Money for the Middle Stage: Part 2 of a Conversation with Scale Venture Partners
I sat down last week with Kate Mitchell and Rory O’Driscoll, both general partners at mid-stage venture firm Scale Venture Partners in Foster City, CA. The firm was interesting to me because it lives up to the name: The folks at Scale don’t invest in early-stage startups, where the nature of the product is often still murky, and they don’t invest in late-stage companies, where often all that’s needed to achieve big time success is more capital. Rather, they specialize in that crucial middle stage, where a company has a proven concept but needs to find the ideal market and scale up its sales process.
Mitchell happens to be chair of the National Venture Capital Association, so the first half of our conversation, summarized last Thursday, focused on big-picture trends for the venture industry, including the relative scarcity of venture funds that’s likely to follow the excessive fundraising of 1999-2009. We spent the rest of the time delving into Scale’s investing model in detail; that’s what you’ll read about below.
One of the most interesting points that Mitchell and O’Driscoll made, to my mind, was that Scale doesn’t always look to revenue growth as a sign that its scale-up investment is working. Sometimes a mid-stage company needs to spend so much to grow that the bottom line looks “horrible,” O’Driscoll says, but the important thing is that the company is building mind (and market) share and repeatable sales.
Xconomy: You closed your most recent fund last year at $255 million. Had you been looking to raise more?
Kate Mitchell: We had looked for $300 to $350 million. This amount fits with our strategy, and was in line with what everybody else experienced. Our view was, “Get on with it.” We’re pleased to have dry powder at this stage. Assuming you are focused on capital-efficient sectors, it’s easier to return a multiple of a smaller fund. How many billion-dollar companies need to be formed to return some of the larger funds? There is a good place in the ecosystem for funds of this size—big enough to support a company through its life cycle, yet small enough to get the job done.
X: How would you describe the type of investing Scale does? It’s not really “growth capital,” it’s one stage before that, right?
Rory O’Driscoll: Our focus is on technology companies already doing $3 million to $5 million in revenue and looking to scale. We will fund from there all the way to companies that are just before an IPO. But the sweet spot for us is making a $5 million, $6 million, or $7 million investment in an early-revenue technology company or the equivalent in healthcare. That’s where we like to play, and for that $250 million is plenty of money. We will end up with a mid-20s number of deals in the fund, which is enough diversification to do what we want to get done.
KM: When you’re talking about software, the real test is can you sell it repeatably and profitably. We focus on underwriting that commercialization phase. The risk that’s presenting itself is the scaling, which is why we picked our name. We are willing to partner with the engineers and the Series A investors to answer that question. Our view is that you run a series of experiments to find out which sales model works, and then you apply capital to that one.
X: Say more about the exact challenge that you’re trying to help companies with at the commercialization stage.
RO: Steve Blank does a great presentation on the first stage, where you don’t even know what you’re doing, and it’s a discovery process just talking to customers and figuring out what you have and locking in on something. Software is easy to make, but it’s not always easy to sell. The second stage is where we come in. You have proven that 20 people will buy it. Now you have to prove that there are 100, or 10,000. It’s really about marketing and distribution. With the first 20 customers you don’t try to be efficient, you just try to get them. Then as you transition from early to mid-stage, the question is how do you help ordinary mortals sell this product. The CEO can sell it; now, can ordinary sales people sell it?
X: How can you tell whether it’s working? Do you push your portfolio companies to start multiplying their revenues?
RO: We have done a body of work over the past eight or nine years that has given us a very strong belief system on what kind of relationship you need to see between sales and marketing and investment and revenue. Across a number of our companies, especially Software as a Service companies like HubSpot, where we have just invested, there is a period of time where for a couple of years, the more successful you are, the worse the numbers look, because you are investing more, you have more expenses, and the revenue doesn’t show through.
KM: You are building an annuity stream, so the revenue doesn’t show in the short run.
RO: Exactly. The GAAP looks horrible, but the value creation is enormous. With HubSpot, Frontbridge, Omniture, ScanSafe, Exact Target, we have been strong advocates of pretty aggressive growth at a point in time when, on a GAAP financial basis, it’s not clear that it’s working, but it’s turned out to be entirely the right decision.
KM: It does go counter to what a traditional VC might say, but our industry experience says that it’s the correct thing to do.
X: You mentioned that you encourage your companies to experiment to find the right commercialization model. What kinds of things should they be experimenting with?
KM: Is it an OEM business, do you partner, do you sell direct, is it self-service? Can customers download an example, try before they buy? Is it something that needs to be sold over the phone? How important is lead generation, telemarketing, the Web, paid search? Is it a freemium product? What is the price point? We put that all under the moniker of helping them achieve velocity and repeatability. For different companies, there might be different answers.
X: Do you tranche your investments, dependent on whether your companies get these experiments right?
RO: You don’t see that kind of tranching. If you trust the company enough to give them the money, you probably trust them to use it wisely. You might see a tranche [withhheld until] something like an FDA approval, but if you are tranching for sales and marketing success, you wind up making a bunch of people feel like they’re going to lose their jobs unless they keep it above a certain number. That is not the way to do business. You want to give them the runway to know they have time to just go out and do it. Otherwise, you’d be trying to replace board governance with money governance. You should just go on the board, iterate fast on what’s working, and kill fast what’s not working.
X: So if all goes well, you end up handing off your companies to growth-capital investors for the final push.
RO: By the time you get to the last round, you know that all it’s going to take to get bigger is capital. When Scale invests, a company might have two sales reps and the CEO and 20 customers. We fund them and two or three years later they have 20 reps and they’re doing $20 million in revenue and they’ve started to become profitable, and they’re at the stage where they’d like to have 50 reps and get to $60 million and then go public.
X: What kinds of companies do you consciously not invest in?
RO: When it’s going to be capital-intensive prior to knowing if you have a product, that’s tough. A new solar panel manufacturing process is going to cost $100 million and you won’t know if it works until you’re done. Those are not businesses we invest in. We wish good luck to those who do, but there is a plenty big market for us within infotech, where we finance the scale-up round. There isn’t anything that I want to know badly enough that I’m willing to pay $100 million to find out. The reality is that most of the really big wins in technology are capital efficient, because the real genius is the guy who figures out when the “objective conditions,” as the Marxists would say, are right and it will only take a small number of components to build a system and ride it all the way. Apple was not cash-consumptive early on, nor were Microsoft or Oracle or Google. The beauty of IT is that if you operate in an infrastructure area and you pay attention and get the timing right, you don’t have to push the rock up the hill alone. You can take advantage of the trends.
KM: We believe that markets drive outcomes in this business. You can take a mediocre company and make it better, but that is not where the big wins come from. Just as we are trying to get our companies up the inflection curve, we are trying to pick markets that are at an inflection point. We do studies of different markets and then do outbound calling. We might be tracking every company in a sector, and we’ll stay in touch to see who is breaking through to our phase, the scaling phase, and then identify who will be the winner and who may not.