Altos Ventures Musings

Fat Startup Watch

I'd like to start tracking the best fat startups to see how they do over time. Please email me suggestions of the latest and greatest fat startups. You can also submit suggestions as a comment to this post (which is how I plan to update this list over time). 

To qualify, the company must raise at least $10mm before they achieve product-market fit. For example, companies such as Facebook, Twitter and Zynga would not qualify as fat startups since they raised the vast majority of their funding after they had significant traction. 

In contrast, a good fat startup example is Tom Siebel's latest company, C3, which is still in stealth mode. I believe they raised $10mm in an initial seed round from individual investors. Since then, they've raised a lot more funding from some great institutional investors at much higher valuations which I cannot disclose. 

Here is an article from the Washington Post talking about C3 closing another $26 million in funding and landing Condoleeza Rice on its Board. Such a high profile person joining a tiny company is not a surprise since one of the defining characteristics of fat startups is an impressive roster of "proven" and/or famous people on the management team and board. 

The second fat startup I'd add to the list is Workday, which is founded by Dave Duffield, former founder/CEO of Peoplesoft. To date, they have raised more than $150 million. I believe the last round was at around $400 million dollar valuation. Good for them.

Let's see what happens...

What Did Bill Gates Worry About? Lean or Fat?

I found this from the transcript of a Charlie Rose interview with Ken Auletta, right after "Googled" was published. It is interesting to hear about what Bill Gates worried about back in 1998, near the all time peak of his power (and the peak of the fat startup era). 

CHARLIE ROSE: And are they on the cutting edge of exciting stuff or are there two more kids in a dormitory room at Stanford that are about ready to come up with something that’s going to blaze new trails? 

KEN AULETTA: Well, we don’t know that. That’s the great thing. I mean, I think I may have told the story when I was on your show, I tell in my book that Bill Gates in ‘98, when I asked him what he worried about, he didn’t say the obvious, which is "My competitors, Netscape, or Oracle or Apple." He said "I worry about someone in a garage inventing something that I haven’t thought of." 

(LAUGHTER)

That year there were two guys in a garage. 

CHARLIE ROSE: Sergey and Larry in a dorm, yes.

KEN AULETTA: Google has the same reason to worry. What is that new technology? One thing they are conscious of is social networking and that could pose a problem for search. 

 

Now, I should also point out that Mark Zuckerberg started Facebook in a dorm room while Kleiner Perkins and Benchmark funded Friendster and Sequoia funded Plaxo during the very early days of social networking.

I feel like a broken record but this is something I wrote in 2006 in Venture Lotto:

The most sought after deals are led by proven managers. Especially popular are entrepreneurs who have made money before - they get investors lining up like sheep.

Ironically, the people who end up creating the blockbusters are usually unproven managers. They emerge from the fringes, and start small, in niche or overlooked markets. They take time to learn and iterate and burn very little capital before turning profitable. They follow a slower, but lower-risk path. In our own portfolio, the companies which raised less funding not only performed far, far better but had much lower failure rates.

Entrepreneurs can't count on a portfolio. The best ones we know are much more risk-averse than conventional wisdom might suggest. They don't take foolish chances. They spend money as if it were their own. They observe, listen and adapt; but fundamentally, they strive to control their own destinies, which is best done by generating profits. They do need a little capital, but they want help and advice even more. 

Ben Horowitz Makes Compelling Case for Lean

Like many of you, I've been following a fascinating and important debate between Ben Horowitz and Fred Wilson over the past couple of days. To recap, it all started with this post: The Case for the Fat Startup.

Fred then responded with Being Fat is Not Healthy which has received a lot of comments worth reading, including some comments from Ben. 

Then earlier today, Ben responded with the best post of all The Revenge of the Fat Guy.

After reading through the posts, I've come to the conclusion that Ben and Fred actually agree on the fundamental points. In fact, the most important point was already made by Steve Blank last year in Lean Startups Aren't Cheap Startups.

Steve, a key figure in the lean startup movement, felt the need make the case that you cannot confuse lean with cheap. He concludes with the point that if you confuse the concepts "when you do find a repeatable and scalable sales model, you will starve your company for resources needed to scale."

The reason I love Ben's latest post is that he helps debunk some myths about Product-Market Fit, which, according Marc Andreessen, is "the only thing that matters" Along the way, he also makes a compelling case (though perhaps unintentionally) for staying lean. 

Ben's post should be a warning for entrepreneurs and VCs who put too much faith behind the magical product market fit concept. Here are some things to watch out for:

1. Product market fit is NOT a discrete, big bang event. If you are fortunate to find product market fit, you will most likely get there through lots of hard work "through partial fits, a few false alarms, and a big dollop of perseverance...there’s no formulaic answer."
2. It's NOT obvious when you have product-market fit. "It’s usually not black and white."
3. Once you achieve product-market fit, you can lose it.
4. Once you have product-market fit, you still have to "sweat the competition."

All of these points should serve as a warning for people with too much money to spend (or invest) and eager to step on the gas once product market fit is found. Given all of the uncertainties, it would be prudent to maintain some humility even if you believe that you've found product-market fit (you can also reach the opposite conclusion - even when in doubt, step on the gas - it's just not the path I'd recommend). 

Ben's last point is important to consider because, on the surface, it makes a case for the fat startup. Since "the best markets are usually the ones in which competition is fierce" you should invest aggressively to make sure you win the market."

I would ask, how much should you raise/invest? How about a billion dollars as Webvan did?

In any huge new market, there is no question competition will heat up. But even a billion dollars is nothing when you are talking about competing against the big guys. 

Rather than focusing on how much money to raise, how about focusing on producing profits and creating a sustainable business model?

When I look at competitors, the ones that scare me are the ones that have found ways to make money and scale at the same time. The "fat startups" that are burning through millions or tens of millions of dollars a month don't scare me.

Ben says that you can't win the market by saving your way there. I totally agree. But conversely, you can't win by spending your way there either. Even if you raise hundreds of millions. For every Loudcloud/Opsware, there are dozens of craters. As David Packard liked to say, "more companies die from indigestion than starvation."

There is no question that Ben is a great entrepreneur who knows first hand how difficult it is to build companies. He knows that it often takes more money and longer than you'd like. So it would make sense to raise more money than you think you need. If someone offers to invest boatloads of money in your company at a great price, you should consider taking it. I agree. But even Ben has said that it should not be your plan A.

If you are one of the very fortunate entrepreneurs who is able to get boatloads of funding at a great price, you should be careful to resist pressures to spend that capital from excited investors. You need to also do your best to resist your own temptations to pursue every great idea that you and your great team comes up with to win the market. A company growing on profits just tends to be much more disciplined than one growing based on boatloads funding.

Just as Ben agues that Twitter is the exception, not the rule, I'd say that Loudcloud/Opsware is the exception, not the rule.

Even Loudcloud/Opsware is not a very compelling case for the fat startup. They raised $346mm in 15 months and went public in March 2001. By September 2002, market cap had fallen to $28mm, which was less than cash on hand and about 8% of capital raised to date. That sounds like value destruction to me. If you were an investor or employee, you'd be pretty bummed right about then.

Then an amazing thing happened. From 2002 to 2007, the company raised no more capital and created tremendous value - great job Ben! They exit for $1.6B in September 2007! I would guess that there was a lot of great technology created in the prior 2 years that helped. But I would also guess that the thought of running out of cash was pretty scary when you are at a $28mm million market cap. If I were in their shoes, I would have been more determined than ever to get to profitability so that I would never have to raise more funding. 

To recap, during the first era (Loudcloud), hundreds of millions are raised and return almost nothing. During the second era (Opsware), if you bought stock, which was publicly available, so any of you could have participated - you did NOT have to be a famous entrepreneur or a hotshot VC to get a chance to invest - you would have made a spectacular return.

Ben Horowitz just reinforced my belief that "fat startup" is not only a bad idea but a dangerous one. Just as the lean startup concept can be harmful if people misunderstand the key points, the fat startup concept can also be harmful. In fact, it can be a LOT more harmful to the VC industry. Entrepreneurs will also suffer from excessive dilution, recaps and wasted lives pursuing bubbles and false dreams.

I'll end with a concept Warren Buffet has repeated over and over again - don't count on the kindness of strangers to save you. Make sure you have enough cash on hand. To me, that is not an argument for the fat startup, it's an argument for the lean startup.

So What's With All This Talk of Failure?

Have you noticed all the talk and blog posts about failing? Here are some examples: 

• Peter Rip: Fail Fast, Fail Often
• Josh Kopelman: Failing Cheaper
• Brad Feld: The Best Entrepreneurs Know How to Fail Fast 
• Scott Wolfgang: Even VCs Should Learn to Fail Fast 
• Auren Hoffman: To Grow a Company You Need to be Good At Killing Things 
• Anthony Lee: Failing Fast 

The main message is this: it's not only OK to fail, but it might be the smart thing to do if you do it quickly and cheaply and learn from the experience. 

In a book called The Dip Seth Godin takes it a step further and advocates the idea of quitting or killing off something early before you even have a chance to fail. To be fair, he also says that - many times - the right thing to do is to keep pushing ahead (because you are just hitting "the dip" before you reach eventual success). But that's just conventional wisdom right? It would not sell many books or drive page-views.  

Mark Suster in his recent post called Why the 'Fail Fast' Mantra Needs to Fail calls bullshit on all this talk of failure. So does Jason Fried who wrote the following in Rework: 

“In the business world, failure has become an expected rite of passage. You hear all the time how nine out of ten new businesses fail. You hear that your business’s chances are slim to none. You hear that failure builds character. People advise, ‘Fail early and fail often.’

“With so much failure in the air, you can’t help but breathe it in. Don’t inhale. Don’t get fooled by the stats. Other people’s failures are just that: other people’s failures."

What people are talking about when they espouse "failing fast" is fairly basic. Before you become great at something you might stumble along for a while. If something's not working, try something new or different. As Einstein said, the definition of insanity is doing the same thing over and over again expecting different results. 

My 3 year old son seems to have no problem grasping this concept. He doesn't have fancy terms like experimentation, iteration or pivoting to describe what he's doing; and he certainly doesn't think he's failing. He's absorbing, learning, trying new things and having fun.  

To become good at anything, you need to give it a shot, experiment, practice, learn, iterate. No big deal. Let's NOT call it failure. Let's call it what it is. Mark's suggestion was "launch and learn" or something else. I hope people take his advice.

Having said all that, I'd like to provide an example of the best fail fast (or quit early) story I've heard in a while and explain why it does make sense to cut your losses sometimes. I also want to explain why I believe the "fail fast" meme took off in the venture community. 

The story was told to me over lunch last week by Glenn McGonnigle who recently started TechOperators, with other proven entrepreneurs and executives in Atlanta. I think they are one of the best VCs in the world in the security market (they are co-investors in a recent deal). 

In the mid 1990s, Glenn started an online backup company. I think you'd all agree that he was a bit early! After some struggles, one of his angel investors Kevin O'Connor approached him to have a little talk. Kevin hinted that the market might not be ready for what he's doing so perhaps he should consider joining a couple of other companies that he was working on. It was totally up to him to decide what to do (but read between the leaves, there will be no more funding).

After thinking it over, Glenn came to the conclusion that he was too early and decided to shut down his company and take up Kevin's offer to check out his other ventures. The first company was targeting the Internet advertising market, which was still in its infancy in 1995. The other company was also in a nascent market for network security and penetration testing software. Glenn decided that he didn't know anything about the ad business and joined the latter as VP Sales. The company had just $50k in angel funding from Kevin and had hired Tom Noonen as CEO (Tom is a co-founder of TechOperators with Glenn). 

In their first year of operations the company did $300k in revenues. The next year they sought their first round of funding. Glenn didn't know any VCs except for one guy he used to work for - Bob Davoli - who had recently joined Sigma partners. The other VC was Dave Strohm of Greylock, who happened to be the only VC that Tom knew. So, in 1996, a little company named Internet Security Systems (ISS) based in Atlanta raised $3.5M from Boston and Bay Area VCs. 

The following year they raised Series B from Kleiner Perkins Caufield and Byers (Ted Schlein, who was formerly with Symantec and knowledgeable about the security space, led the round). The year after that (1998) they completed an IPO and the stock shot up 70% the first day. The year after that ISS completed a BILLION dollar secondary offering. At its peak, ISS reached a market cap of $4B. Even after the Dotcom crash they continued to grow to $400mm in revenues and were eventually acquired by IBM for $1.4B in 2006.

It was an amazing return for everyone especially Kevin O'Connor who bought an initial 30% stake in the company for $50k. Given that Kevin recruited both the CEO and VP Sales that took the company public, I'd say that he deserved it (the technical founder, Chris Klaus, was a student out of Georgia Tech). 

BTW, the company that Glenn passed on is the company that Kevin O'Connor is better known for - DoubleClick, which also completed its IPO in 1998. They initially had a different name and were based in Atlanta before moving to NY where most of their customers were based. 

So, as it turned out, Glenn could have chosen either company and would have done great. The only wrong choice would have been to stick with his original company! 

The lesson in all this? Sometimes it is better to move on. However, as Mark Suster points out, when you take money from investors you have a moral responsibility. To just walk away and abandon customers, investors and other stakeholders would be "irresponsible, unethical and heartless" using Mark's eloquent words.  

Although I agree with Mark, I would like to point out something which helps explain why the fail fast meme took off in the VC world. In my experience, entrepreneurs are usually the last people to quit. VCs typically give up on companies long before entrepreneurs do! 

One example from my personal experience is the founder of Enwisen, one of our portfolio companies from 1996. Everyone gave up on the company except for the founder and his wife who were both in their 60s. They just refused to give up even with no more funding and no employees left in the building. 

The founder has since retired but the company lives on. All debts have been paid off and all VC and angel investors have a chance to not only get their money back but make a profit. The company has been profitable for years and grew 60% last year, even during one of the worst recessions in decades. The CEO gets calls all the time about potential M&A or growth equity rounds. Maybe one day they could even go public, like Financial Engines did today in the hottest IPO of 2010 (they were also founded in 1996). 

When you are working with true entrepreneurs, you don't have to encourage them to keep going. More often than not, you have to provide a different perspective, point out the realities and, as Kevin O'Connor did, provide some alternatives that might mean moving on.

It really should be up to entrepreneurs to decide whether to quit or to keep going. As a VC, if I picked the right person to back, I don't have to worry about him/her quitting on me. But, sometimes, I do have to have a little talk to point out realities that the ever optimistic and passionate entrepreneur might not see.