Milestone Group Quarterly: April 2006
Articles
Investment Viewpoint:
Michael Skok, a General Partner at North Bridge Venture Partners
Milestone: How do you characterize North Bridge’s defining principles in terms of how you invest and how you think?
Skok: We think about ourselves as very active early stage investors and that typically means focusing on three things: the size of the market opportunity, the value proposition and most importantly the people behind it. Being active in the early stages typically means filling in gaps in any or all of those three areas. Most often that’s helping to recruit a great team around a founder, but it can also be helping entrepreneurs find the right definition, focus and starting segment for a market. Or better still working to get an initial value proposition that rewrites the rules and provides some sustainable advantage rather than just comes out as some order of magnitude improvement over and above what is there today.
Milestone: When you say rewrite the rules, what does that mean?
Skok: The typical approach to building a new product or new service or going after a new market is to make a technological improvement. The problem with that is even if it is an order of magnitude better how do you sustain it? If for example you can change the business model as well as the technology platform you can rewrite the rules of the game so that existing incumbents may not even be able to afford to play your game, and even if they do it has to be on your turf, with your rules and your own metrics for success. That way you’re not only advantaged on day one, you can drive the advantage.
Milestone: What would be an example of a rule that you would have to rewrite?
Skok: Google did it to Microsoft. They may have better search that’s built a cheaper predominantly open source platform, but more importantly they have a new advertising driven business model. Microsoft can’t afford to ditch Windows and Office to compete with free. Ultimately we’ll see what makes Google sustainable, personally I predict it will be their business model combined with their reach.
Milestone:Your model is very unusual, hands on, the senior partners invest a lot of time and involvement with the company, which is interesting because time is one of those things that there is only so much of. How does that work for you? How do you find that balance in terms of investing the right amount of time?
Skok: That’s a great question. It’s actually the great dichotomy of the venture business. It has the potential to really rip the venture business apart. The danger is that the attraction to raise more money has caused more funds to move up market and leave open the early stage investment business. We are an “and” fund. We believe in being both active in the early stage and following through to continue to back our companies right through their full funding cycle. This gives us the basis on which to influence the starting point where a degree can turn into a mile very quickly and still follow on where we see the success of a good early strategy playing out. Putting in this early stage investment of time to get the company formation right is in stark contrast to simply letting capital define the value add. After all everyone’s money is green. The entrepreneur’s biggest investment is their lives and we respect and reflect that, making our biggest investment our own time to support them. That’s why we’re so selective in our investing.
Milestone: It’s not unusual for you to seed a project with an initial commitment of $100,000 or $500,000 in saying that you recognize something in that company that indicates to you it is worth the time, what is it that you see?
Skok: Let me give you a specific example since we are doing this interview at Linux World. There is a company downstairs called rPath that we were lucky enough to get involved with. It just won an award here today, for the best new systems management product. They are a classic case in point. When we first met them, they had a different business with a different proposition, going after a different market. Even a different CEO and company name. But all I saw, was a brilliant founder who when separated from all that and given the chance expounded an incredible vision for a huge disruptive play. It didn’t hurt that he was the first VP of Engineering at Redhat who uniquely had the right to an opinion regarding the particular problem he was addressing.
When you see somebody like that and you are willing to listen and have the patience to understand their vision, many things can happen. What we love to do at that point is take the time to figure out how to build a business around that. The founders deserve all the credit for challenging us to feed their vision, find them a CEO and support the hiring of a great team.
Here we are just over a year later with an award winning company, that surpassed 20,000 downloads in it’s first quarter and now has 450 active open source projects built using their product and some great partnerships with companies like VMWare. It’s still a long road ahead, but the team deserves all the credit in the world for making it happen.
Milestone: What would you do in a more typical model where it was not the same philosophy?
Skok: We would have passed on the deal just as I know many other top tier VCs did.
Milestone: And for what reasons?
Skok: If you had looked at the deal at face value, I would have passed on it too. This was a deal that was initially going after a small market, with a first time CEO that really wasn’t commercially driven. From a value proposition, one had to look beneath the surface and understand what problem was really being solved. It turned out to be a very painful problem with a big potential need, if focused at the right market.
I will say there is one other thing that is fundamental, and that is preparedness. If you aren’t prepared with your own vision of what is both possible from a technology standpoint and also aware of what pain and need there is in the marketplace, you won’t be able to connect the dots. We are not the innovators, we are not the entrepreneurs; we are not the guys who have the ideas but we do like to listen and come prepared to connect the dots.
Milestone: A lot of the Milestone VCs that have been featured in this newsletter, their network has been on the West Coast. Do you see any different between West Coast and East Coast?
Skok: You mean apart from the fact that we make better sports fans with the Sox and Patriots? I will say something that is probably very controversial. What we need to change on the East Coast is not the volume of deal flow or even the quality. It is the attitude of the entrepreneurs and the principle of investing for long-term sustainable value.
For example on the East Coast we have lived too long in the shadow of DEC, Lotus and DG, without building enough of the next great industry players. There are of course always notable exceptions like EMC and PTC, but where are the newcomers? We have been lucky enough to back some of them, like Sonus and Sycamore, but we need to see more on the East Coast that are long term, sustainable, valuable companies that create categories and industry leadership for this region to continue to stand tall and not always feel that they have to exit to larger partners on the West Coast. That is a mentality we are determined to work to change. We are looking for the next generation of entrepreneurs who really want to build, not just flip, companies.
Back to the Sox and the Patriots, we want home runs, not just singles and we want entrepreneurs who can take a leaf out of Bob Kraft’s book and pursue their vision against all odds. It’s no accident he was one of our keynote speakers at our CEO day last year.
Milestone: What’s your vision for doing that?
Skok: It’s going to take time. We have to do it by example. We have to be patient and see it through. And it won’t always be rewarded. For example one of our most recent exits is a company called iLogix, which was 12 years old before we had a relatively successful exit but by no means a home run. But it can also really pay off too. The most recent company we took public, Phase Forward, we continue to own stock in. We hope it will become a sustainable long-term valuable company in its own right.
Milestone: What’s going on in global markets, do you see anything interesting particularly in the Asian Rim?
Skok: There are many smarter experts on globalization than myself; but we, from a VC perspective, tend to think about global markets in three regards: IP, production and consumption. It’s true to say that today largely the IP continues to be very much generated in the US and in some of the core markets around the world. That is changing, though, rapidly. We are seeing some interesting innovation that is coming out of Indochina and Russia, so we don’t underestimate the potential. But for now, we are primarily concentrating on the benefits of outsourcing and off shoring on the production side. For example one of our companies Veveo is doing most all of their development in India at a fraction of the cost of doing it here. However the IP is quite clearly being developed in the US.
That brings us to the third point, which is consumption. For example, another of our companies, Starent, it’s first major market was China and where their products are now at the core of some of the original build-out of the Chinese mobile infrastructure. This was a huge advantage of the company as they moved to take on Europe and will ultimately come back to take on the US markets too.
The net of it is that we think that globalization is extremely important. It’s important to think of it in those three terms, the IP, production and consumption and to be clear what aspect of globalization you take advantage of where, so for example you don’t run into IP issues in China but instead leverage consumption there and more obviously you tap the great IP in the USA but don’t try to scale it locally if it can be done for a fraction of the cost in India.
Milestone: What is the strategy when you think of moving a company to exit, you have had significant recent acquisition with AppIQ; how did that play out in terms of your overall strategy?
Skok: In AppIQ’s case they had an extraordinary solution to managing heterogeneous storage which is extremely valuable in today’s distributed, increasingly digital, world. But we knew upfront that the storage market was dominated by a few major players, HP, Sun, EMC, etc. The management team was smart enough to establish from day one the kinds of partnerships that set them up for success in any eventuality whether they were to be acquired or ultimately to go public. They had the balance of the major players as partners so that they could be independently successful without relying on anyone but they also had the outcome in this case that one of those partners, HP, decided they were too important and too strategic. Because of the team’s good work, we (as investors) were not caught without options and we also had the willingness to continue to back the company for the long haul. As a result, the exit was extremely good for the company, and it’s a win for HP because they’re now in a very strong position for a key growth market.
Milestone: Let’s talk about the trend to smaller market segments and the need to balance that with going after large returns.
Skok: People do tend to say, “Let’s pick a smaller market as a starting point.” But that is the difference between vision and the vital focus of initial execution. In the early stages for a company there is no finer word than focus. The smaller the segment and the more carefully and tightly defined it is, the more likely you are to be able to focus on meeting it’s needs. That is often the basis for early discussion in the first go to market stages of a company. Beyond that you have to have a very clear vision, and that is the balance to this, about what large market you are going to earn. Not own, earn. To balance this, you have to make many very critical decisions along the way, both as a management team and investor group, and stay in synch about expectations of each stage of execution. But one question above all is key upfront. Do you have an adaptation or do you have a disruption?
Let me give you an example of this with a company we invested in called Intrusic. This is in the security space (which has the greatest problem of all in terms of segmentation because there’s apparently only one really big market and there are so many point solutions). I call it the land of a thousand islands. For example even though I was lucky enough to be involved with Symantec from it’s early days where I learned from some really smart people, and enjoyed a great run, I am still an incredibly skeptical about security investments. So for the hundreds and hundreds of security deals we see, I have only invested in just one company in three years. Why? Well it’s back to the question. Focus on a small segment might work, but it also might just marginalize you to being another point solution. So the question of disruption is key. But it’s also a tough one, as there really are very few fundamental disruptions in security.
When I saw Intrusic I knew it was not only a disruptive technology; it changes and even broadens the market. To be more precise they turn it inside out! They recognized that the real problem is not just stopping bad people, or things like viruses getting in to a business, but instead it’s been proven that where 80% of the problem comes from is insiders taking valuable IP, and data such as customer records out.
So while we’ll still start by focusing on a small market segment, we know we have a huge potential market and we can afford to invest in the deep technology to defend that position for a great return if we execute. There’s of course never any substitute for good execution. That comes back to great people and you can attract the best if you have a really disruptive play going after a large market. There we are again, reinforcing those fundamental tenets of our investment criteria.
Milestone: What is the future of the software industry? Any wild forecasts?
Skok: That’s a big question obviously. I know that if I look back at my 20 plus years in this industry, the only certainty is my predictions will be wrong – and the only real question is by how much? Usually the challenge is not what but when, e.g. the question is one of timing, and that’s the challenge with investment pace too. But not to avoid the question, I see that there will always be a rolling series of innovations rippling through the ‘stack’ with significant points of inflection. For example, if you go back through the series of hardware innovations from the original mainframe and mini eras to the shift to PCs and client server or the shift to the Internet, each of those could be considered a point of inflection for technological change. And with each change it rippled through the stack in a fairly predictable way. Technology changes come up through infrastructure and the OS and tools and then up to the middleware. And finally up to the layer where the applications get built and ultimately services get delivered. Betting against those shifts is dangerous, and with them is profitable. For example, in first shift to the Internet era apart from the madness of market expectations being out of whack, the technology got out of synch. We had companies trying to build Internet applications serving half a trillion Internet users with most of them using nothing more than POTS infrastructure. 20/20 hindsight for me to say that but let’s look ahead.
Now, we have more ubiquitous broadband infrastructure and it’s both wired and wireless so we can consider the future. So Web 2.0 or whatever you want to call it is realistic and yes I do believe there’s plenty of room for innovation up the stack from companies like Bungee Labs that we’ve just invested in that will lead to richer and richer more distributed applications that deliver on demand. I think that covers a lot of the future thinking buzzwords.
To bring it into focus now let’s consider a recent investment in a company called DEMAND-ware, which is the next generation of ecommerce but instead of being built - in the classic “you have to buy, manage and maintain all of the infrastructure, hardware and software yourself” - it is delivered at a dramatically lower cost using open source technology and commodity hardware over the Internet on-demand and it even enables true remote customization and development. You can put up the quality of an Amazon-like experience literally for thousands of dollars a month and pay as you go; use it as you need it. As you grow your business, you scale your usage, so it is literally cost effective from day one onwards. This was not possible on the old infrastructure. Things like Broadband, things like Open Source have made it possible economically to do DEMANDware right.
I think the future is history. We are going to see continued innovation. The thing I’m trying to learn is the pace at which people and markets can adopt it because I think that’s the key to pacing our investments for good returns.
Milestone: What two or three key pieces of advice would you give an entrepreneur starting out today?
Skok: That’s always a fun one. Know your market, know their pain and need and how you solve it uniquely well but most importantly know yourself. The first two are obvious, the last is so ob-vious people don’t consider it. And yet it’s fundamental. As an entrepreneur understanding what you do best and knowing what you need help with is the starting point for building a great team to match your strengths and weaknesses, and as I’ve said, a great company is about having a great team that can deliver value and build on that repeatedly.
Milestone: Is part of knowing yourself your tolerance for risk and your appetite for sleepless nights?
Skok: Absolutely. I once gave one of my best managers a bad review after he met plan for the third year in a row. He wasn’t very happy. But I told him that he hadn’t failed yet. He was more puzzled. Obviously, I didn’t want him to fail overall, but I wanted him to at least risk enough that he might innovate or break out of his plan. And if he never failed I knew he couldn’t be exploring all the ways he could do that. After all, experimentation leads to both failure and innovation. Innovation is at the heart of value creation. In order to ask him to step up and innovate I knew I had to be able to live up to taking those risks myself. I’ve observed that great leaders know that and always have enough tolerance to risk failure in search of breaking new ground. And if you have any conscience at all, sleepless nights go along with that as you think of the people you are accountable to, not to let them down if you fail.
Milestone: How do you look for this? Is there a test to look for those people?
Skok: Let’s put it this way, if they can get through our diligence, they pass our test. We often talk about “the diligence is the deal.” What we mean by that is that if we don’t see the entrepreneur drive with the passion, persistence and indeed the paranoia of closing the deal with us as we walk them through the diligence process, we know they are not for us. By the way, that is not to say they are not great people, we just know that they are not a North Bridge investment.
And while great entrepreneurs may not even get it right the first time, we’re rewarded to see them come back and succeed a second time and sometimes over and over again. Returning entrepreneurs start many of our companies like for example Aylus. That’s the not so secret sauce. We want to do such a great job supporting them that they chose us first when they do it again. And it’s not just the CEOs we want to come back, but the VPs, Directors, Founders and Engineers that come back to work with us. That is one of the keys to our business, to create an environment for people to be more successful each time we engage with them.
Milestone: If you had $10 million to invest in a competitor’s fund, who would it be and why?
Skok: The irony of this business is that we already do invest in our competitor’s funds every time we do a deal, as we never invest in a company alone. We are already co-investors with all the major players, whether it is Sequoia and Norwest on the West Coast, or Matrix and General Catalyst on the East Coast. We believe it is in the entrepreneur’s best interest to have two initial investors. It’s sort of like Martinis. One is not enough, three is too many, especially on an early stage board. At the board level we are also very careful to ensure that we have outsiders that are both the voice of reason in an operating regard or with domain expertise but who also balance the investment perspective.
Milestone: I looked at your website and saw the venture partner’s cricket tournament. Do you hold that in the United States? With North American players?
Skok: Yes we do. But not just with American players.
Milestone: How long does it take them to realize the rules of baseball don’t apply?
Skok: Not long. Just ask the question of who’s on ‘first’ (base)? Or is it ‘over’ yet? Puns intended. This was the brainchild of my partner Jamie. To his credit, what he recognized was that globalization is going on in our own backyard. We have many cricket players amongst the ranks, from Sri Lanka, India, Barbados or wherever in the world, you name it. In fact you would be astounded to see just how rich an international gathering it is. What we liked about it was that it brought diversity of both backgrounds and talent out to play. We get people from all areas of our companies coming out with their families.
Milestone: I know that Americans can’t quite get their heads around some of the principles around cricket, particularly the number of runs being scored.
Skok: True, but you know what is really impressive about the Americans, though? They really understand the meaning of teaming. It might not be baseball, it might be cricket but it is always about the team. That is why it’s so much fun for us to do this. We enjoy seeing people get out of their element and build teams across roles, companies, and even countries. It’s really a lot of fun. It may not be ‘cricket’ to mix this metaphor but I hope it helps our players hit a six out of the ballpark.
Michael has served on many private and public company boards as well as supported various software industry groups such as the Software Publishers Association where he was Chairman for a number of years in Europe. He is currently active on the boards of all his recent investments in North Bridge Venture Partners portfolio companies.
Michael is a graduate of Nottingham University in the United Kingdom (awarded joint honors in Management Sciences and Engineering). |
