Pattern Recognition, by Ian Sigalow

Winner Take All

Introduction

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Ian Sigalow

<p>Ian is a co-founder and partner at Greycroft Partners in New York City. He has been a venture capitalist since 2001.</p>


LATEST POSTS

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Winner Take All

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I recently realized that I have given a lot of entrepreneurs bad advice when it comes to software sales.  Unfortunately I have been doing it for many years as an investor.

I used to think that the goal of a Series A software investor was to build a great team, build a great product, and prove that customers were willing to pay for your product.  I thought that if I could de-risk the sales cycle and get some proof points, that would be adequate to get other investors to follow on later with capital for scaling.

Almost all my companies are in greenfield market opportunities, where there is no incumbent and the sales cycle is completely unknown, so I put a lot of emphasis on figuring out how to sell early.  I have nothing against brownfield markets, but I find it more interesting to build something for the first time.

Since my companies are evangelizing new areas, I used to tell CEOs that they should price high enough to recoup sales and marketing costs.  With a field sales team that is inevitably a six figure price point.  Customer payments also defer operating costs in the early days, which is helpful because we are a smaller fund.

The mistake I made, which is painfully clear to me now, is that many SAAS markets have a winner-take-all dynamic.  This is especially true if your products are sticky, or if they have network effects.  There is a new trend called “consumerization of the enterprise” that takes this a step further, with software companies that don’t use sales teams at all.  Instead they market like consumer companies and grow virally.

When a company is in a winner-take-all market there will typically be one major outcome, worth billions in enterprise value at exit.  Other companies in the sector either survive as a tuck-in acquisition or go bankrupt.  This is radically different from “non-winner-take-all” markets where there could be a half dozen reasonable exits.  If you are investing in a winner-take-all market the only thing that matters is making sure your money is in the winner.

This “winner take all” strategy thrives in Silicon Valley, where there are a lot of smart programmers who can replicate and improve upon any product.  Moreover, these programmers are not motivated by revenues – they only want the world to use their tools.

This trend arrived at the right time, because we are currently in a market with infinite growth capital.  If you look at the IPO class of 2013, which is heavily weighted towards west coast software companies, the average paid-in capital prior to IPO was $103MM. That is not a typo.  To reinforce the point, almost all of these companies are still losing money, and some are losing more money as they get larger.  All that matters today is growth.

My companies, which were focused on revenues, would go to market and build up a base of $5 to $10 million per year in recurring revenue.  Once that success became known competitors swarmed in, offering a similar product for free.  Some customers would churn and others would renew at 25-50% of the initial contract value.  It is impossible to maintain high pricing against free alternatives.  The net result is that for a period of 1-2 years my companies would struggle to stay afloat as the existing book of business became an anchor to growth.  This is a death spiral for venture-backed companies because nobody funds flat growth.

I have now seen this happen twice, and I have vowed to never let it happen again.

The right strategy in winner-take-all markets is to get as many customers as you can, as fast as you can.  Instead of proving early on that customers will pay, prove that the market for your product is vast and that customer acquisition scales quickly.

My new view is that early pricing is irrelevant.  If anything, pricing high in the near term is a hindrance.  It is better to under-price initially and raise prices over time – increasing dollar renewal rates will amplify future growth.  If you are lucky this will coincide with the exact time that you are looking to exit or raise capital.  That is a recipe for success.

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Ian Sigalow

http://sigalow.com

<p>Ian is a co-founder and partner at Greycroft Partners in New York City. He has been a venture capitalist since 2001.</p>

Comments
  • user

    AUTHOR markevans

    Posted on 11:43 am October 18, 2013.
    Reply

    Given the priority about getting as many customers as you can, what role does marketing play? Should it have a higher and earlier profile to drive brand awareness and customer acquisition?

  • user

    AUTHOR aripap

    Posted on 4:27 pm October 18, 2013.
    Reply

    Quick counter-point: I’ve seen a bunch of SaaS companies that were crippled by early decisions to not charge enough or to charge on the wrong model. So while you shouldn’t be profit maximizing, you should be fully cognizant of the true value of the product being offered.

  • user

    AUTHOR sigalow

    Posted on 4:29 pm October 18, 2013.
    Reply

    aripap It is a good counter point.  In a way it completely depends on the market environment.  Right now the world is focused on growth and in this environment early revenues are less material than early users.

  • user

    AUTHOR sigalow

    Posted on 4:30 pm October 18, 2013.
    Reply

    markevans The winner take all model is unusual because people are hiring marketing (or customer acquisition) people before they are hiring sales people.  The CEOs are doing the initial sales and outreach to heavy users.

  • user

    AUTHOR fengtality

    Posted on 2:52 am October 19, 2013.
    Reply

    Interesting post.  However, I would argue that enterprise SaaS doesn’t exhibit the same winner-take-all dynamics that consumer does.  None of the recent IPOs (with possible exception of Veeva which is vertically focused) are really dominating their markets.  
    Also, I think it’s important to price enterprise SaaS sufficiently high to signal quality.

  • user

    AUTHOR sigalow

    Posted on 8:53 am October 19, 2013.
    Reply

    fengtality The SAAS category leaders like Salesforce (CRM), Workday (HR), Marketo (Marketing Automation) have large market share (25%-50% among SAAS implementations) and are growing 3-4x faster than the headline growth in their respective markets.  In my view that looks like a consolidating market with winner-take-all dynamics.  It doesn’t happen overnight, but over a 7-10 year start-up investment cycle this appears to be the case.

  • user

    AUTHOR Lucv

    Posted on 9:12 am October 19, 2013.
    Reply

    There are two kinds of b2b saas products, the cheap (per seat) and cheerful products like e-signature or online storage and the more complex ones that require some setup and integration. If you are selling the latter, a too low price point will scare away many of your best prospects.

  • user

    AUTHOR markorgan

    Posted on 4:41 pm October 19, 2013.
    Reply

    Ian, I can feel your frustration in this post. But I think that a strategy of winning as many customers as possible, as quickly as possible, is not a wise one and may be just as ill-fated as your advice to recoup sales and marketing expense from early customers.
    Your earlier belief that the goals for the series A company is to build a great team, product and price that customers value the service is fundamentally sound. To that I would add to build as many advocates as possible – people at companies who are generating value greatly in excess of the cost. This requires careful market entry strategy, identifying the right segments of the market that are going to generate ridiculous ROI. And it also requires careful pricing strategy .
    This does not mean free, although having a free component somewhere in the offering can help shorten the time to advocacy somewhat. I think that the right price is that which causes the buying company to take the project seriously and put their best people on it. If the product is under-priced , you might get a temp intern on the assignment and that is not conducive to advocacy.
    I like your point about undercharging and then increasing upon renewal. That has been the pattern for me both at Eloqua and Influitive. A reasonable goal is to increase pricing by 50% in year 1, 25% in year 2, tapering to 10% increase in year 4+. We had lots of free competitors at Eloqua and they were not the problem.
    That said, I see your point on consumerization of the enterprise and overfunding of cheap, design-led alternatives in the Valley. The way to beat them is by developing network effects in the business and deep domain expertise, fuelling relevant innovation in the target segments. I think the pure-play SaaS companies have had their day in the sun and the players who will be the next big stories in B2B combine deep domain expertise and network effects. LinkedIn is a great example of what I think the dominant enterprise software vendors of the future are going to look like.

  • user

    AUTHOR sigalow

    Posted on 5:21 pm October 19, 2013.
    Reply

    markorgan This is a great comment.  I spoke a number of times with Joe Payne after you left Eloqua, and they had the same problem I described above about declining prices on renewal business because Marketo’s entry strategy was to win at any price.  In a market with a surplus of capital it is often better to be a fast follower.  I agree that network effects are great if you can get them.

  • user

    AUTHOR CFederman

    Posted on 12:08 pm October 24, 2013.
    Reply

    Ian, Nice post. Given the ‘winner take all’ philosophy, it seems as if the capital each of your investments will consume should go up appreciably. If that’s so will you be changing your capital allocation model? Also, the Greycroft approach previously was predicated on anticipated exits of $100mm. Has this changed too?

  • user

    AUTHOR sigalow

    Posted on 10:39 pm October 24, 2013.
    Reply

    CFederman Charlie, I will answer the second question first.  Our model is predicated on the idea that if you plot the expected exits of our investments at the time of a Series A that they should have a similar distribution as other venture-backed companies at the same stage of investment.  We call this the base rate.
    The base rate in our industry over the past few years has been an average successful outcome of $120MM (via M&A), and a median outcome in the 50s.  At the time of our first investment, when revenues are small and the risk is large, that seems like a fair set of assumptions.
    I would like to think that we do a better job picking winners and growing companies than the industry average, but it is unrealistic to assume that every company we fund at the A round will be a 99th percentile outcome.
    A lot of VCs are putting big dollars at risk, at high valuations, in very early stage companies.  We would normally call these deals $3-4MM Series A rounds, but the dollars coming in look like a $15-$20MM growth financing. When VCs make that sort of investment in pre-revenue, pre-traction companies they are making the implicit assumption that the return profile will somehow defy the odds over time.  That strategy has not done so well historically.  It is one thing we try to avoid.
    Once companies get past the Series A and Series B rounds and have demonstrated revenue then they get into a different set of outcomes.  It is the same as life expectancy – if you are 90 years old your life expectancy is higher by virtue of the fact that you have already passed the average.  We are much more comfortable writing bigger checks at this point and adjust our expected outcomes proportionately.  We have funded companies at $300MM pre-money valuations before and still made a 3x+.
    On to your first question, which is harder to answer.  It is true that our successful companies will consume a lot more capital than we initially anticipated when we set off to build greycroft.  The good news is that there are a lot of investors who want to write growth equity checks for later stage companies.  That means we don’t have to reserve all the way to the end.
    Our model suggests that the additional dollars are better put to work by making more A and B investments than by being a “lifecycle VC” and reserving 10MM for a potential growth round five years from now for every 1MM series A investment we make today. Plus it is hard to forecast these rounds in an early stage fund, so we would likely end up with either too much reserved or too little reserved.
    The bad news is that we will likely get diluted in later rounds as companies raise more money. Ideally the valuations are high enough that it won’t create a significant damper on our returns.  It is also an opportunity for us some day if we want to do a growth vehicle because we have accumulated a lot of pro-rata rights.
    I hope this all helps.

  • user

    AUTHOR dcoppins

    Posted on 11:53 am October 25, 2013.
    Reply

    Great post.  Just finished some historical analysis of exactly that point in our industry.  I think it is shaping up to happen again with a new round of innovative players.  Seems that the most important question is “how do you know you are in a winner-take-all market?”  I hear your point about “sticky” and “network effects”.  Are there any other indicators?

  • user

    AUTHOR sigalow

    Posted on 2:03 pm October 25, 2013.
    Reply

    dcoppins I think a handful of factors determine what the final market share allocation will be among the top players in a specific software category.  The big factors that come to mind are switching costs, barriers to entry, customization, speed of on-boarding, amt of required integration, and cost of support.  The best companies are trying to maximize the first two factors above and minimize the next four.
    SAAS products today have almost zero marginal cost, while on-premise software products had hardware costs back in the day.  There is probably an economics PhD dissertation in here somewhere…

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