Burnham's Beat

Just How Much Did VCs Pocket On Google?

A reporter asked me the other day what impact Google would have on the two main VCs in the Google deal, Kleiner Perkins and Sequoia, and it got me to thinking:  just how much money did those funds really pull out of Google?    Filled with a wistful sense of VC envy, I wondered over to Edgar to try and piece together the details.  In doing so I made some pretty interesting discoveries which I don't think have been discussed to date.

How to Turn $12.5M into $4.3BN
As many may know, all the way back in 1999 Kleiner and Sequoia each invested $12.5M in Google for a 10% stake.  Fast forward to the Summer of 2004 and these stakes were worth $2.03BN at Google's IPO price of $85/share.   While they originally intended to sell about 10% of their stakes in the IPO, both Kleiner and Sequoia backed off from this plan when the IPO ran into some investor jitters over valuation (which in hindsight look somewhat misplaced).  Lucky for the VCs, Google's shares have basically been on a straight line to the moon since IPO and now trade at $290/share less than a year after the IPO, so being forced to hold on to their shares was a blessing in disguise.

As it currently stands, both Kleiner and Sequoia have already distributed the vast majority of their stakes to their LPs.  Thanks to the wonder of the SEC's Form 4, it's possible to go back and calculate exactly how much money the firms have made for their LPs to date.  It's also possible to see how much the individual VCs have received (John Doerr and Mike Moritz) and even to make a realtively precise guess at the specific carried interests that each VC has in their respective fund.

In the case of Kleiner, they made their first big distribution of shares to LPs on 11/17/04 when they distributed about 5.7M shares, about a quarter of their total stake, at $172.5 a share which equates to about $983M.  They made another distribution on 2/4 of 11.4M shares, about 54% of their stake, at $203.66 per share for a cool $2.3BN.  On 5/2/04, they made another distribution of 1.1M shares worth $247M.  In total, to date they have distributed shares worth $3.549BN.   They still have another 2.6M shares worth $752M as of yesterday's close, so the total value of their stake is $4.3BN which represents a 344X return on their investment of $12.5M ... not too shabby.

The Mystery of The Disappearing Shares
There is one significant mystery about Kleiner's stake.  In the initial drafts of Google's S1, Kleiner was represented to have 23.9 shares, a stake equal to Sequoia's.  However about a month before the IPO, sometime between July 12th and July 26th, about 2.85M of Kleiner's shares mysteriously disappeared from the cap table.  At the same time a new entity affiliated with Kleiner called "Vallejo Ventures Trust" appeared in the footnotes owning 1.8M shares.  I can't find any information on Vallejo Ventures (my thought is that it is a seperate private partnership 100% owned and funded by the Kleiner partners, but that's just a complete guess), but it would appear that Kleiner sold off the 2.85M shares, possibly to an entity that had some relationship to Vallejo, or possibly to a third party.

One theory would be that once it was apparent to Kleiner that it was not going to be able to sell secondary shares in the IPO that it struck a private deal with a third party to sell some shares in advance of the IPO.  Another would be that Morgan and Goldman simply got the share count wrong in the first few drafts.  I have a hard time believing that the share count was wrong because it has been widely reported that both firms invested the same amount of money and had the same ownerships stakes, so there's no good reason that Kleiner would own 2.85M less shares than Sequoia.

I am going to assume then that Kleiner did own those shares and that they sold them to a third party at the IPO price of $85/share (I will guess Morgan Stanley), so you can add another $242M to their take to bring the total to $4.5BN and maybe, just maybe, $5BN, if they figured out some way to move those shares offshore and still hold them without having to report them to the SEC (which seems unlikely and unecessary, but you never know) .  Anyway, if anyone has better information on what happened to these shares please post a comment.

Quite a Bit of Carry?
One other tibit of information that one can plausibly deduce from Kleiner's SEC filings on Google is just how large John Doerr's personal carried interest is in Kleiner's funds.  Carried interest is the % of the profits of the fund that an individual partner is entitled to receive.  The Kleiner funds that made the investment in Google are reported to give the Kleiner partners a 30% carried interest in the profits of the funds.   Because Kleiner distributed stock and because the SEC requires Doerr to disclose how much stock he directly received from such distributions, it's possible to make a reasonably well informed deduction about Doerr's personal carried interest in the Kleiner funds.  According to the SEC documents, to date Doerr has personally received 2.162M shares or 12% of the 18.2M shares distributed to date.  Assuming that Kleiner has a 30% carry on the fund, that means they were entitled to 5.46M shares of the 18.2M.  This means that Doerr has received 40% of Kleiner's total carry and also has a personal carried interest of 12% in the fund.  [See the UPDATE below as these #s are definitely wrong based on some discussions I've just had]  It also means that to date he has received $422M worth of Google shares and has another $90M worth of shares yet to be distributed.  God Bless America!

Now don't get me wrong, John Doerr deserves every penny of his carry.  His personal track record is absolutely fantastic.  However I was amazed to figure that he is entitled to 40% of the profits at Kleiner.  Afterall, Vinod Khosla is no slouch himself and he was in the same fund.  If they both receive 40% of the profits that would leave just 20% for all the other partners.  I had heard that Kleiner's economics were heavily skewed to the "big two", but that is a bit more skewed that I had thought.  Perhaps the answer is that the Kleiner's carried interest is actually 35% or 40% which would reduce Doerr's share down to a still very high, but less onerous, 35-30%.  [UPDATE:  As I say below I forgot to include the proceeds from any personal investments, so basically there's no way to really figure out what the real carried interest is but it's definitely lower than the 40% that I calculated and probably lower than the 30-35%.]

Last But Not Least
Sequoia's total take to date is a bit more difficult to figure thanks to their relatively tardy filing of Form 4, but we know that they had 23.9M shares to start worth $2.03BN at the IPO price of $85.  Unlike Kleiner, there are no missing shares here.  Sequoia clearly held on to all 23.9M of their shares pre and post IPO.  They made their first distributions of 7M shares in late November/early December 04.  It's interesting to note that unlike Kleiner which just distributed its shares in one big block on a single day, Sequoia doled its shares out over three weeks, presumeably in an effort to mitigate the impact of its distributions on the market.

According to the latest proxy statement, Sequoia has subseqently distributed another 13M shares but because they haven't yet filed a Form 4, it's impossible to determine exactly when they distributed them and at what price.  However making an educated guess they have returned about $3.8BN to date and have stock worth another $940M left to distribute for a total return of close to $4.7BN which is about $200M higher than Kleiner's $4.5BN (with the mystery shares).  Based on their $200M more in proceeds for the same stake and their careful doling out of shares to protect the market, Sequoia wins the award for best distrubution process.

As for Mike Moritz, who now has two of the Internet era's biggest VC Grand Slams under his belt in Yahoo and Google (although I personally admire his X.com/PayPal exit the most), applying the same deductive logic to his personal distributions as we did to John Doerr's we see that he received 394K of the first 7M shares distributed which was about 5.6% of the total.  Assuming the same 30% carry for Sequoia's fund, that means that he has received about 19% of the partnership profits, although his actual share is probably closer to 21.5% given that the first distribution was no doubt depressed by the return of capital. [UPDATE: See below, but basically the 21.5% doesn't account for any personal investments in the fund which means that the personal carried interest of Moritz is likely lower than the 21.5%.]

Now 21.5% is a highly respectable share of the profits fund, but it is somewhat ironic to note that Moritz made the same investment as Doerr, presumeably did the same work (although one could even argue that Moritz's connections at Yahoo were the key to Google's success), but is going to get paid about $306M which is about $200M (40%) less than Doerr, despite returning $200M more to his LPs.   Go figure!  [UPDATE:  See, below but one of the main reasons for the difference in personal income between Moritz and Doerr is likely that Doerr invested a lot of personal money in Kleiner's fund and thus got more because he risked more, which is what investing is all about!]

UPDATE:
I recently talked with some folks who definitely know many of the actual numbers involved and they pointed out to me what in hindsight is a rather embarassingly obvious fact: that the distributions received by individual partners include both carried interest as well as the proceeds from any personal investments made by the partners themselves into their fund, something which I had, quite stupidly, not figured into my deductions.  In many venture funds, these investments are usally quite small, somewhere between 1-2%, however in some funds partners make very significant personal investments and it's likely that both of the partners involved in Google had substantial personal investments in their own funds.

Based on this, I have no doubt now that the 40% share of profits that I deduced for John Doerr at Kleiner is wrong and that the 21.5% share I deduced for Mike Moritz is probably wrong as well.  Both of their carried interest shares are lower and in the case of Doerr, significantly lower than the 40% number I deduced.

While the absolute # of shares that have been distributed to them is still correct, there's no way to figure out what portion of those shares were for their carried interest in the fund and what portion were for their own personal investments in the fund without more infomation, so it's impossible to estimate their specific carried interests without that information and it is therefore in many ways irresponsible of me to even hazzard a guess.

As I said in my original post, both VCs deserved every penny they earned and now that it's clear a fair number of those pennies came from the partner's personal money they put at risk and invested into the fund I have to say that I think they deserved their rewards even more that I though at first.

For the Love of God People, Enterprise Software Is Not Dead

There has been a lot of talk recently including a number of blog posts (such as this one, this one, and this one) that enterprise software is “dead” with the implication that investing in enterprise software is akin to throwing good money after bad.  The basic thesis is that a combination of market saturation, customer fatigue, and open source has doomed enterprise software to be a rather uninteresting and unprofitable IT backwater for the foreseeable future.

While there is no doubt that major changes are underway in enterprise software and that many of the old business models in the industry are under assault, it is anything but dead.  In fact, it would be impossible for anyone closely following the enterprise software space to credibly say that it is “dead” due to the wide range of important core technical innovations occurring in the space as well as the major platform and business model transitions in process.

Change Is A Good Thing
At a core technical level, there are a number of very interesting trends underway including Service Oriented Architectures, Data Abstraction, and Message Aware Networking (to name a few) many of which I laid out my recent “Top 10 Trends in software" posts.

Most of the enterprise software critics would probably concede these trends and instead would maintain that the real issue is that the traditional business model of enterprise software (large per seat license fees, huge professional services bills, and heavy long term maintenance contracts) is no longer sustainable and that no clear replacement has emerged.

These critics are correct that the old enterprise software model is highly challenged these days, but it’s not like there are no clear replacements for that model.  For example, Software as a Service (SaaS) is quickly gaining acceptance as not only a viable way to deliver software but as a viable way to grow a profitable business.  In fact, rightly or wrongly, SaaS-based software companies such as Salesforce.com, Concur, and Websense are some of the most richly valued software stocks in the stock market right now.  Other viable models include appliance-based software and open-source (aka services/maintenance revenues).   The point is that just because seat licenses for shrink-wrapped disks are dead that doesn’t mean that the whole industry is irrevocably screwed.

Fact is, there is plenty of demand for good enterprise software out there, vendors just need to re-architect their business models and market approach so that they can deliver their software in a way that best meets the needs of customers while conforming with the new business realities of the market.

Stratify Makes The Change
For example, one of my venture investments, a company called Stratify, was having a very hard time growing its business a couple years ago.  Stratify had fantastic unstructured data management software, but was selling it as a generic infrastructure software platform to large enterprises.  This software generally cost $500K-$1M and then customers had to spend more money customizing it.  They also had to dedicate resources to maintaining the software.  The result for Stratify was a very long sales cycles, very uneven sales, and a very small set of prospects that could even afford the investment required.  In many ways I’d say that Stratify suffered from all of the major ills that are leading many to condemn enterprise software: long sales cycles, expensive direct sales forces, and limited market opportunity.

To its credit, Stratify realized this two years ago, but rather than throw in the towel they thought very hard about what core assets they had and how they could better deliver them to customers.  As it turned out, Stratify refocused the business away from being a generic licensed infrastructure platform to being a vertically focused SaaS platform for unstructured data management.  The company decided to focus its efforts on a particular vertical space, legal “eDiscovery”, where unstructured data management was a critical business need.  Instead of selling $1M licenses, Stratify switched to selling a hosted service that lawyers could use for each specific legal case.  Costs are tied to the amount of information that the system must manage for each case.  This made Stratify an easy purchase for lawyers: they could be up and running in a matter of a few days for each case without having to make any long term commitments and it allowed Stratify to sell to its software very qucikly and in easy to swallow bite size increments.

These days Stratify is growing like a weed and kicking ass with its legal eDiscovery service.  It still has its core enterprise software platform (that’s what its eDiscovery service is based on) but it only sells it by request.   Granted, Stratify is lucky to have successfully made the transition and there are plenty of other enterprise software companies in a similar position to Stratify that failed to make the switch (and whose deaths are now contributing to the whole “enterprise software is dead” attitude), but the lesson here is that enterprise software isn’t dead it’s just very different now and requires different approaches to be successful.

Thus, to invest in enterprise software these days you not only have to understand the technology trends, but to understand the business trends such as SaaS and Open Source. Once you understand these trends and move to apply them it’s readily apparent that the space is anything but dead.

Bad Mouthing May Actually Be A Good Thing
The really funny thing is that being declared a “dead” investment space by Silicon Valley conventional wisdom is probably the best thing that has ever happened to Enterprise Software.  Just look at consumer internet deals, they were declared “dead” a few years ago and now are white hot.

In fact, it seems as if many of the people declaring the enterprise software space “dead” are the same consumer internet investing refugees that magically became software investors overnight in late 2000 early 2001.  They are all piling back into the consumer space now, only to be playing catch up to the few consumer guys who stuck to their guns and never left.  By the time these nomads get up to speed, the space will be so overheated that they will get their hats handed to them again and then probably retreat back to software saying all the while saying "consumer internet is dead".  Thank god for them: the world needs the 3rd and 4th quartiles.

See you guys in 3 years!

The Rehabilitation Of Consumer Internet VCs

Just a short time ago any VC that mentioned “consumer internet” would have been summarily executed and had their body left in a box by the side of Sand Hill Road a la Ned from Unforgiven.  Faced with such a reception, most “consumer internet” VCs either laid low somewhere in the Santa Cruz Mountains or entered the internet VC protection program, otherwise known as software investing.  Ah, what a difference a couple of years make.

These days it is almost fashionable for consumer internet VCs to come out of hiding and declare that they never lost faith… they just got distracted.  It is a performance that often times would make St. Peter blush.

A Cautionary Tale
If anything the resurgence of interest in consumer internet investing offers a cautionary tell about the increasingly fickle nature of venture capital investing.  An investment space that was supposedly “dead” just a short time ago, is now white hot.   Yet anyone following the core trends of consumer Internet usage in the US over the past few years would have known that the consumer internet was anything but dead.  Since 2000, the percent of US consumers that use the Internet is up from less than half to over 2/3rds.  This increased usage, combined with heavy broadband adoption and increasing e-commerce activity has created an extremely vibrant and dynamic consumer internet market.

The reality is that the VCs that will make the most money off of the great consumer internet “re-rush” of 2005 are the few that put money to work in consumer internet startups during the dark ages of 2001-2003.  Unfortunately, thanks to the group think that pervades Silicon Valley very little money was actually put to work during that time because no one wanted to end up like Ned.    Now that Google has shown the light and there is no longer a stigma attached to consumer internet VC investing, there’s little chance that VCs making new investments will end up like Ned, but there’s also little chance that they will make outsized returns because everyone else is plowing money into the space driving up valuations and funding marginal deals.

Perhaps the best lesson from all this is that given the increasingly competitive and fickle nature of venture capital the best place to invest is the one that is the most out of favor according to conventional wisdom.

Internet Stocks Update: May 2005

The Internet Stock Index was up a blistering 15.6% in May compared to the NASDAQ's 7.6% gain.  The average stock was up only 6.6% which means that big cap stocks carried the day.  Which big cap stock you say?  Why none other than the single largest pure play internet stock on the planet, that of Google.  GOOG was up an impressive 31% this month which is all the more impressive given that it was up 22% in April.  The stock is, quite simply, "en fuego".   The big question now is with an $80BN market cap, does Google have much more steam left in it?   At $80BN it is now just a few hundred million dollars short of media giant Time Warner and once it surpasses TWX it will be not just the largest internet company, but the largest media company in the US period.  Bigger than Walt Disney, Vivendi or Time Warner.  About the only company left to overtake will be Microsoft ($275BN Market cap), and that's a company with 10X the revenues and profits of GOOG.

For a detailed breakdown of all the stock statistics including a record of all of the M&A in the space, click here click to download an Excel spreadsheet with the data and click here to get Microsoft's automatic stock quote downloading plug-in for Excel if you don't already have it.

Software Stocks Update: May 2005

The Software Stock Index was up a strong 5.2% in May compared to the NASDAQ's even stronger 7.6% gain.  The average stock was up 6.7% indicating that small caps slightly outperformed big caps.  This month's best performning sectors were secruity (20%+), collaboration (17.7%), and supply chain (16.8%).  This was the first up month for supply chain in awhile (it is still the leading loser for the year at -25%).  For the first time in a long time, no sector posted a loss which is pretty amazing and shows how broad based the May rally in stocks was.

For a detailed breakdown of all the stock statistics including a record of all of the M&A in the space, click here to download an Excel spreadsheet with the data and click here to get Microsoft's automatic stock quote downloading plug-in for Excel if you don't already have it.

Conflicts and Cash: Industry Analysts and Start-ups

The popular impression of industry analysts is that they are the unbiased oracles of technology truth.  Their clients, mostly Global 2000 CIOs, pay them handsome sums to serve as a kind of digital consiglieri in charge of vetting new technology vendors and products.  Such is the power of these industry analysts, that when they recommend certain technologies or products, vendors typically rush to issue press releases touting the endorsement as though God himself had declared them a preferred IT supplier to heaven.

What’s less well known about these industry analysts is that many of them do a booming business in “sell side consulting” to the same vendors that they are supposedly objectively evaluating on behalf of CIOs.  If one is willing to write a large enough check, any vendor, be it a start-up or major corporation, can become of client of most these industry analysts.   As clients, vendors often get direct and frequent access to the same analysts that evaluate them.  These analysts not only provide advice on how the vendors might improve their products to make them more attractive to CIOs, but also give advice on competitive positioning and market trends.

Conflicted Advice
Clearly, this is a situation pregnant with a couple of major conflicts-of-interest including:

1. Conflict with duty to provide objective advice to CIOs:  When evaluating vendors’ products, if some of those products are from vendors that are also paying clients, the analysts face an obvious conflict of interest: if they give their clients’ products a bad review, they risk losing their business.
2. Competitive conflict:  Because of their demonstrated influence with technology buyers, many vendors give industry analysts highly detailed product presentations and disclose typically confidential information such as actual customer names, sales, and product road maps.  Should the analyst later find itself in the position of consulting to one of the vendor’s competitors they face another obvious conflict: how does one provide advice on competitive positioning and market trends without relying on, either directly or indirectly, the information that they were given under another premise by direct competitors.

If you ask the analyst firms themselves about these potential conflicts they are all likely to A) deny that they even exist or deny that they succumb to them B) point to various rules and regulations they have put in place to make sure that these conflicts do not “pollute” their core research processes.  Granted, there are some progressive analyst firms that tackle these conflicts in an open and straightforward manner but many firms seem to pretend that they don’t exist.

Pay to Play
On the flip side, ask any marketing director at a high-tech company these days and they are likely to tell you that they clearly perceive this space to be a “pay to play” opportunity.   From their perspective, if you are willing to pay, you have an exponentially better chance of getting favorably coverage and exposure from an industry analyst.  If you don’t pay, you might as well spend your energy elsewhere.

This is not such a big deal for large established technology firms as their marketing budgets are easily large enough to pay at least the minimum fees required by most industry analysts, but it is an incredibly difficult decision for a start-up that has precious little marketing dollars to begin with.

Many of these analyst firms aggressively solicit consulting business from startup firms because they know that startups in particular often need endorsements from respected third parties in order to help skeptical corporate buyers overcome some of their concerns about dealing with a young company.  Most of the firms are careful to avoid explicit “quid pro quos”, but the message from their salesmen is usually pretty clear: if you want get our attention you are going to have to pay us.

Prisoner’s Dilemma
This kind of soft blackmail is particularly galling for a startup when it refuses to “pay to play” but its competitors do not.  Invariably, a few months down the road a competitor is touting some luke warm endorsements of their products from the same “unbiased third party research” firm that hit up the startup and it’s clear the only reason the good ink is flowing is because the money is too.

As a case in point, I recently visited the website of a competitor to one of my venture investments.  Their website was touting in a press release that their product had been named a “cool technology” (whatever that is) by a respected industry analyst.  The same website also included a dead give away that they were paying that same analyst: there was a joint conference call upcoming between that analyst and the startup (something that is usually part of “the package” that vendors buy from these firms).   There was no disclosure of any kind of payments from the vendor to the analyst, but why should there be as such disclosures are not required.  (Of course there’s a chance this vendor is not paying the analyst, but I’d be willing to make a substantial wager that they are).

As a former Wall Street analyst, I actually have a lot of sympathy for the individual industry analysts that have to write these reports and deal with the conflicts of interest.  They face a very similar situation to what I faced when dealing with investment banking clients and having observed them interact with their salespeople in a couple of meetings I can see that many of them are uncomfortable with the assumed but unspoken benefits of paying their firms.

Disclosure Is A Beautiful Thing
That said, I also think that at a bare minimum these firms owe it to their corporate/CIO clients, to the press, and to themselves to clearly disclose in their reports and speeches when a vendor that they mention is actually a paying client.   Asking industry analysts to simply note when a vendor they mention also happens to be a client is not a huge imposition and it gives people a “heads up” that there’s at least the potential for a conflict of interest.    Wall Street analysts have been required to do this for years and it hasn’t proved to be a burden.

I don’t believe in more drastic regulatory steps because those are typically counterproductive and would likely reduce the quality of research over time (just look at Wall Street), but disclosure is simply more information, and more information is never a bad thing when it comes to research.  In the absence of such disclosure, I think that industry analysts are really running the risk of becoming Elliot Spitzer’s next victim, something which even Wall Street analysts would surely advise against.

Top 10 Warning Signs that Your Vendor Is Paying Off Industry Analysts
1.    They receive lame awards like “Cool Technology” or “Up and Coming” from Industry Analysts.
2.    They host conference calls with supposedly objective industry analysts
3.    They have a booth at an Industry analyst’s technology fair/conference.
4.    They are the only start-up in the magic quadrant.
5.    They prominently feature industry analyst logo on their website.
6.    They have written a glowing research report specifically on a start-up.

I stopped at 6 in the hopes that other folks could come with the final 4.  If you have a suggested “Top 10” reason please just create a comment below (or send me an e-mail) and let me know.  I will repost the completed Top 10 later.