The mobile black hole – can VC finally escape?

Happy New Year and what an exciting start to 2010! Already we have seen the acquisition of Quattro by Apple, the launch of the Google-branded and specified Nexus One phone and growing anticipation of an Apple Tablet computer. I wanted to summarise some of my thoughts on what these events may mean for the Venture Capital.

Anyone familiar with the VC industry will know the bulk of positive returns tend to be driven by a fairly concentrated set of investments made by the Venture Capital industry. Often literally a handful of companies can drive the bulk of the entire venture ecosystem return over the course of a decade. Obvious examples over the last few years have been Facebook, Google, Youtube, Skype*, Betfair* and perhaps a few more companies spread over enterprise software, semiconductor and cleantech. Notably absent are any venture-backed businesses which have used the mobile platform as their primary means to establish a multi-billion dollar company. In fact the mobile applications sector has been a virtual black-hole for venture capital. Money poured in, yet between Jamba selling to Verisign in 2004 until the recent exits of Admob and Quattro, examples of good venture-backed exits have been like parrots in the Arctic – that is non-existent.

Why mobile (mostly) sucked for so long for VC?

I would boil it down to four major factors:

1. Operator Channel – Selling products and services to a mobile operator or relying on mobile operators to get applications to market has dire economic consequences for most VC-backed companies. Revenue share is typically exorbitant driving low gross margins. The length of the sales cycle and also the subsequent qualification, testing and implementation burden imposed by operators drives overheads to a level which ultimately can’t be funded.
2. Device Fragmentation – This kills an application or services company for two reasons. Firstly the cost and complexity to build, test and support an application on multiple handsets (which are subsequently configured differently by the operators) is prohibitive. Secondly and less well understood, marketing a service to a fragmented device ecosystem is much harder. In particular viral channels break down where people cannot easily adopt applications and services unless they share exactly the same device as their friends and colleagues. The perception that having a few common operating systems would largely solve this problem is I believe wrong. A standard OS helps, but if factors such as screen size, CPU performance, memory, user input mechanic and sensors (e.g. cameras, tilt-sensors, multi-touch, GPS) even differ slightly across phones running on the same OS, then the application developer still faces a meaningful fragmentation problem. This is particularly true for complex applications such as games. Hence why Google changed course with Android. Originally Google was adamant that Android was their mobile offering and they wouldn’t offer a phone per se. The launch of the Nexus One is I believe driven the realisation that that to build an application ecosystem to rival Apple’s, they need to specify the device as well as the OS or else the fundamental fragmentation problem is not solved.
3. Low smartphone penetration – Until recently, simply not enough phones in circulation had the screen size, CPU, browsing ability etc. to provide an audience large enough to build a big mobile application company around.
4. Consumer confusion over mobile data tariffs – The emergence of flat-rate plans played a key role in the initial phase of consumer internet adoption on the PC (e.g. Freeserve in the UK). Before these emerged people were nervous and unsure of what costs would be incurred when logging on. Mobile flat-rate plans are now widely available and bundled with most Smartphone purchases, although some areas such as international roaming can still spring nasty surprises on consumers.

As a result of these factors, Index Ventures over the last few years made relatively few investments in the mobile area and those that we did such as Rebtel* had business models which we believed specifically avoided the pitfalls outlined above.

Now however after 10 years of false dawns and frustration, the next few years could be very exciting and highly rewarding for VCs who place the right bets. Firstly almost all the issues listed above have now been largely eroded, at least in the high-end smartphone sector. While this still accounts for a small portion of the overall market, it is growing the fastest and is the most profitable sector. Apple alone may account for as much as 50% of all handset industry profits despite having one phone model (thanks Hussein.)

Another critical factor which will drive better VC returns is the very aggressive turf war that is now playing out:

• Apple will want to extend its iPhone dominance as the high-end smartphone sector moves into the broader mass market;
• Google needs to ensure its dominant position in the web advertising is preserved and extended as consumers increasingly access the internet from mobile devices;
• Operators will try to dress themselves up as anything other than the dumb-pipes they seem destined to become;
• Nokia, Motorola, Samsung and other handset makers will need to decide how to fight more convincingly in the handset sector or whether to retrench to low-end phones or developing markets;
• Facebook, eBay, Amazon and other web players will also need to invest in providing existing web customers with new and better services which leverage the mobile platform;

Which will mean acquisitions – Admob (Google), Quattro (Apple), and Jajah (Telefonica) will be just the beginning. I will get as involved as I can in finding great companies to invest in in this sector. Good luck to everyone for 2010!

*Current or past Index Ventures investments.

Playfish acquired by EA

Congratulations to Kristian, Sami, Shukri, Seb and the entire Playfish team. It was simply wonderful to be involved with Playfish even if only for a short time.

ACCEL PARTNERS AND INDEX VENTURES ANNOUNCE EXIT OF PORTFOLIO COMPANY PLAYFISH TO ELECTRONIC ARTS

LONDON, ENGLAND – November 9, 2009 : Index Ventures and Accel Partners, two leading global venture capital firms, today announce the sale of portfolio company Playfish Inc. to Electronic Arts (NASDAQ: ERTS).  Playfish was acquired for a consideration of up to $400 million including an earnout of up to $100 million and excluding cash balances.

Kevin Comolli, board member from Accel Partners stated, “As the original institutional seed investor in Playfish it has been a pleasure to work with the founders and management team and to see them achieve such extraordinary growth.  Playfish has been recognized in the industry for its innovation and creativity and continues to change the way people play games by creating more social and connected experiences. We are sure they will continue to thrive under the ownership of Electronic Arts.”

Ben Holmes, board member from Index Ventures said, “We want to congratulate Kristian Segerstråle, the other founders and the entire Playfish team for what they have achieved in such a short time.  We are delighted to have been one of the investors in such a forward-thinking company and we wish them every success in the future.”

Kristian Segerstråle, Playfish CEO, commented, “I want to thank Accel Partners and Index Ventures who bought into our vision for a new type of games company and have supported us from the start and through our sale to Electronic Arts.”

The social media investment conundrum

Social media has been the investment sector which has created many of the biggest companies within the tech industry over the last decade. By social media, I’m using a broad definition of businesses which either rely heavily on user generated content as the underpinning of the service and / or user to user (viral) communication as the principal means of propagating and marketing the service. Successful exits in this space include Youtube, Skype, Last.fm, Bebo and MySpace and big private companies include Facebook, Linkedin, Yelp, Zynga and Playfish.

The appeal of this sector to venture investors are clear

• Rapidity of value creation. The ability to create multi-hundred and billion $ value companies in the space of a 1-3 years is almost exclusive to social media. Try doing that in software, semiconductors, ecommerce or cleantech. All typically require 5-10yrs to grow to this scale
• Reasonable cost / capex requirements. Limited capital is required to launch and test a product. Often the successful social media companies breakeven or at least have the ability to breakeven quickly. Hence capital at risk is lower and multiples on successful exits can be higher than in many other sectors
• Defensibility. Once at scale, network effects give these businesses a competitive advantage and robustness which acquirors value. Over the next 12-18 months, we will probably get to see how public markets value some of the key players in this space also.

So lots of good reasons to invest and a few exciting businesses which already validate the investment thesis. So far so good, now for the challenges…

The chart above shows the various stages which a social media business may go through and what the usage, revenue and valuation metrics might typically be at each stage. Also my perception of the probability of the business ultimately generating a great return which not only justifies VC investment but can contribute a substantial return.

This evidences some of the real challenges with investing in this sector

• Volume of investment opportunities in social media sector can be overwhelming. Particularly at early stages we see twenty business plans / investment opportunities for social media businesses for every one we see across the whole spectrum of other investment sectors (software, life science, hardware, semi, cleantech, etc). This means the chance of ultimate success for investments at pre-launch and early stages (1-2)  is vanishingly small and even the low valuations don’t typically reflect the risk inherent at these stages
• Late stage valuations (5-6) are very high and often leave limited upside for investors.
• Pinpoint timing is required. In my experience the best time to invest for a venture capital firm is post launch when the business has 100,000’s or low millions in Monthly uniques (stages 3-4). Here the metrics and to an extent the business model may be proven and the valuation still gives room for venture returns. However businesses can often pass through this stage  in a matter of a few months, so unless you are already very close to an investment opportunity as it moves from stage 2 into stages 3 and 4 you will likely miss the opportunity
• Early metrics are useful, but often don’t differentiate between future leaders and losers. The red and blue lines show the trajectories of 2 social networks (can you guess which?). These are essentially the same until a specific breakout point for one of them.

So while social media can offer the big and quick rewards for venture investors, it can also be a minefield and is particularly challenging and unpredictable for those tasked with making early stage investments.

The Three T’s

Here is a presentation I put together last year that looks at a few topics.

• Whether to seek VC money and what to think of before you embark on the process;
• What a Venture Capitalist looks for and how to get fund-raising off on the right foot;
• A brief explanation of some of the typical terms you might find in a termsheet; and
• Recommendations on how to prioritise which VC to work with when you have multiple offers.

One of the topics introduced is the “Three Ts” (Team, Technology, Traction) which is my crude framework for prioritising investments. I typically don’t agonise about finding good reasons and robust intellectual arguments for not doing a deal. Generally we just look at these three factors for a Company and hope to find something exceptional in at least one of them. Obviously team is important but occasionally, particularly in the internet area we come across phenomena which have gained amazing traction, even though the team may not on the face of it have enormous experience. These situations can be just as exciting. As I outline in the presentation, it is more interesting to have an A* against one of the “Three Ts” rather than having an unexceptional B+ across the board.

There are a few other points covered in the presentation which I may return to future posts. Thanks to Ryan Carson for letting me present this at his event.