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.
