Running Money, page 13
“Cisco offered $200,000 for it,” the CEO of the software company told me.
“Per year? Per server?” I asked.
“Nope, just $200,000. They wanted to own it, source code and all. You can’t get paid for software anymore.”
“So what are you doing?”
“We just implemented the same code on a chip. Turns out Cisco will pay us $50 for each chip, so we are designed into one of their switches that ships 10,000 units a month.”
“And how much do you make?” I asked.
“Well, it’s our design, so we can charge what we want. Don’t tell anyone, but they cost us $15 to make out of Taiwan. It makes a difference how you get paid.”
How true. It was all about how you were getting paid. Drug companies sell little patent-protected pills that cost pennies for $10 a dose. Hollywood sells copyright-protected silvery DVD disks for $19.99 that cost a buck at most to manufacture.
But then again, music is copyright protected but fits in a five-megabyte file and can move across the Internet in a few seconds. The CD is broken. Same with a lot of software; it’s tough to get paid for it.
It’s not just intellectual property—it’s how it’s packaged and how it’s protected.
Nobodies in That Deal
PALO ALTO, CALIFORNIA—EARLY 1998
I was warming up, taking a few shots and getting my creaky body stretched before the games started. For the last five years, I’ve been playing pickup basketball on weekends on a tennis court behind Jay Hoag’s house in Palo Alto. Jay, an old friend who used to run money in New York, is one of the top fund managers in the area, investing in both public and private companies. In fact, Fred and I modeled our fund a little like Jay’s, but different enough so that we really didn’t compete and so I could continue to play basketball at his house.
A core group of successful venture capitalists and company execs showed up each week. A few were like me—white guys who can’t jump. It was hard for me because we were still trying to get our fund to a level of respectability, and here was a group of hitters in the Valley. The usual question was, “So, how much money you got?” It wasn’t so much asset envy as a desire to, well, to jump with the best of them.
Because of this, I tried to avoid business talk, but I would overhear a few juicy conversations. This morning, two VCs were talking about a company trying to raise money.
“Did you meet with those guys from Cybersource?” This piqued my interest because I happened to be a small investor in the company, which was really two companies, one that sold software online and another that did fraud detection for credit card transactions.
“Yeah, they came in yesterday. They’ve been making the rounds.”
“What did you think?”
“I’m not sure.”
“Me neither. My concern is that nobody’s in the deal.” This was a not-so-veiled reference that no big-name venture capital firm was an investor in the company. Without that Good Housekeeping Seal of Approval, it’s tough for a new player to step up and put in money.
One of the VCs turned to me and asked, “Andy, aren’t you in this deal?”
My face probably turned red, but I answered, “Yup, but I agree with you—nobody’s in this deal.”
“Sorry, no offense.”
“None taken,” I said.
“Well, in that case, I don’t like to say nobody’s in the deal. I prefer to say that there are a bunch of nobodies in the deal.”
I should have been offended at that, but oddly I wasn’t. This was white-guy trash talk—you gotta take it to be able to dish it out. Plus, we were struggling and not destined to be top-tier venture capitalists with an A-list of portfolio companies and fancy offices on Sand Hill Road. But you don’t have to be a so-called player to make money in Silicon Valley, just smart enough to find a few good companies and avoid the fashionable ones. Like public investors, VCs are notorious momentum investors—each one often investing in two or three companies in the same market, hoping something works. This was a big reason for the boom-bust cycle in the valley: VCs fund 30 plus companies in each hot segment, and after a run-up and boom in taking companies public, a shakeout is almost inevitable.
“Hi, Andy. This is Dominic Orr. We met a couple of months ago at the networking dinner that PaineWebber held in Palo Alto.”
“Oh, yes, hi, Dominic.” I was racking my brains to remember him. I can barely remember what I had for breakfast. Gigabit Ethernet was the latest hot market for venture capitalists—another overdone market segment. I had been to lots of meetings and dinners with analysts and companies, but this one started coming back into focus. I had sat next to a guy who used to work at Hewlett-Packard and Bay Networks and now ran one of the gigabit companies. He spent most of the evening trying to convince me that his company, Alteon, which sold networking cards like everyone else, was not in the commodity business. The real money was to be made in switches that sit next to Web servers. This made sense, but so what? There were lots of switch companies too.
“What about Cisco?” I remember asking.
“Oh, they do routers, which is layer 2. Some guys like Extreme and Foundry, who were also at the dinner, do layer 3 switching; Alteon is doing layers 4 through 7.”
I had nodded in understanding, but I really had no clue what he was talking about. I remembered from my days at Bell Labs about seven layers of communications but had long ago forgotten what they meant.
Dominic continued. “So, we are doing another round of financing, and I remembered you had a fund that did public and later-stage private and was wondering if you wanted to come take a look?”
I was flattered that he remembered me, but my bullshit detector immediately sprang into action. We had a small fund, were not huge players in the Valley, and so something must be wrong with this thing. Which isn’t necessarily bad—I just needed to figure out what was wrong before investing.
The next morning, I read about layer 3 switching and layers 4–7 smart switching and then instantly filed that knowledge into a holding tank in my brain. Then Fred and I went down to South San Jose to meet Dominic and the rest of the management team. They left the door of the conference room open. We heard about the benefits of layer 4–7 switching, which had to do with controlling the flow of information between a local-area network and a wide-area network. I liked the space. As bandwidth grows, these are precisely the type of products that will scale.
Alteon had raised $40 million in their last round from some big-name venture capitalists. It was a bunch of somebodies. Alteon’s business was growing, although it had leveled off. I still didn’t understand why they needed us.
While they were talking, I cruised through their historic numbers and projections. It all seemed straightforward until I noticed a $10 million increase in costs the last quarter that didn’t quite fit with the other quarters.
“What happened last quarter?”
“With our revenues?” Dominic asked.
“No, with costs. There seems to be $10 million in additional costs last quarter.”
“Oh, that was our chip screwup.”
“Your what?”
“Well, we make custom chips. We embed our software into silicon so we can operate at high speeds and also to make our products unique and defensible. LSI Logic makes our parts—or they did. There was a screwup, and I’d rather not say whose fault it was—except to say it wasn’t ours.”
“Ten million dollars’ worth?”
“Yeah, we had to have them throw wafer starts at the problem to get enough chips to keep our shipments flat while we design our next chip. You can see our sales go flat too,” Dominic explained.
If Alteon was a public company, their stock would have gotten whacked, down to a point where we might have stepped up and bought it in size.
“So that’s why you need to raise $10–15 million more?”
“That’s it.”
“And the problem is behind you?”
“Seems to be. We’ve already gotten the next iteration of our chips back and they work, so we should start scaling again next quarter.”
Alteon had great investors, but nobody was willing to step up to fund the company. They needed an outsider to come in to validate their thinking, even if the outsider was a nobody like us. Plus, they had it right: a monster market, a competitive advantage by having their intelligence embedded in silicon and a business model that should work. They charged $5,000 for what looked like a couple hundred bucks of chips and plastic.
I looked at Fred, who gave an almost imperceptible nod with his head. We were thinking the same thing. We were in on this deal.
It Works Again!
PALO ALTO, CALIFORNIA—MID-1998
Holy shit! I can’t even believe it. General Magic stock, the one we had been buying for $1 and $1.50 when they had $2.50 per share in the bank, has started running. They launched a trial of their voice recognition system, and investors were intrigued. The stock went from $2 to $3. But this is unbelievable—the unexpected happened. Microsoft, a company worth almost 10,000 times more than General Magic, stepped up and licensed their voice technology—and invested in the company. The stock just this minute doubled to $6.
Fred was on the road, but I got him on the phone and we agreed to start selling, a little at a time, but start selling. We really hadn’t sold anything. Our portfolio was more of a Roach Motel—stocks came in and never left. This was exciting.
We had visited the company half a dozen times and could never get comfortable with the management team or how they were going to make money on this voice service. When you are buying $2.50 in cash for $1.25, you don’t worry about these things. But now the stock was valued at two or three times the cash. So, sell we did—at $6, then at $7, then at $11, and we even got some off at close to $14. You can’t sell a million shares overnight—a valuable lesson—but over several months, we eased out of General Magic until it was a distant memory.
Other things were working too. Real Networks was now public—selling for $30 versus the $6 we paid for it. And then there was Inktomi—god bless Inktomi.
Inktomi ran a cluster of servers that provided a search service for the people on the Web. They were a wholesaler in that they didn’t run a search service themselves, they ran it for others. The only real customer they had was HotWired.com, not really awe-inspiring. Inktomi also sold caching systems. When you pulled up a Web page with, say, CNN’s logo, a cache might store frequently requested items close to users. You didn’t have to go all the way to a Web server in Atlanta to get the CNN logo, it might be in memory at your Internet provider. Inktomi caches sped up Web surfing and made it cheaper for Internet providers to run their service since they might use less telecom bandwidth.
Goldman Sachs was teed up to take Inktomi public but was worried that there was no name-search company using their service, let alone any interesting customers for their cache software. So Goldman told Inktomi to come back when they had some real customers, and the company ended up doing a private investment round. We took a look. It was very interesting except for that little “no real customer” thing. But Fred’s nose twitched, and he said it felt a little like Cisco did way back when and, what the heck, maybe we should do it. We made tons of due diligence calls, and everything was great except they had no real customers—but we already knew that.
So in February we invested. In March, Yahoo signed up for their search service, giving Inktomi a percentage of the ad dollars they generated per search results page served. Ka-ching. In April, America Online started buying Inktomi cache software. Goldman came back, and by June, Inktomi was a public company—priced at $18 and ending its first day at $36. We had paid $6.
We still didn’t have much capital—barely $45 million. But since we’d started less than two years earlier, we were up over 60%.
It’s working again. Like I said—holy shit!
Heartbreak Hotel
PALO ALTO, CALIFORNIA—SUMMER 1998
“How’s my money?” It was Frank Bonsal, making his monthly call to harass us.
Frank was one of the trio that bolted from investment banking firm Alex Brown and started the venture capital firm New Enterprise Associates. He and Art Marks worked out of a townhouse in Baltimore with Dick Kramlich out in Silicon Valley. It didn’t seem like Frank did much with NEA anymore, just cruised around putting his own money to work.
“Hey, Frank, how you doing?” I loved talking to Frank Bonsal. The guy was a living legend. It was said that Bonsal could throw his hat in the middle of a room and people would empty their pockets and throw all the money they had into the hat, such a great moneymaker he was. I just enjoyed his aw-shucks good old boy style that masked a brilliant man.
Plus, he was the reason Fred and I were together. When Fred was running tech portfolios at JP Morgan and I was a sell-side analyst, he was one of my favorite clients. In fact, Fred was everybody’s favorite client. In the early ’90s, Fred and I met and discussed the idea of running money together—until we realized how much we didn’t know. I was restless in 1995 and had called Frank Bonsal to ask for advice about what I might do next. He said he had another guy calling him, also asking him what he should do next and that the two of us were complementary and ought to meet. Some guy named Fred Kittler.
“I’m OK, but what the hail have you boys been up to, don’t see too much good coming from you folks.”
“Frank, the markets have been a little rough, but we just keep loading up on the names we have conviction in.”
“That’s it, boy.”
“We look at a lot of private deals, but there is so much garbage, we are pretty picky.”
“Well, I like some of the stuff you all are doing. Real and Inktomi are hot and I hear that Tut is a home run.”
“We’re pretty happy, but it’s getting crowded out here. Lots of money is flowing into the Valley.”
“Don’t I know it. Just stick to your guns. Find those things that are growing like a weed. It ain’t easy, but when you find it, you can’t miss.” Frank Bonsal knew what he was talking about. He’d been involved in home run after home run, always seeming to be early in companies that had big, almost never-ending growth cycles. “Not this horse crap of a quick flash in the pan. Find those big-ass trends you can ride like a bull rider.”
“We like growth.”
“Now, Andy, I don’t mean just growth. I mean the stuff that you just plant the seed and it grows like a sum-bitch. You know what I’m talkin’ about?”
“I think so.”
“Look, you guys are doin’ a great job. I like your style. You guys think a little different, a little ahead of the rest of the clowns out there. You’ll find what you’re lookin’ for.”
“We turn over a lot of rocks.”
“Thatta boy. Listen, you like that multimedia stuff, right?”
“I guess.”
“Good. Now, listen. A friend of mine in LA has got this interesting little company in the music business. It’s hard to describe. You’ve got to see it for yourself.” I thought I heard a little snicker—it was hard to tell when Frank turned serious.
“What’s the name of the company?”
“Shotz or Snotz or Shnotz, something like that. I’ll have the CEO call you. He’s out there now in the Bay Area.”
“Happy to see him for you, Frank.”
“Nah, this is for you. Call me when you’re done. See ya.”
I made plans to meet with Danny, the CEO of Hotz, at the San Francisco Airport Marriott the next morning. I learned over time that when Frank said jump, you jumped. Plus I was open to see anything interesting, especially in the music business. Real Networks had a huge business shipping software for PCs that allowed music to be streamed over the Internet. Even search company Inktomi was cashing in; their top searches were people looking for songs and artists. There were a lot of oddball ways to invest, I thought to myself as I rode the elevator at the Marriott.
I knocked on the door of room 1211. When I saw the person who answered the door, I immediately checked my itinerary to make sure I was in the right place.
“Room 1211?”
“Yup.”
“You Danny?”
“Yup.”
“OK, I’m in the right place.”
It turns out that Danny was the ultimate “oddball way to invest.” He was wearing a black leather jacket with tassles dangling from it. He filled all of the jacket and then some—it appeared that he liked to eat a few too many Cheez Doodles. His black leather pants were obscenely tight, so I had to divert my eyes, and I ended up staring a little too long at the snakeskin boots he had on.
I followed Danny as he waddled into his room.
“So, Frank Bonsal tells me you have some hot music technology.”
“Yup, let me ’splain.”
Danny started talking, and I had a hard time holding back one of those nasty belly laughs. His round face was framed by flowing puffs of kinky black hair, sticking out in all directions. He had on a white puffy shirt, with a wide collar sticking out over his leather jacket. The top several buttons were undone, but I couldn’t look long enough to count since his chest hairs were intermingled with four or five necklaces dangling from his neck. I had to check, and sure enough, Danny was sporting not one but two pinky rings.
“You all know that music is nuttin’ more than a bunch of bundled harmonics.” Danny’s voice was a deep baritone, almost booming, and filled the room.
And then it hit me: Frank Bonsal had set me up with a fucking Elvis impersonator CEO. And a dorky one at that.
“Everybudy enjoys music, but not so many kin play. It’s tough to git the pitch and tempo right, let alone figur’ out a piano keyboard. So we help ’em along.”
