Burnham's Beat

Are VC Funds Getting Too Big For Their Own Good?

I’ve recently had very similar conversations on separate occasions with a number of different entrepreneurs.  The basic gist of these conversations, which Peter Rip touches on in his own post, was that the interests of VC funds and entrepreneurs seem to be diverging more than ever thanks to several trends, the most important of which is the increasing size of VC funds.

Problems On the Way In...
Large funds are creating both entry and exit problems.  On entry, large funds create problems because they are under pressure to invest as much as possible in each deal in order to preserve the operating leverage of the fund.  This means that it’s increasingly difficult for entrepreneurs to assemble a syndicate of VC firms as each firm wants 100% of the deal from themselves.  Syndicates are important for entrepreneurs because they disperse control and leverage multiple networks.  More importantly, the VC’s desire to put as much money to work as soon as possible often results in very significant up-front dilution for entrepreneurs.  Many VCs now say that they have minimum initial investments, usually around $3 to $5M, which can give the entrepreneur a frustrating choice between no funding and too much money with too much dilution.

... and Problems On The Way Out
On exit, large funds once again can cause problems because the funds are heavily biased towards “pressing their bets” and trying to get a home run vs. selling out more quickly for single or double because singles and doubles on $5M don’t “move the needle”.  Thus, entrepreneurs often find VCs dragging their feet on potential M&A deals because they don’t think a smaller early return is worth the time and capital they have invested.  On the other hand, many entrepreneurs want to sell out early because the money on the table is significant from their perspective and they are worried that in going for the home run they may ultimately strike out and end up with nothing.  Put another way, entrepreneurs don’t have the luxury of portfolio diversification so a bird in hand is as good as five in the bush.

These tensions are being exacerbated by two other trends.  The first is that thanks to dramatically lower technology costs in some sectors, it often takes less money to get a company off the ground than it has in the past.  Thus, VCs are paradoxically looking to write larger checks into industries that actually need less money.  Second, exit valuations have become more predictable and less rich which means that dilution stings more than ever.  Giving up 50% of a business that could be worth $500M in a few years is a lot easier than giving up 50% of a business that will likely on be worth $25-$50M.

The Bad News and The Good News
The bad news for large VC funds is that if my recent conversations are any guide it seems like more and more entrepreneurs are picking up on the implications of these dynamics and adjusting their behavior accordingly.  These changes could lead to a serious case of adverse selection, wherein the best entrepreneurs with the most capital efficient ideas either self-fund or raise money from angles while only relatively risky ideas with large capital requirements seek capital from large funds.

The problem for entrepreneurs is that there’s not a lot they can do to change the behavior of the large funds.  For the most part these funds are behaving rationally and really couldn’t change how they behave if they wanted too given the economic incentives/restrictions they face.  The good news is that for those less sensitive to dilution there’s a lot of money out there and it’s easier than ever in some respects (save perhaps Q1 2000) to raise a large amount of money if you need to.

If It Fits, Sign It
The best advice that I would have relative to this trend for an entrepreneur is that if you have the luxury of choosing your VC firm, you should try to pick a firm whose financial interests are best aligned with your own and not necessarily the best “name” or the best price.  If you have an idea that will take a lot of money to get off the ground and if success if more important to you than money, you are probably best off taking money from a large firm as they are not going to sweat writing big checks and will likely be more patient than the average VC.  If you have a very capital efficient idea and are interested in making money as soon as possible I suggest you go with a small VC firm whose investment in your company will be material enough from their perspective to align everyone's incentives.

Google Base Is The Merchant of Record, Now That's Interesting

I wrote a short post today on Google Base now intermediating payments between buyers and sellers.  One point that I feel compelled to elaborate on a bit more is that Google is apparently the merchant of record in these purchases. This is very interesting.

In contrast, EBay has done everything they can not to become the merchant of record for transactions on its site.  Anyone who has purchased something on EBay knows that you settle up with the merchant directly, usually via Pay-Pal, and not through EBay.  In contrast, when you buy something via Google Base, you will pay Google who in turn will pay the merchant.  Even though the Terms of Service contain language which says that legally the transaction is between the buyer and seller and not between the buyer and Google, that's not actually what is happening in terms of money flows.

Anyone familar with the credit card industry is bound to be very surprised by this given that the merchant of record typically takes responsibility for all charge backs, fraud, etc.  Google claims that all transactions processed are non-refundable, but if they are processed via credit cards that is not the case because the issuing bank can always refuse to pay the merchant bank and the merchant bank will typically then stick the merchant with the so-called charge-back. Given this, it is not clear to me how Google can realistically plan on avoiding charge-backs (my guess is that they will force the end sellers to accept them).   Now there's a lot of verbiage in the terms of service that basically say they don't have to follow the standard credit card rules, but I wonder how these would stand up in court or more importantly a challenge from an issuing bank.

Why would Google go to the trouble of taking on all this additional risk?  I am not 100% sure but I have a few gusses:

1. They wanted to make the buying experience as seemless and immediate as possible.  Having a single seller from a payment perspective clearly accomplishes this.  Just enter your payment details once and you will theoretically be able to purchase from thousands of different sellers through the same consistent interface without ever having to enter your billing details again.
2. They are laying the goundwork for an escrow service.  Once all payments flow through them they can escrow them quite easily which theoretically would reduce fraud and improve the buyer experience while generating additional revenues.
3. They are being greedy about the float.  They plan on collecting payment from buyers and then sitting on the float for a while as a way of making additional margin without raising transaction fees.
4. They plan on becoming a full fledged merchant bank and even issuing their own branded credit card at some point.  Who needs rules when you are both the card association, issuing bank and the merchant bank.  A stretch, but you never know.

Whatever the case (it may be a little of all 4), it is a very different approach from EBay and one that promises to make the buying process on Google Base very easy, but in the process also promises to expose Google to a lot more headaches than EBay.  It will be particularly interesting to see how they deal with disputes because I don't care what the legal docs say, people are still going to contact them when there's a problem and they are going to be aren't going to be happy when Google says they have no standing because of the "terms of service". (You also have to wonder what their acquiring bank is going to say.)

One more thing, if Google does get away with this I don't see why EBay won't be forced to follow suit.  The buyer experience on Google Base will just be a lot better than on EBay, similar to the "one click buying" that Amazon pioneered.

UPDATE:  Murali left a comment and pointed out that EBay has already announced that they will be offering "Ebay Express" sometime this spring.  EBay Express supposedly offers a similar universal wallet capability however as Scott (who seems to know EBay well) pointed out in a comment below Ebay will not be the merchant of record but will just create a multi-seller shopping cart with a separate Pay-Pal account for each seller.  In addition to what Scott mentioned, everything posted in EBay Express will also apparently be an EBay listing and presumably subject to all the existing EBay fees.  Also, EBay Express is not integrated into a larger search engine and it's not clear that they will let other engines index their site (which seems unlikely).  So the net is that EBay Express is pretty different from what Google is doing from a payments perspective.

Uh oh EBay: Google Base is now facilitating payments

Some very significant, if not predictable, news out of Google today.  Google Base is going to start beta-testing payment intermediation in which buyers can buy items off of Google Base using their Google Account, while sellers can register to have Google accept payments on their behalf.

This is very interesting for several reasons:

1. This initiative is clearly taking dead aim at EBay's "Buy it Now" business, which as of last quarter was 34% of their volume.  Only Google is not charging listing fees (at least as far as I can tell) they are just going to charge transaction fees.  In my opinion this is potentially very bad news for EBay.  Most of the incremental sellers that EBay has added in the last few years are merchants that are just using EBay as a distribution channel.  To them, the auctions are more an annoyance than anything else as they would much prefer just to sell their wares at a fixed price.  Google Base will now allow merchants to feed all their listings to Google for free and just take a cut of transaction.   What's even better is that this basically obviates much of the need for merchants to buy click-through adds on Google as why would you buy an add if your stuff is already indexed and ready to buy via GoogleBase.  What's more, why wouldn't you sign up for this service if you were a merchant as there's basically no down side.  I don't want to be too dramatic, but EBay could be looking at a collapse of its listings fees by the end of 2006 similar to what they saw in China with Ali Baba if this gets any traction and I don't see why it won't at this point.
2. You do not just wake up and decide to intermediate credit card transactions between buyers and sellers.  This takes a considerable amount of planning and infrastructure development, particularly on the payments side.   It stands to reason now that Google has essentially completed the infrastructure it needs to launch a Pay-Pal equivalent which one has to believe is now rather far along in its development and will be launched sometime in 2006.  In fact, another post on Google's official blog today basically hints at this pretty heavily.
3. It is a great example of how search-based edge aggregators can layer a bit of process flow and payments technology on top of a search engine and  all of a sudden become a direct threat to a previously untouchable walled garden.

Personally, I am surprised that they moved this quickly to fill out the payments functionality before putting a better front end on Google Base, but I guess they figure if they build it, people will come.  It will be interesting to see how the market reacts to this monday.

UPDATE:  Murali left a comment below and pointed out that EBay has already announced that they will be offering "Ebay Express" sometime this spring.  EBay Express supposedly offers a similar universal wallet capability however as Scott (who seems to know EBay well) pointed out in a comment on my other post on this topic that Ebay will not be the merchant of record but will just create a multi-seller shopping cart with a separate Pay-Pal account for each seller.  In addition to what Scott mentioned, everything posted in EBay Express will also apparently be an EBay listing and presumably subject to all the existing EBay fees. Also, EBay Express is not integrated into a larger search engine and it's not clear that they will let other engines index their site (which seems unlikely).  So the net is that EBay Express is pretty different from what Google is doing from a payments perspective and the strategic impact of Google's move into the space remains the same.

Hedge Funds, Venture Capital and The 25% Solution

If you put your ear to the ground on Sand Hill Road these days you can just hear them.  They are the faint rumblings of a potentially massive sea change in the venture capital industry.  Originating, of all places, on the east coast and traveling across the country at an ever quickening pace, the epicenter of these rumblings can be found somewhere between 40th and 60th Street on the east side of Manhattan.  Those familiar with commercial real estate trends will recognize that this epicenter just happens to correspond with the world’s largest concentration of hedge funds.  The correlation is no coincidence.

Hedge funds now have hundreds of billions of dollars under management and increasingly fewer public places to put them.  As the buyout industry has already discovered, this over supply of capital is rapidly spilling over from the public world into the private world and causing all kinds of disruptions in the process.  The supply of capital is such that the hedge funds are not likely to stop with buyouts, indeed it’s only a matter of time before they start making their presence felt in the venture capital market.  Very quietly some initial beachheads have already been established by a number of hedge funds, such as DeShaw.  More funds are rumored to be following in their footsteps and there are several examples of funds dipping their toes in the late stage end of the VC market a bit lately.

Inside their cozy, redwood-lined conference rooms, most West Coast VCs are either too insulated to hear the distant rumblings or convinced that this is just another wave of hapless VC carpet baggers destined to quickly fall upon the clubby ramparts of Silicon Valley.  However most of the VCs don’t realize that hedge funds have no intention of storming the gates with a bunch of ex-traders in black Armani suits, rather they intend to “hollow out” the best VC firms with a powerful weapon heretofore unknown in Silicon Valley: the 25% solution.

A Simple Question of Economics
The economics behind Venture Capital partnerships are pretty simple.  The baseline fee structure in the industry is a 2% management fee and a 20% share of any profits (known as the carry).  The best firms get a 3% fee and a 30% carry.  A few rare birds do even better than that.   While some firms split the profits equally between the partners, most skew the GP split to favor the more senior (though not necessarily the most successful) partners.  Because, due to the time intensive nature of venture investing, it is not easy to generate a lot of operating leverage at VC firms, there tends to be a high correlation between the assets under management and the number of partners in a firm.  As the number of partners and the assets under management grow, the ability of any one return to really “move the needle” in terms of generating significant profits diminishes significantly while the return of the overall portfolio becomes much more likely to just hit the average return of the category. 

What this means is that growing assets under management is a double edged sword for most VC firms because it inevitably leads to greater dilution and lower returns.  This dynamic dictates that as firms grow in size, the senior partners tend to become much more attuned to the management fees than to the carry because they typically have direct control over the management fees and can basically dictate an outsized annuity to themselves in the form of disproportionate management fees, while convincing the junior partners that they are not being too greedy because there is not a huge difference in the GP profit split.  If you are wondering why many VC firms seem to be rapidly increasing assets under management and building bigger partnerships even though it appears that the industry already has more than enough capital, wonder no more, this is the answer.

Now there is nothing inherently wrong with this structure (many partnerships tend to work like this), however it has in many ways help create a huge opening for hedge funds to get into the business.

A Different World
The economics in the hedge fund industry are very different from venture capital.  While the standard fees charged by hedge funds are somewhat similar (a 1-2% management fee and around a 20% carry) there is a lot more variability reflecting the much more diverse set of investment approaches and managers.  Some program trading funds charge less than average because they are designed to deliver single digit returns with very little risk, while some other funds charge significantly higher fees either due to past performance or the dynamics of their particular niche.  For example, one of the most successful long/short equity funds charges no management fees, but a 50% carry.

What’s perhaps most important about hedge funds relative to venture funds is how hedge funds allocate ownership of the profits.   Unlike venture funds, hedge funds tend to be much more closely held with 100% of the profits often held by just a few individuals and in many cases held by just a single founder.  Hedge funds can get away with this inequality for several reasons:

1. They generate mostly short term gains so there are few tax benefits to owning a piece of the general partner vs. just getting a large bonus.
2. They have much greater operating leverage than VC funds because they can often profitably invest tens if not hundreds of millions in a single investment idea and because they take no operating role in their investments, the average PM can manage a much larger number of ideas than the average VC.
3. They offer, in comparison to VC funds, very generous profit sharing splits to their Portfolio Managers. (PMs are the hedge fund equivalent of a VC partner)

The 25% Solution
From a practical perspective what this all boils down to is that hedge funds can offer an individual PM around a 25% share of the profits they generate on “their portfolio”.  While some PMs get more and some get less, 25% is roughly “market” right now.  This profit share compares very favorably to most large VC funds where the share of profits is generally smaller.   In fact, a 25% share of the profits is probably a higher share of the profits than many of the best known partners at the best known VC firms receive.  Even better, these profits are typically paid independent of other PMs and on a “rain or shine” basis meaning that PMs are paid their profits independent of how the overall firm does which enables them to be paid their full share even if some of the other PMs in the fund didn’t pull their weight.  Finally, there are generally no clawbacks in hedge funds, which means PMs never have to worry about paying back profits should future performance turn sour.

Compare this to VCs who almost always have “communal” carry where one partner’s poor performance can significantly reduce or eliminate the profits for the all the others and where the threat of clawbacks is very real and it’s easy to see that for a VC willing to bet the farm on their own performance, the 25% solution is likely to look very attractive.

The true beauty of the 25% solution is that it is infinitely replicable and results in no incremental dilution to the GP.  Thus the founder or founders of the hedge fund can grow assets to the moon and still have a 75% share of profits.  Therefore what looks to be an very generous profit share from a single VC’s perspective is actually still heavily skewed to the founders.

The Opportunity
Putting two and two together, it is easy to see how hedge funds could rapidly gain a major presence in Silicon Valley.  Not only do they have the capital, but they have the economics that should allow them to recruit many of the top performing partners, especially the younger generation of “up and coming” partners that are on the losing side of the fee and profit skew.

The ironic thing is that most hedge funds will probably do this as almost an afterthought.  With some funds having gross exposures in the tens of billions of dollars, they could dedicate just a few percent of their assets to venture and become a major player overnight.  While the direct returns on such funds probably wouldn’t move their own needles, the private market information flow that the hedge funds would gain access to could be worth a few hundred basis points of edge on their public holdings, which is nothing to sneeze at when your are levered 2-1 on $10BN.  Thus, the day a hedge fund walks down Sand Hill Road offering the “25% solution” is the day that those rumblings of change might just become a full blown earthquake.

Long or Short Capital's Web 2.0 Analysis

If you are a financial and technical geek, such as myself, and you enjoy a good dose of humor every once and a while you owe it to yourself to check out Long or Short Capital. They recently published a hilarious analysis of Web 2.0 companies that will make you laugh.  Their Satan's Portfolio post is an absolute classic.

They are also the only website I know of that claims to pay a quarterly cash dividend back to their users (I have asked them to pay mine "in kind" with Cheetos and Redvines) which they do mostly for humorous effect but given all the discussion about Yahoo and Microsoft's research into paying their search customers I wonder if the crew at Long or Short haven't hit on a business model (or perhaps just a cost of doing business) that will inevitably become much more prominent in the blogsphere.

Edgeio and the “Write Once, Publish Everywhere” Web

A few weeks ago I wrote a post in which I theorized that people would use personal websites as a platform for publishing various types of “listings” making the web a kind of “write once, publish everywhere” nirvana.  Just a few days after creating that post I was contacted by Keith Teare who, along with Mike Arrington of TechCrunch, is about to launch a site called Edgeio.

As it happens, Edgeio is basically founded with the same premise in mind that I outlined in my post which means that Keith and Mike were, not unsurprisingly, not only way ahead of me in that they saw this coming awhile ago, but so far ahead that they have already built a start-up to take advantage of it.  I am not sure when they are officially launching but they have raised seed money from a bunch of top tier angels and from my tour of their new site, they appear to be well on their way to having the first vertical search engine that explicitly targets personal listings embedded inside individual web sites and blogs.

If that weren’t enough, I was having lunch the other day with someone who I regard to be one of the best technology minds in the valley and he told me that he was being recruited to be CTO of a start-up that competes directly with Edgeio.  I had to laugh though because only in Silicon Valley can you have two supposedly “stealth” companies competing with each other before either of them is even launched.  Amazing.

Anyway, for better or for worse then it appears as though we are on the cusp of several new “edge” focused search engines that plan to aggregate blog-based listings and then compete with established classified oriented sites such as Realtor.com, Craig’s List, Ebay, etc.

Living On The Edge
In Edgeio’s case, they are attempting to leverage as much of the existing blog/web infrastructure as possible in order to make the listings process as painless as possible.  On its own, Edgeio is already crawling almost 26 million websites, most of which one has to assume are blogs.   If you have a blog and it has an RSS feed, chances are they are already indexing your content.  The only thing a blog owner needs to do to get a listing included in Edgeio’s listings database is to tag a post with the word “listing”.   That’s it.

Edgeio then processes all incoming RSS feeds and splits off any new posts with a “listing” tag and automatically incorporates them into its listings database.  That database can be searched at Edgeio.com but is also available to other websites, presumably via some kind of RSS meta-feeds.  One of the more ingenious aspects of Edgeio’s design is that they let the blogger know their listing has been successfully indexed by posting a “Trackback” to the specific post on the blog that has been indexed.  They also leverage the increasingly important “ping server” networks to figure out when new posts are created.

While Edgeio does not fully embrace the precepts of Structured Blogging yet, it does allow owners to embellish listings on Edgeio’s site once they are indexed and it’s pretty clear that Edgeio could easily support more advanced tagging or structured blogging initiatives if it chooses to.

End users searching Edgeio’s listings can contact the owners via “anonymous” e-mail addresses, which Edgeio intermediates (and which also provides a convenient monetization point).  Owners can also leverage their reputation from other services such as EBay, Linked-In, by allowing end users to see their user ID for these services.  Presumably, someone interested in a particular listing might look up what someone’s reputation is on EBay to see if they want to deal with them or not.  Spam is addressed by allowing end users to flag a posting as spam which I suspect will lead to greater scrutiny and perhaps even blocking of whatever RSS feed that spam came from.

Edgeio vs. Google Base
In many ways, Edgeio is kind of like an independent version of Google Base, only with a much easier way for owners to get listings into the site (they don’t have to lift a finger) and with a much more end-user friendly interface.   Rather than get bogged down in the numerous “hard” computer science issues that plague unstructured data management, Edgeio has instead tried to keep its whole architecture very lightweight and loose and to leverage as much of the existing web and blog infrastructure as possible.  It’s a very cool example of how it’s possible to put a fairly rich application together on the web today without a lot of heavy lifting.  By comparison, Google Base relies on a “build it and they will come” approach that requires owners to comply with complex schemas and puts 100% of the burden of listing an item on the owner.  Not surprisingly, Google’s approach reflects that of an Internet titan that expects everyone to beat a path to its door, while Edgeio’s approach reflects the zero-up front investment and customer-friendly approach that start-ups must often take.

Cart Before the Horse?
While I am impressed with the vision and execution behind Edgeio, I am also concerned that in some ways building the infrastructure to process and distribute blog based listings might be putting the cart before the horse in many respects.   Even though there are supposedly 28M blogs out there right now, the average blog is not optimized for creating classified listings and the average user is unlikely to seek out this functionality.  Even a geek such as myself would have to create a separate blog for my listings as I don’t want a lot of random posts cluttering up my main feed.

What’s needed then for services like Edgeio to really take off is a new kind of blogging platform, or at least an extension of existing blogging/social networking platforms, that explicitly contemplates and enables people to post and manage listings.  The sites that are coming the closest to such a platform right now are the social networking sites, such as MySpace, which are allowing their users to post an increasing amount of information which they presumably can start indexing and re-publishing, however no one is really doing a good job of it yet.

I’d say that there’s a good start-up opportunity to create this kind of blogging platform, but given my experience with Edgeio I suspect that someone already has, I just don’t know about it yet.  Either way, I think that services such as Edgeio will find it hard to get critical mass until either new blogging platforms that explicitly contemplate personal listings emerge or existing platforms upgrade and enhance their offerings to explicitly enable this capability.  The good news is that both things are bound to happen in the near future which means that the vision of a “write once, publish everywhere” web will soon become a reality.

Vonage: It's All About Customer NPV

VOIP pioneer Vonage filed for its IPO last week and the financials contained in its S1 have set off a lot of discussion.  Om Malik, who has followed Vonage very closely over the years, thinks that the S1 contains more red flags than Boston's Big Dig, while Michael Parekh is having a serious case of late 1990's deja vu thanks to Vonage's enormous losses.

As for me, I think the S1 makes it plain as day that Vonage is simply following the same game plan that the major online trading firms followed in the late 1990s.  As I outlined in a mid-2004 post, the key metric for Vonage is not current period Net Income, but Net Present Value (NPV) per customer.  As long as the incremental customer NPV is sufficiently high, Vonage should not only continue running losses, but it may actually make sense to dramatically increase near term losses in order to create more long term value.  Indeed, one look at the financials tells you that this is exactly what Vonage did in 2005.

While this is great in theory, up until now there has been no hard data publicly available to see if Vonage was in fact succeeding with this strategy.  While the recently filed S1 doesn't have all of the information needed to make a 100% accurate assessment of Vonage's incremental customer NPV, it has more than enough data to make a decent estimate and so with that in mind I dusted off some of my old online trading customer NPV models (I covered the online trading industry when I was a Wall Street analyst) and took a crack at it.

The 5 Keys To Estimating NPV
Customer NPV models generally have 5 key pieces of data.  Below I have identified each piece of data and described what, if any data is available from Vonage.

1. Net acquisition costs per customer.   Acquisition costs are probably the most important part of an NPV model.  In the S1, Vonage claims that its marketing cost per customer in Q3 05 was $209. This is a bit understated though because this figure does not include the costs associated with deploying customer premise equipment (ATAs) which appear as "Direct Cost of Goods Sold" in the financials.  These costs in turn are somewhat offset by "Customer Equipment and Shipping" revenue.  Including these additional figures results in a line acquisition cost of $233.24, which is further reduced to $203.25 by the activation fee of $29.99.  The actual cost is probably a bit higher because Vonage accounts for cash incentives and rebates as a contra against revenue, but these costs don't appear to be highly significant right now so I am going to go with a $203.25 cost in my model.
2. Average customer life.  The key determinant of average customer life is what's commonly known as "churn".  The higher the churn, the lower the average customer life, the less aggregate cash flow a given customer will generate.  In the S1, Vonage inexplicably decided to calculate churn based on customers as opposed to lines, even though it doesn't provide any statistics on how many customers it has each quarter.  That said, it's possible to calculate the line churn easily and it has been 2.1%/month for the past two quarters.  At this churn rate, the average customer life is roughly 4.2 years.  According to the S1, Vonage is assuming a 5 year average customer life as that is how long they are choosing to amortize their activation fees.  I am going to be generous and give them their 5 year customer life under the assumption their accountants signed off on it so it and it’s not that far from the range they have been running lately.
3. Average yearly customer revenues.  With fixed rate monthly subscriptions, Vonage's revenue/line tends to be relatively stable although it has been declining over time thanks to price cuts.  In Q3 2005, the average monthly telephony revenue per line was $24.84 or about $298/year.  This includes a small portion of the activation fees, so I am going to use a $292/year figure to account for the activation fees after doing some rough estimates.
4. Operating margins before customer acquisition costs.  In an NPV analysis you have to separate out customer acquisition costs from on-going operating costs in order to determine what the "out year" margins are on customer cash flows.  In Vonage's case, when you strip out all of the marketing costs as well as all the equipment costs and revenues, you get an operating margin of 5.5% in Q3 05.  This is down sharply from Q1 of 05 when operating margin before marketing costs peaked at 22.2%.  It's not completely clear why margins have declined so much (they should be increasing) but it's possible that one-time costs associated with the IPO and some e911 requirements led to a spike in expenses.  In light of this, I am going to give them the benefit of the doubt and use a 20% operating margin in Year 1 although it will be very interesting to see what direction these margins go in Q4.
5. Discount Rates.  Discount rates are a fairly subjective matter when it comes to NPV analyses.  At a minimum, discount rates should at least be set to the expected rate of inflation so that you have a "real dollar" cash flow.  However, most organizations use a discount rate in excess of inflation, usually one that is either their Weighted Average Cost of Capital (WACC) or some targeted premium to WACC (to create economic value and/or sustain their premium market valuations).   For high risk private companies a 10%+ discount rate is typical.  In my online trading models I used to set the discount rate equal to the market consensus long term growth rate estimate (which was usually in the 20-25% range) under the conservative (and somewhat convoluted) theory that this meant people were expecting the company to grow earnings 25% a year and thus any NPV analysis should reflect those expectations.  I don’t know what Vonage’s market value will be, nor do I know it’s WACC, but I do know that they have used a lot of venture capital to fund their build out and the long term IRR of early stage venture capital is around 18%.  Given this I am going to use a discount rate of 18% even though this is admittedly mixing apples and oranges when it comes to finance theory.

One last assumption I have to make is what will happen to annual revenues and margins in the “out years”.  Vonage has already cut prices several times and it stands to reason that they may do so again in the future.  In addition, pre-marketing operating margins are likely to change in the future, although margin pressure from price cuts may be more than offset by the benefits of increased operating scale.  For example, in the late 1990’s many of the online trading firms ran pre-marketing operating margins in the 20-30% range, but now those margins are now in the 40-50% range thanks to scale effects.  To account for these dynamics, I am going to assume a 5% year decline in revenue and a 5% year increase in operating margins (which leads to a 24.3% pre-marketing operating margin 5 years out).  I have no idea what these will actually be but I think that these are reasonable guesses.

And The Answer Is…
So where do all these assumptions get us?  As the table below illustrates, these assumptions, plus the hard data from the S1, generate an incremental customer NPV of $(21.39) for Vonage in Q3 of 2005.

Obviously, a negative NPV, even a small one like $21, is not a good thing and may indicate that Vonage is actually destroying value (at least relative to return expectations) despite its rapid growth.

This conclusion is tempered somewhat by the following facts though:

1. This is admittedly a very simplistic customer NPV model based on incomplete data and tenuous assumptions.  However, anyone thinking about buying Vonage’s stock will basically have to go through the same exercise with the same data, so they will face the same challenges and may come to similar conclusions.
2. Vonage’s customer acquisition costs may be inflated due to their very heavy ad spending in 2005.  In the online trading industry, many companies had similar spikes in spending and saw greatly reduced customer acquisition costs after they ramped down that spending thanks to the residual brand-value created by the advertising spikes.   Given this, it is possible that Vonage could lower customer acquisition costs in the near future.
3. Vonage’s pre-marketing operating margin may increase much faster than modeled.  There’s a strong argument that Vonage will be able increase its operating margins significantly, not only due to normal operating scale, but due to lower bandwidth costs and lower termination costs as Vonage processes more “on us” calls that stay within it’s own network.

All that said though, Vonage is clearly cutting things pretty close.  For comparisons sake, the last model I did for E*Trade in June 1999 showed that they had a $299 acquisition cost but a NPV of +$140 at a 26% discount rate which clearly provides a lot more room for error than Vonage currently has.

A Simple Matter of Price
What this all boils down to is really more of a valuation question than anything else.  At a 5% discount rate (which amazingly is higher than the yield on 30yr treasuries right now), Vonage is actually generating +$48 in value for each customer it added in Q3 2005, but at an 18% discount rate they are losing $21.  This means that investors should theoretically be willing to pay a price that equates to a discount rate of somewhere between 5% and 18%.   Just what price they settle on will probably depend on how persuasive Vonage’s management team is on their road show.

Admittedly, this post fails to address some of the larger (and arguably much more important) strategic issues facing Vonage such as competition from the MSOs, regulatory risk, and “free” VOIP from the Skype’s of the world, but from a pure historical #s perspective you can’t really say that Vonage isn’t creating value, you can just argue that they aren’t currently creating enough value to justify the return expectations embedded in the capital they are using.  That is potentially bad news for Vonage’s VCs but not necessarily bad news for public investors if they price the shares correctly.  It will be interesting to see just what that price is.

Virtual Stock Portfolio: January 2006

January marks the 2 year anniversary of the Burnham's Beat Virtual Stock Portfolio and as it happens the portfolio closed out it's second full year on a high note, generating its second best monthly return ever at 12.8%.  Over the last 24 months the portfolio has had 27 different positions and is now up a total of 107% with the average pick up 28.7%.  The key to generating the returns has not only been stocking picking but keeping the portfolio roughly 50/50 in terms of long and short exposure as this has allowed it generate positive returns in good and bad markets with lower overall risk.

January was an exceptional month, so it will be a tough act to follow.  Both long and short positions made money which means it was a good stock picking month.  I am going to add a few new positions this month to try and spread out the portfolio a bit more and make the short side a little bit more "jumpy" given that February tends to be a very tough month for stocks.

Long Picks

Company: Microstrategy Ticker: MSTR
Sub-sector: Business Intelligence
Investment Thesis: I like the BI space in general and have been keeping my eye on Microstrategy.  This has recently been one of the cheaper stocks in the space, yet it also has one of the better product portfolios and market positions.  Businesses are still spending big bucks on BI and MSTR should be a big beneficiary.
Performance: Since 3/31/05: +77.1%,  Jan. vs. Dec.: 16.3%
Comments: Another nice month which can't be good news for the shorts in this stock.  They reported on the last day of the month and missed their EPS a bit due to weak license sales, but not enough to cause serious damage.  A new release of their flagship product should be good news for license sales this quarter and with $100M in cash flow they will probably start buying stock back again in a few months as well.  Given this, I can't see why I won't hold this through the end of this quarter especially given that the shorts are going to continue to suffer.

Company: Actuate Ticker: ACTU
Sub-sector: Business Intelligence
Investment Thesis: Acutate is a business intelligence company with a particular focus on enterprise reporting.  I had a long position in ACTU in 2004 and lost money on it, but I think the stock is back on the upswing now thanks to an improved product line and focus.   ACTU trades at a healthy discount to rest of the BI group (kind of like SPSS did at one point) and every penny of upside in its EPS could really move the stock.
Performance: Since 9/30/05: +59.7%  Jan. vs. Dec.: 28.7%
Comments: This stock was "en fuego" in December as folks bid it up in anticipation of a good Q4.  The company reported on the last day of the quarter and did in fact beat top and bottom, but people didn't like it's guidance for 06 and it traded off 7% or so.  I am still going to hold here for a bit as there seem to be some big buyers and with the stock trading in the mid-teens PE vs. mid 20's for the comps there is still some significant upside room.

Company: OpenText Ticker: OTEX
Sub-sector: Content Management
Investment Thesis: OpenText is a content management company that went on an acquisition binge in 2003 and 2004.  The stock suffered from all the M&A related charges and fallout but management now claims that they are going to resolutely focus on EPS growth.  OTEX trades at a healthy discount to the rest of the content management group and has a broad product portfolio.  Integration snafus could trip them up, but the low multiple on the stock should limit any potential damage.
Performance: Since 9/30/05: +18.5%  Jan. vs. Dec.: 17.4%
Comments: Had a strong January after a weak December (perhaps driven by tax loss selling).  Looks like people think it will have a good report.  Still trading at a healthy discount to the rest of the content management group which has been on a tear lately.
 

Company: Cryptologic Ticker: CRYP
Sub-sector: Gaming Software
Investment Thesis: Cryptologic is a provider of gambling software to online casinos and poker rooms.  They license their software to numerous companies in return for a cut of the take.  About 70% of their revenues are from casino related software sales and about 30% from poker related sales.  Since they are a technology provider and not an operator they actually are listed in the US and do not appear to be in danger of violating any online gambling laws.
Performance: Since 9/30/05: 31.6%  Jan vs. Dec.: 18.0%
Comments: Nice month that eliminated some of the discount between CRYP and the rest of the online gambling sector, but still some room for improvement.

Company: Party Gaming Ticker: PRTY.L
Sub-sector: Online Gambling
Investment Thesis: Party gaming is the largest online gambling company in the world with a focus on poker, but a very quickly growing casino operation as well.  Some may recall that I had PRTY long in a successful pair trade in Q4.  After seeing Party's Q4 report and doing some modeling I feel compelled to add them into the portfolio as a pure long bet.  Party not only showed good growth in poker in Q4, but had an absolute blow-out quarter in its casino business thanks to cross selling into its poker base.  By my calculations the stock is currently trading at 11X 2006 EPS even though it should grow 30%-40% on the top/bottom line without adding any new businesses.  Oh, and there's a 3% dividend payment coming in May.
Performance: Since 1/31/06: 0%  Jan. vs. Dec.: NA
Comments: You could probably pair this up against SBT again (SBT is going to look very pricey once people figure in all the shares they are issuing), but I figure that PRTY is compelling enough by itself.  This is a volatile stock, but the valuation is just compelling, especially relative to the land-based casinos.

Company: Agile Software Ticker: AGIL
Sub-sector: Supply Chain
Investment Thesis: The supply chain sector has been a complete disaster the last few years and Agile's stock has been no exception.  However, AGIL has actually grown revenue over the last four years and while it's still GAAP negative it actually seems to have turned the corner in terms of generating positive operating cash flow.  It's only trading at about 1.2X EV/Sales which is low given it's potential leverage once it gets its expense base in order.
Performance: Since 1/31/06: 0%  Jan. vs. Dec.: NA
Comments: The stock is about 35% off it's low so I am a little late to the party, but I think supply chain will see some renewed investor interest this year.

Short Picks

Company: Wave Systems Ticker: WAVX
Sub-sector: Security
Investment Thesis: I first encountered Wave when I wrote my initial analyst report on Wall Street in the mid-1990s. Wave has remained in business largely by claiming that it is developing revolutionary security technologies, kind of like a bio-tech company that never gets out of trials. With a grand total of $1.4M in revenues over the last 3.5 years, a $4M/quarter cash burn rate and only $4M or so in the bank, a day of reckoning is fast approaching.
Performance: Since 10/1/04: +27.5%  Jan vs. Dec.: 2.9%
Comments: Relatively quite month.  They will need to raise more money by end of the quarter and it's hard to imagine that they can offer a bigger discount than they did last time.  They may have decent Dell-related revenues this report which might spike the stock, but I will try to have patience.

Company: Citadel Security Software Ticker: CDSS
Sub-sector: Security
Investment Thesis: Citadel offers a subscription service to help companies spot security vulnerabilities.  It's a good idea, but a lot of other companies including a number of private companies offer the same service.  Lately Citadel's business has been falling off a cliff.  They are buring cash to the tune of $5M/quarter and yet the management team hasn't done any major cost cutting.  As a VC, I can tell you first hand that it is incredibly difficult to turn around this kind of situation even if you get some product momentum.  I haven't seen a single company in this kind of shape pull it out.
Performance: Since 9/30/05: 49.9%    Jan. vs. Dec: 3.1%
Comments: I am covering this position this month.  There's still a good chance the company is sold at a price below the preferred prefs and debt (thus wiping out what's left of the equity), but I've made a good return and it's important not to be too greedy.  In addition, the CEO has guaranteed the company's debt which shows some real conviction and the company continues to land large contracts which means that there is clearly something of value there that will sell for something.  I have no idea how they are paying the bills though...

Company: Entrust  Ticker:  ENTU
Sub-sector: Security
Investment Thesis: Entrust started out providing Certificate Authority software for use in public key encryption and now has a broader line of identify management products.  I know them from my days covering the security sector on Wall Street.  They seem to disappoint at least once a year and given that the stock has now fully recovered from their last disappointment they should be due again.  It doesn't help that most of the major software players, including IBM, Oracle and CA, have made their own identity management acquisitions in the past 18 months either.
Performance: Since 9/30/05: +28% Jan. Vs. Dec.: +16.7%
Comments:  Like old reliable, Entrust disappointed again and the stock traded off nicely.  They actually hit their Q4 numbers but guided down for the year and people came to their senses and asked "why I am paying close to 30X for this stock again?".  I will keep it in the portfolio this month as February is usually choppy but I am worried that the management team may support the stock by continuing to their ill-advised buy backs.

Company: Convera  Ticker:   CNVR
Sub-sector: Content Management
Investment Thesis: Some may recall that I was short Convera the first half of last year on the theory that the management team would not deliver on their much hyped enterprise web search product.  That turned out to be a bad short as the hype around search was just too big of a reality distortion field.  Well, reality has begun to settle in and I am back for another beating.
Performance: Since 1/31/06: NA Jan. Vs. Dec.: NA
Comments:  I am, admittedly, late to the party on this one give that it has traded off 40%+ in the last two months.  Despite the decline, the stock is still trading at a crazy 19X EV/Sales despite zero traction for the new product and a substantial negative cash flow.  I will have to be careful given the hype, but this should be trading lower six months from now.  I am a glutton for punishment.

Company: BankRate  Ticker:  RATE
Sub-sector: Internet Content
Investment Thesis: I spent a lot of time at one point in consulting to Fannie Mae and I spent a lot of time at one point analyze financial services related internet companies.  Bankrate is a web content site focused on financial services, but its growth is largely being driven by mortgage related advertising and referral fees.  With interest rates rising, I don't think they will have trouble hitting their Q4 #w, but I can't imagine they aren't going to have to talk the analysts down a bit on off their pretty aggressive 06 growth #s.
Performance: Since 1/31/06: NA Jan. Vs. Dec.: NA
Comments:  Close to it's 52 week high and not the kind of chart you like to bet against, but the mortgage industry is highly cyclical and can change on a dime.  I am bearish on long term rates/housing, so this is a good Internet related play on those themes.  Also, pay-per-click searching is undermining some of the growth in the referral market.  There are some other potentially good mortgage-related Internet shorts (NTBK, HOMS), but this is the most attractively priced.