as Carlyle, Blackstone and KKR – each earmarking a $1 billion or more toward India.