The Jewish holidays are an interesting time of reflection and soul-searching.  One of the concepts I found myself mulling over this holiday season was the notion of accountability.  One of the most critical elements of Yom Kippur is to stand before G-d and be accountable for your actions of the past year.  Webster has a pretty simple definition for this word:  “having to answer for what was done”.  With the holidays behind us, I was thinking about the nature of VC accountability, a concept that can be subtle to understand, but critical for entrepreneurs to get their arms around.

For entrepreneurs, it’s really simple.  Every month, quarter and year, an operating executive is held accountable for results.  The VP of sales is accountable for revenue.  The VP of engineering is accountable for shipping products on time.  The VP of marketing is accountable for prioritizing sales and engineering resources, generating leads and providing superior positioning to the competition.   And the CEO is accountable for everything – revenue, expense and cash position – all as compared to the board-approved plan of record.  The consequences:  a nice bonus on the one extreme and preparing your resume on the other.

What about the VC?  What is the VC accountable for?  If posed that question, many entrepreneurs would smirk, roll their eyes and crack that VCs seem to be highly unaccountable creatures.  But that is a misguided view.  VCs are, in fact, highly accountable in two ways, and I would suggest a third as well.

First, VCs have to answer for their actions over a multi-year period to achieve what they are paid to achieve – make money.  Over some (typically long) period, how much money did they invest as compared to how much they returned?  The Limited Partner (“LP”, the VC’s investor) cares primarily about results.  After all, they, in turn, are accountable to their investment committees to make money, and so that accountability flows right to the VC.  Although the operating executive has a shorter time fuse, the VC is no less answerable for their performance and that performance is extremely measurable.

Second, VCs have to answer to their partners.  In a VC partnership, each VC is investing the money of their peers as well as theirs, and affecting the overall results of the fund.  And so while an LP may not hold a VC accountable for periods shorter than 6-10 years (the period after which fund performance is well-known), VCs are accountable to their partner every week at the partners meeting.  For 4-6 hours, the partners pour over their strategies for deploying the capital, high-priority projects and individual portfolios.  Every week, each individual VC must stand and deliver and demonstrate in front of their partners that they are on track to fulfill their obligation to their LPs to make money.

The third source of accountability is the one that is most often neglected – accountability to the portfolio company.  Some VCs take this very seriously.  When I was an entrepreneur, one of my VC investors shocked me when he said: “I’m simply a service provider – I work for you”.  It was a refreshing attitude that I’ve always taken to heart – good VCs are those that answer to the entrepreneurs.  What did they deliver in terms of value-add that month, quarter, year to their portfolio company?  I would recommend entrepreneurs not be shy about holding their VCs accountable.  Just as the board of directors evaluates the CEO/entrepreneur every year for their performance against results, the CEO/entrepreneur should have the license to evaluate their VCs for their performance.  Who did they help recruit?  What business development introductions did they make?  Were they proactive in giving critical strategic advice?  Were they available and responsive when needed for emergency issues?

No harm in a little extra accountability for VCs, don’t you think?

Today’s post is brought to you by a guest blogger:  Chip Hazard, my partner at IDG Ventures.  By way of background, Chip’s been a VC specializing in enterprise IT for twelve years and has a great perspective as someone who has seen the good times, bad times and everything in between.

[Chip Hazard]

Many pundits, from Larry Ellison to…uh…Jeff Bussgang, have pontificated on the maturation, consolidation and eventual death of the enterprise software business – at least for companies whose names are not IBM, Microsoft, Oracle, SAP or Symantec.  The general thesis goes something like the following: 1) corporate IT departments are looking to reduce, not increase their number of vendors and are therefore not inclined to work with start-ups; 2) customers no longer are pursuing best of breed strategies but instead want integrated suites; 3) the sales and marketing costs of large enterprise software solutions are extremely high and drive a need for significant investments that are beyond the capabilities of many early stage companies; 4) the overall rate of growth of the software industry as a whole has slowed and there are few areas for innovation.  Common analogies used by these pundits include the maturation and consolidation of the automobile and railroad industries in the early to mid 1900s.  Pretty depressing stuff.

So where does that leave a talented entrepreneur (or VC for that matter) with deep experience in this now passé field?  While challenging, if you look at some recent successes (deliberately selected from outside our portfolio), themes and strategies emerge that entrepreneurs can adopt to drive the creation of successful companies.

These are discussed below:

• Innovate to drive efficiency.  For many times over the last decade, enterprise software companies positioned themselves as automating certain functional departments of corporations.  First it was manufacturing, then financials, supply chain, sales, marketing etc.  If this is your view of the enterprise software environment, then by and large Larry Ellison is right – there is little room for new categories and innovation.  That said, if you spend time with you average CIO, you will hear a different story.  In today’s “post-bubble” environment the average CIO has seen their staff and capital budgets cut back, but the demands on their organizations from business executives have continued to increase as companies seek to have a more flexible and cost-effective IT organization to support their business plans.  Compounding this challenge of doing more with less is the sheer magnitude of the accumulated applications and technologies that have been deployed by enterprises over the last 20 years.  As a result, there remains a robust opportunity for focused vendors to drive innovative technology into enterprises to drive efficiency in IT operations.  The bar, however, is quite high.  If you can’t drive a 5 to 10 times reduction in key metrics, the status quo will prevail.  A recent success story is VMWare, which EMC acquired in early 2004 for $635 million, primarily due to the company’s success in enabling server consolidation, a primary method of driving efficiency in IT operations.  Other examples indicate there is a relatively healthy M&A market, as these innovative companies fill key product gaps for large acquirers, such as IBM, Microsoft, Oracle, HP and EMC, as well as mid-sized public companies such as BMC, Mercury, CA and Symantec.
• Dominate a niche.  Start-ups are often caught in a quandary.  To raise money and hire the best people, they need to convince VCs, employees and other supporters of the company they are going after a billion dollar market.  To do so, however, they run the risk of going too broad, too quickly and losing the laser focused approach to solving problems that allows start-ups to win versus large, incumbent vendors.  A better strategy is to instead think about climbing a staircase.  You know you want to reach the next floor, but you don’t do that by trying to jump up 13 stairs all at once.  Ask yourself, “What can I uniquely do today for a customer that solves a real problem and also provides a link to doing more things for those customers in the future?”  Unica, a recently public $80 million in revenue marketing automation company in Boston is a good example of this.  When they first got going, they had the best data mining tools for marketing analysts on the planet.  Not a huge market, but one that valued innovation and provided a logical steppingstone to campaign management, lead generation, planning and the other marketing tools that the company sells today. 
• Explore SaaS (software-as-a-service).  If the key barrier to success for early stage enterprise software companies is excessive sales and marketing costs, adopting a software as a service model may be the right approach.  This is more that just selling your software on a term or subscription, versus perpetual license, basis.  Instead SaaS is all about making it easy for customers to understand, try and ultimately gain value from your software.  In 5 minutes and for no money down, I can become a user of Salesforce.com and within the 30 day trial period I can qualify myself and decide if it is the right solution for me that I am willing to pay for.  Most importantly, I can potentially do this without consuming a single dollar of their sales and marketing spend.  None of the airplane trips, four-legged sales calls, custom demos, proofs of concept or lengthy contract negotiations that lead to the 6 to 12 month sales cycle that costs a traditional software firm 75% of their new license revenue in a given quarter.
• Consider Open Source.  To us, Open-Source is not about free software, but rather products that have seen, or have the potential to see, widespread grassroots customer adoption.  A passionate end-user community has the benefit of driving a development cycle that quickly surfaces key product requirements and needed bug fixes. Further, the grassroots adoption of the product provides a ready installed base of early adopters who will promote the product across their enterprise, purchase professional services and acquire more feature rich versions of the product.  Like SaaS, this is a way to mitigate high sales and marketing costs.  RedHat’s version of Linux, Jboss’s version of the application server and SugarCRM are three of the best known examples, but other opportunities abound.
• Go Vertical.  In today’s age of rapid development, componentized software and offshore resources, software code is relatively easy and cheap to write and is no longer the “barrier to entry” and source of competitive advantage it was ten or twenty years ago.  Instead what matters to customers, and potential acquirers, is the deep domain specific knowledge instantiated in that software.  For an early stage company to build this knowledge, they need to be incredibly focused in a given domain and make sure they have people on their team who understand a customer’s business better than the customer does themselves.  Profitlogic, another Boston area company that recently sold to Oracle, is a good example.  Profitlogic’s products were all about the retail industry, and in fact a particular part of the retail industry related to pricing optimization.  Their team knew more about the margins, operating metrics and best practices of this industry than their customers often did, and it showed up in how their software was architected, deployed and operated.  No wonder Oracle made the group a key part of their Retail industry vertical as an add-on to their Retek acquisition.

Enterprise Software entrepreneurship and investing is certainly not for the faint of heart, but when pursued with some combination of the strategies above, we believe interesting opportunities remain for innovative companies to make their mark in the world and have a positive impact. It is also worth noting, again contrary to the claims of many, that it is still possible to build these companies in a relatively capital efficient manner.  Sticking to the examples cited above, according to VentureSource, VMWare raised $26 million of venture capital, Unica $11 million, Red Hat $16 million, Jboss $10 million, and ProfitLogic $38 million.  Only Salesforce.com raised a lot of capital – $64 million – although almost 75% of that came in their last round when one would assume there was evidence the model was beginning to work. 

In the end, we believe the analogy to the automotive industry is flawed.  The manufacture and distribution of cars is fundamentally different from the software industry.  In auto industry, there are tremendous benefits of scale, the underlying platform (tires, chasis, internal combustion engine, frame and skin) has remained the same for decades and there is little room for small players to access end-users.  Software, on the other hand, is a digital good and an information business.  Innovation is limited only by the creativity of the author.  Small teams can be extraordinarily productive – often times more so than larger teams and organizations. The underlying platform and architecture has changed several times in the last 30 years and there is no physical product to distribute, thus end-users can be accessed much more directly.  Is there a benefit to the incumbency and distribution might of IBM, Oracle or EMC? Absolutely.  Does that mean there is no place for creativity, innovation and entrepreneurship in this industry?  Absolutely not.