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June 8, 2011 / Michael Klein

Groupon’s Business Model Grind: Trying to Make a Dollar out of 15 Cents

Find the P deep in the grind slangin’ dope fiends double ups
And pretty soon I’ll be back to a whole thing
If I had to do it again I’d probably do the same thing
- Master P

Groupon‘s much anticipated IPO filing on Thursday of last week yielded both fanfare and criticism.  I have noticed many coming to quick judgments about the company’s prospects based on its financial statements.  Most are drawing conclusions based on Groupon’s GAAP financial statements listed in its S-1 without considering the company’s business model.  How can a company with $645 million in revenue lose $117 million from operations in the same quarter!?!  Either Groupon and its investors are crazy (and expect public market investors to be crazy too) or there is another piece to the puzzle.

The problem with looking at Groupon’s historical financial statements is that they don’t reflect the way the business is being operated or give consideration to the investments it is making today.  If I were an investor in Groupon (I am not), operating income is not the metric I would focus on at this stage in the company.  Many of the metrics laid out in Groupon’s S-1 are lagging indicators.  Revenue explains the investments it has made in the past, but not the investments it is making today.  People are right to focus on customer acquisition expense (i.e. marketing) since it is in fact a leading indicator (along with merchant acquisition expense), but it takes a deeper analysis to determine whether it’s a good investment.

I have witnessed this with our portfolio companies such as Kabam and Zoosk, which like The Point, discovered awesome business models (albeit in different industries).  When magic like this happens, you have to move quickly capitalize on it.  For example, let’s say you have a business where you can invest $0.15 today and receive $1 over the next 12 months in equal installments each month.  Forget the business for a moment.  Now what if you could repeat this process a couple billion times?  Although you’d have to raise a boatload of money, that would make for a pretty good business.  Don’t you think?

Now let’s assume this same mythical company had a 40% gross margin and some other general operating expenses. If the company had its financial statements audited after one quarter of operations, the results would be a quarter in revenue, a dime in gross profit, 15 cents in marketing expense and a big fat loss.  Of course you wouldn’t care because you’d know that you would make money over the rest of the year.  This may sound like a silly example, but is actually quite similar to the marketing investments Groupon is making today.  Of course it took Groupon some time and data to figure this out.

In many ways, Groupon is all grown up with 7,000 employees and billions of annual revenue, but in other ways it is still a young company – only 30 months old to be exact – with a new business model in an evolving industry.  What can be said for sure is that it is tapping into a massive market for local advertising and commerce.  Given it looks to have a promising business model (other companies normally don’t copy bad ones); it makes sense to invest in growth to capture that market.

Generally Accepted Accounting Principles (GAAP) and the SEC are not concerned with adapting their policies to fit companies with unique business models, although I also wouldn’t expect them to keep up with a company that grew revenue 1,357% in its most recent quarter.  As a result, historical GAAP financial statements do a bad job at explaining early stage companies and unique business models such as subscription-based businesses where marketing is spent on day one to acquire a customer where value will be realized over several years.  This is only exaggerated for companies growing rapidly and making large investments to support growth.  That’s why early stage investors rarely focus on GAAP metrics.  The real question is: will Groupon’s investments pay off?   In order to answer this question, we need to understand the company’s customer acquisition model.  Although we don’t have all the information in Groupon’s S-1 (this information will be shared later during the roadshow), there is enough information to shed some light on its business model.  Let’s take a look at these metrics.

Average Selling Price.  Groupon makes $23 in revenue for each Groupon it sells (total revenue divided by total Groupons sold for the period).  This metric has remained fairly constant since 2009, ranging from $23-$25.

Gross Margin.  In Q1 2011, Groupon kept 42% of total revenue and paid out the rest to merchants.  Gross margin has been widely singled out as one of the key risks to Groupon’s business model.  Many have argued that low barriers to entry and increased competition will result in decreased gross margins as Groupon gives merchants more value to keep them on their platform.  The data actually suggests the opposite, with gross margins increasing from 36% in 2009 to 42% in Q1 2011.  Groupon has gained scale but the landscape of local merchants remains highly fragmented.  Small business owners have little negotiating power over Groupon if they want access to its large customer base, along with a dearth of alternative local advertising solutions.  Gross margin could decrease as Groupon offers new kinds of deals that are national in scope or adds new verticals such as travel and tickets, but these deals can be incrementally more profitable since they can be cross sold to its existing customer base requiring no new marketing expense.  There is, of course, a competitive risk as Facebook and Google move into the space with their large user bases and new competitive offerings.

% of Paying Customers. Many subscribers will sign up to receive Groupons, but for a host of reasons (like too much spam in their email inbox), they will never actually purchase.  On average, 19% of subscribers purchase a Groupon (cumulative customers divided by cumulative subscribers). This could increase as Groupon adds more relevant offerings or decrease if new subscribers purchase less frequently than old ones, but since 2009 this has actually remained fairly constant, ranging from 18%-21%.

Average Number of Transactions per Customer.  This is one of the biggest levers in Groupon’s business model and one that they don’t break out in their S-1.  Data is still emerging with the evolution of the market.  e-Commerce businesses often have a high degree of repeat customers.  People that shop at Diapers.com will inevitably need diapers every other month.  Amazon’s best customers (enabled by Amazon Prime), will find something to buy once a week or more.  Given the nature of these businesses, they act like quasi-subscriptions.  This varies by business and product, but it is typical to experience patterns of repeat purchasing behavior emerge.  In its S-1, Groupon points to data from its Q2 2010 cohort, which is when it started investing heavily into marketing, as indicative of its North American business.  During this quarter it acquired 3.7 million subscribers and sold 1.2 million Groupons.  This implies 1.7 Groupons per quarter per customer if 19% of subscribers purchase a Groupon.  So the big question is: how long will this behavior persist?  Groupon doesn’t tell us – even they have less than a year of data following new marketing campaigns – and the market is evolving.  Given the offline use case of coupon clipping, I would not be surprised to see a percentage of people exhibiting very high repeat purchase behavior.  This is purely an assumption, but I have assumed a monthly churn rate of 5%, which is a percentage point higher than Netflix.  This implies a 1.7 year life for each customer and an average number of transactions of 11.

Customer Lifetime Value.  The product of gross profit and the average number of transactions per customer yields Groupon’s customer lifetime value (CLV).  Whether or not CLV is attractive depends on how much Groupon pays to acquire a customer and if there is enough left over to cover other operating expenses.

Cost per Subscriber.  Groupon spends approximately $6.40 to acquire a subscriber, or an email address (total marketing spend divided by total subscribers acquired during the period).  There is a chance that you can spend marketing in one period and acquire a subscriber in a subsequent period, but these two numbers should be fairly temporal since Groupon is primarily using performance-based online marketing campaigns such as search, display and referrals.  I have included brand and offline ads such as its infamous Super Bowl commercial since branding will continue to be a big part of their marketing program going forward even if it is harder to measure.

Cost per Paying Customer.  The cost per paying customer is calculated by the cost per subscriber divided by the % of paying customers.  This is one metric that has risen significantly since 2009, increasing from $12 in 2009 to $34 in Q1 2011.  This is to be expected with a significant increase in marketing and a new marketing channel becomes saturated.  While it does suggest a decreasing return on investment, it does not imply a bad investment.

With these metrics we can estimate Groupon’s customer acquisition model below.  Aside from customer acquisition costs, most of the metrics point to a relatively stable business model since 2009.  This is not surprising given Groupon’s growth strategy of replicating the model in new geographies and a relatively constant product offering.

Average Selling Price

$23

$23

$23

Gross Margin

42%

42%

42%

Gross Profit

$10

$10

$10

Average Transactions per Customer

7

11

15

Customer Lifetime Value (CLV)  

$67

$109

$144

Cost per Subscriber

$6

$6

$6

% Paying Customer

19%

19%

19%

Cost per Paying Customer  

$34

$34

$34

         
Contribution Margin (before other expenses)  

$34

$76

$110

% Return on Marketing Spend  

100%

225%

328%

I have posted this spreadsheet on Google docs so you can play with the assumptions here. In a world where U.S. treasuries earn ~1%, public equities earn ~10% and private equity assets earn ~20-30%, a 225% return on marketing investments over the life of a customer ($109 in gross profit for every $34 spent to acquire a customer) looks pretty good.  Of course, this is provided it is sufficient to cover other operating expenses, which includes Groupon’s large salesforce for acquiring merchants.  Since 2009 these operating expenses have ranged from 17%-33% of total revenue, and were 28% in Q1 2011.  These expenses are less discretionary and more fixed in nature, therefore likely to trend down over time as long as the cost to service merchants does not increase.  Based on this, we can try to create a unit economic model over the life of a customer.  Groupon’s financial statements should begin to look more like this as growth slows and investments decelerate.

Average Transactions per Customer

7

11

15

Average Selling Price

$23

$23

$23

Total Revenue  

$161

$261

$344

Gross Profit  

$67

$109

$144

% of Total Revenue  

42%

42%

42%

Marketing (one-time)

$34

$34

$34

Contribution Margin (before other expenses)  

$34

$76

$110

% of Total Revenue  

21%

29%

32%

In Q1 2010, Groupon had operating income of $9 million, or 19% of total revenue.  This was before a significant increase in investments to acquire both merchants and customers, and an increase in customer acquisition costs.  Ironically, this increase in customer acquisition costs is one of the biggest barriers to entry for clones and smaller competitors.  This would suggest that Groupon is managing the business for growth today and will look to increase returns and profitability by leveraging its brand value, subscriber list (83 million), customer base (16 million) and merchant network (57 thousand) along with new initiatives such as Groupon Now.

This analysis is not to say that Groupon is a good investment, or without risk – that judgment will be based on a lot of other factors.  However, it does provide a framework for evaluating the marketing investments it is making today, which is key to evaluating its business model.  The hard questions remain: can Groupon successfully reinvent itself, and continue to thrive in the face of increasingly fierce competition?

Groupon is a unique IPO in today’s climate to be sure.  It’s rare to find a company so large and growing so fast.  It is indicative of a new world order for Internet companies where business models can emerge quickly and reach hundreds of millions of consumers in just a few years.  These trends are only accelerating.  It will make for an exciting time for startups, and soon, public companies such as Groupon.  That makes Groupon a rare opportunity for public market investors to own such a dynamic business.  This uniqueness should only help its valuation.  With that said, a lot can change in 30 months, as Groupon has already shown.

April 21, 2011 / Michael Klein

Let The Music Play

“We started dancing
And love put us into a groove
As soon as we started to move
The music played”
- Shannon, Let the Music Play

[Written while listening to Le Tigre, VHS or Beta, Tove Strkye, Adrian Lux,Veronica Maggio and Petter and September – recently discovered thanks to the Swedes (I would have linked to Spotify, but U.S users can’t use).]

Fred Wilson had a nice post today with some thoughts on the music business.  I would encourage you to go check it out here.  I have had a post on the same topic marinating in my head ever since I began using Spotify at the beginning of this year (don’t ask me why I’m so lucky, but it did take a little MacGuyver action).

I have always been a music lover.  Back when I was little, I would spend hours listening to just about every kind of music imaginable – from gangster rap to country to dance and everything in between.  I was so obsessed that I am left with the unique gift of being able to recite the lyrics of every gangster rap song from Easy-E (circa 1987) to Eminem (circa 2000), much to my mother’s chagrin.  If you don’t believe me, I challenge you to a rap battle the next time you see me.

I remember signing up for BMG and getting 12 CDs in the mail.  I can still remember that day.  I opened the package and set in front of my stereo for hours until it was time to go to bed – listening to PM Dawn, Ace of Base, Arrested Development and Compton’s Most Wanted (all of which have found their way on to my Spotify playlists again).  That was such a joyous day, and remarkable that even though it was over 15 years ago I can still remember it today.

It wasn’t too many years after that day, something called the internet started getting going.  I tinkered with it as a kid, but it wasn’t until Napster that I had an a ha moment.  My realization then was “this whole Internet thing is really useful”.  But in hindsight, it represented something more – that media is not a physical good, and the internet is a compelling medium for distributing it.  It started then and still continues today, not just with music, but with any good that is digital such as video, software, news, games, money, etc.

It was around that time I stopped spending money on music.  My logic was “why pay for something that you can readily get for free?”  But as I grew older, I had less time and I stopped using P2P downloading services because the experience was so clunky and time-consuming.  The sad part was that as a result I listened to less music than before.  I was also relegated to music purgatory where I would be forced to listen to the same five songs that were continuously played on the radio.  For over a decade, I spent exactly $0 on music through iTunes and other services.

Then enter Spotify, which created a music experience that was dramatically better.  For the uninitiated, Spotify is an on demand streaming music service.  The easiest way to put it, is that it’s the iTunes catalog whenever and wherever you want it without ever having to download a song or pay – sounds pretty good right?  It also provides a playlist function with a simple click of a button, social tie-ins (follow your friend with good music taste or some stranger), offline sync (so you can listen when you’re not online) and a few other things.

The user experience was so good, and the value proposition of being able to take my music with me on my iPhone so great, that within a week I signed up for a subscription at $10 per month (or $120 per year).  This means that within a week of using Spotfiy I was spending 2x the amount of the average iTunes user.  This would be impressive if I was an average iTunes user, but I wasn’t.  I didn’t spend a dime.  Even more, because my music was now in the cloud I could take it with me – iPhone, car, iPad, work computer, home computer, TV – pretty much anywhere I might want lovely music emitting from the ether.

So what was the difference between iTunes and Spotify?  Why was I willing to pay for one, but not the other?  The difference is one was sold as a good (i.e. a can of Pepsi) vs an experience.  And the experience was so much better that I now spend 4-5x more time with the medium.  From a high level, this should be a great thing for the music industry – a 4-5x increase in demand of an industry’s good or service is obviously a very good thing (and probably correlates to 4-5x increase in demand for concerts and related goods and services).  The problem is that the music industry can’t get their heads around the fact they are in the media business, or more appropriately, the music experience business (this lack of consciousness is fueled by their current revenue model).  Music is not a physical good, and thus should not be sold as one.  Consumers on the other hand are willing to pay real money for experiences.  Artists already make a bulk of their money through selling experiences (i.e. concerts).

Now with the cloud, which is being enabled by new devices, the music experience has never been such a compelling one.  Media (and music) is like water.  You don’t care what the vehicle is for consuming it – when you’re thirsty a bucket is just as good as a cup.  Now with smartphones and tablets, and soon smartTVs and connected cars, there have never been so many opportunities for media companies to reach consumers – this is both a challenge and an opportunity, but a boon for those that capitalize on it.  We have reached the inflection point and now is the time for the music industry to capitalize on this opportunity.

Once the music industry accepts that music is not a widget, but something far more powerful – an experience that people are extremely passionate about – they can get on with their business of letting the music play, and start growing again.  With all the hype and excitement around social, it befuddles me why music is not social today.  With the exception of SoundCloud, which has a put a social music graph around its service, music is largely not enabled to be social.  We share YouTube links, but there is a lot more you can do.  Think about the billions of dollars the music companies could save if they encourage sharing and viral marketing on the internet.  I know it sounds far-fetched.  And from the user’s perspective, maybe we could listen to more and better artists, instead of this on repeat.

January 25, 2011 / Michael Klein

From Schnitzel to Startups in Vienna

“Innovation is not the product of logical thought, although the result is tied to logical structure.” – Albert Einstein

I recently had the opportunity to go Austria to evaluate early-stage technology companies in Vienna and Linz with Plug and Play Tech Center, a technology accelerator in Silicon Valley.  Although Austria may not be the tech hub of the world, I was quite impressed with the entrepreneurs I met with and it gave me a new perspective on startups that was different from Silicon Valley.

Plug and Play Tech Center has partnered with a number of governmental organizations like Chambers of Commerce and Trade Commissions all over the world in places such as Austria, Belgium and Spain.  The partnership includes evaluating and selecting startups in the local market to go to Silicon Valley on a facilitated exchange program at Plug and Play Tech Center.

I was accompanied by JT Buffmire from Plug and Play Tech Center and Joel Yarmon from Draper Associates.  Over the course of several days we presented, met with and evaluated over 40 startups throughout Austria organized in conjunction with the Austrian Economic Chamber of Commerce.  On Friday, we also stopped by The Merger and i5 invest, early stage venture firms in Austria, and sektor5, a co-working space, where we met with another 10 or so startups including Tripwolf, Soup.io and Qriously.

As one can imagine, there are rather stark differences between Vienna and Silicon Valley so I have posted a few of my observations.

Why is the Austrian government (and others) interested in Silicon Valley

The world looks to Silicon Valley as a beacon of innovation.  It is a magnet that brings together talented, passionate and like-minded individuals from all over the world.  The network in Silicon Valley is like few others. Silicon Valley has large tech companies like Cisco, Google and HP that other companies are eager to partner with.  It also has the most robust funding market for early stage technology companies with nearly 40% of U.S. investments taking place in Silicon Valley and approximately a quarter of the world’s investments taking place there.  Merely by mixing with other startups working on cutting edge technologies, entrepreneurs hope to gain the ethos of  Silicon Valley and develop new, or refine exiting, ideas.  Given that VC-backed companies are associated with job creation accounting for 21% of U.S. GDP, it is no wonder that other countries hamstrung by unemployment are taking note. 

The main differentiator is the ecosystem

The main differentiator and the driver of Silicon Valley’s success is the ecosystem.  See my old post here on what creates a successful incubator. There is an established ecosystem of talented entrepreneurs, camaraderie amongst like-minded individuals, role models provided by successful entrepreneurs, mentorship, domain expertise (i.e. technology, product, design, marketing, etc), tech related news (i.e. TechCrunch), tech related services (i.e. cloud computing services, legal, finance, real estate, etc) and venture capital.  This may seem like a chicken or the egg problem since they are all self reinforcing – how do you get one without the others?

Differences in philosophy between Silicon Valley and Austria

There are stark differences in philosophy between Silicon Valley and Austria.  Due to a lack of funding, companies in Vienna have to come up with creative strategies to build and grow their business.  That means many of them are university spin-offs from R&D done in academia.  Others were forced to be profitable from virtually day one and thus adopted a services approach instead of a more risky, but potentially more valuable, product or technology approach.  In Austria, the fear of failure for a startup is much greater. In Silicon Valley, nearly every entrepreneur has failed at least once previously and every startup has “pivoted”. Despite Silicon Valley having a deep technical competency, there is just as much, if not more, of an emphasis on doing.  All the patents in the world would not have made Google or Facebook successful.  Austrian startups put a much larger emphasis on engineering in hopes to get the perfect 1.0 release, which is often not as valuable as getting market feedback. Many of the entrepreneurs we met with had ideas born out of their many years of experience, but they didn’t ask critical questions about the size of the market.  No doubt, this is influenced by the fact Austria is a country of only 8 million people, but if a market is only $5 million per year, how much capital can you realistically raise?

So what does all this mean for Austria?  How can they start to build this ecosystem? Does it mean they should build 500 accelerators?  I don’t know if that is the answer.  The truth is, it doesn’t happen overnight.  It takes a lot of time and a lot of hard work.  The good news is, even Silicon Valley didn’t develop overnight.  Below is a good talk by Steve Blank that chronicles just how long Silicon Valley took to become what it is today.

With that said, there are already some pretty cool things that Austria is doing.  There have been some successful exits that have helped pave the way for young Austrian entrepreneurs such as Last.fm being acquired by CBS Interactive for $280 million, JaJa being acquired by Telefonica for $208 million and 3united being acquired by VeriSign for $69 million.  It was the entrepreneurs behind 3united that started a new incubator and early stage VC fund called The Merger to provide mentorship and support to Austrian entrepreneurs – this is exactly what is needed.  Startup Europe is another organization acting as a catalyst for the startup community in Austria by bringing together like-minded individuals and sponsoring collaboration, education and events.  As well as the actual physical infrastructure such as co-working space like sektor5 provides to facilitate collaboration. Y Combinator has proven that with the right support, focus and teamwork, good things can happen.

Overall, I was very impressed with the people I met in Austria and strongly believe there is a lot of potential waiting to be realized.  Joel told me that even though most of DFJ’s investments are in the U.S., approximately 70% of their recent profits have come from foreign investments like Skype and Baidu. I would expect this trend to continue, not only in Europe and China, but other places like India and Brazil. We don’t want every Austrian startup to copy precisely what Silicon Valley is doing – that would be cutting short their potential.  Every place is different and has something unique to offer, like semantics and ontology in Austria. That is what innovation is all about – bringing different ideas and people together to marinate with each other in hopes of creating something really special.

January 3, 2011 / Michael Klein

The Alternative Computing Power: The Crowd

“The amount of knowledge and talent dispersed among the human race has always outstripped our capacity to harness it.” – Jeff Howe, contributing editor at Wired Magazine

I am actively involved with a handful of portfolio companies spanning different markets, business models and stages of development.  Despite the differences in their businesses, all are maniacally focused on getting the greatest scale and leverage out of each of their investments.  These are two pillars of the decision-making process at any startup in the tech industry.  For example, it was the virality and extensive global reach of the Facebook platform that allowed Kabam and Zoosk to grow to tens of millions of users in only a couple of years.

Cloud computing has been a boon for startups for this reason.  It has provided startups with increased leverage and ability to scale their IT infrastructure with little initial investment.  In short, the cloud saves both precious time and money and allows entrepreneurs to focus on their unique value proposition.  It also removes an enormous barrier to entry that challenged startups as little as five years ago.

Similar to the cloud, there is now an alternative computing power available to startups – the crowd.  The crowd, often referred to as crowdsourcing, allows anyone to tap into a large and distributed global workforce on demand through the connectivity of the Internet or a connected device.  Jeff Howe defines crowdsourcing as “the act of taking a job traditionally performed by a designated agent (usually an employee) and outsourcing it to an undefined, generally large group of people in the form of an open call.” or “the application of Open Source principles to fields outside of software.”  This definition is somewhat open-ended, but appropriate, given the platform like properties and broad applications of crowdsourcing.  And this ecosystem is just beginning to be built out.

Although crowdsourcing is not a new concept, in fact, some of the largest internet successes were built upon the crowd.  For example, Wikipedia is completely created and edited by the crowd.  Some attribute Wikipedia’s success, in part, to the fact it is a not-for-profit organization.  This was one of Wikipedia’s founding principles, but misses the more important diver of the crowd – the community.    Before the internet, communities were defined by family ties, physical distance, national identity, sovereign borders, race, religion or some other affiliation.  The internet has created a robust, standardized protocol where there is no single centralized computer that runs the network.  This provides a platform where networks can be recreated virtually based on shared interests, passions or just about any other topic of your heart’s delight such as knowledge, civic duty, news, sports, design, linguistics, photography, cartography, ornithology, and the list goes on.  Money is certainly a factor (or even boredom), but the desire and ability to meaningfully contribute to communities on subjects people are passionate about and be recognized for their contribution is a powerful motivator.  Socialization, personalization and self-expression on the internet will fuel this sense of community.

There are tons of examples of successful companies that have tapped into the crowd and the applications are far-reaching.  Facebook relied on its user base to translate the site into 75 languages.  Associated Content, one of our portfolio companies that was acquired by Yahoo! in May 2010, relied on its community of 350,000 ‘citizen journalists’ to contribute content and news.  There are many more applications such as:

This is by no ways an exhaustive list of the applications or companies using crowdsourcing.  If you’re an entrepreneur and are using crowdsourcing in an innovative way, shoot me an email or leave a comment.

Some companies have built their own community and many others rely on open platforms like Mechanical Turk, which was created by Amazon in 2005 to coordinate human tasks which computers were unable to do (or could be done more efficiently by humans) such as choosing product photos or writing product descriptions.  Mechanical Turk gets its name after The Turk, which was a mechanical illusion that allowed a human chess master hiding inside to operate a machine and beat many opponents including Napoleon Bonaparte and Benjamin Franklin.

Today, Mechanical Turk is the largest open platform for crowdsourcing.  Turkers, or people who complete tasks, are paid as little as a penny or two for completing tasks.  Although the prices vary based on the size and difficulty of the task, the amount rarely adds up to the minimum wage in the U.S.  However, it can provide a meaningful amount to a prolific Turker from India or Eastern Europe.  According to some estimates, the value of tasks on Mechanical Turk may be as low $2,000 each day, or less than $1 million each year.  Amazon keeps just 10% so it is not producing any material revenue from Mechanical Turk.  However, Amazon does use the platform for completing tasks itself which saves it a significant amount in labor costs.  Amazon reports that there are more than 200,000 Turkers registered and as many as 100,000 human intelligence tasks to be completed at any given time.  Although the demographic of Turkers may be skewed towards the U.S., people tell me that the volume or work being done if very much globally distributed.  This implies that there is a huge opportunity given the global imbalance in labor supply.  With over 2 billion people in developing countries like India, China, Brazil, Nigeria, Kenya, etc. that are now connected by mobile devices, there is surely a massive amount of labor waiting to be utilized.

Crowdsourcing even has the potential to leapfrog technologies in developing countries such as the creation of map information.  In places like Pakistan and India, not only is it significantly cheaper, but it is often more effective.  Many of these cities are developing so quickly that the roads literally change faster than they can be mapped by present technologies.  What would take years, the crowd can do in days or months.  Below is a time-lapsed video from June 2008 through January 2009 showing the map of the city of Lahore, Pakistan being crowdsourced using Google’s Map Maker.

As cheap and useful as Mechanical Turk is, I believe it is representative of Phase One of crowdsourcing, which was characterized by cheap labor completing miscellaneous, low-value tasks.  The marketplaces were chaotic and prone to spammers.  The answers were often wrong or the quality of the work was low.  Other cases were the tasks were differentiated arose often unintentionally (i.e. iStock, Threadless) or was non-for-profit (i.e. Wikipedia).

Today, nearly every startup I talk to is either currently using or thinking about how to incorporate crowdsourcing to get greater scale and leverage out of their business.  500 Startups has even set up a $250,000 fund to invest in startups using CrowdFlower’s crowd-powered platform to build their business.  Crowdsourcing may not have the same level of strategic sponsorship as the cloud by Amazon.com, Google, Salesforce.com, and Rackspace.  However, I think this will soon change as more companies leverage the crowd to deliver cost-effective applications, not to mention that many of them are already using crowdsourcing in different ways.  Given the activity and innovation in the crowdsourcing industry, I believe we are entering Phase Two of the crowdsourcing wave.

Phase Two will be characterized by private crowds based on certain expertise or differentiated skill sets.  These crowds will be a competitive differentiator for the companies that sponsor them.  Given the differentiated nature of their skill sets, they will be significantly higher value and therefore the crowd  operator will be able to pay a higher price to the workers for their services.  These crowds will be increasingly global as they tap into different skill sets across the globe and allow workers to access them via different connected devices.  This is the sort of crowd that SkillSlate, another one of our portfolio companies, is building to automate local content.

I am excited about the potential that crowdsourcing presents for startups and humans.  I believe the crowdsourcing wave is just getting going.  The value that will be created by the next phase will be huge and the number of successes many.  The internet and the crowd will get us closer to harnessing the knowledge and talent dispersed amongst the human race.

December 5, 2010 / Michael Klein

The Regulator

“And if your ass is a buster
213 will regulate” – Warren G

On Wednesday evening, December 1, 2010, I lost one of my childhood friends, Andrea Applegate.  She was diagnosed with lymphoma four months ago at the age of 29.  She fought against this cancer with every bone in her body.  As recently as a week ago, the doctors reported that she had beat the cancer into remission.  Unfortunately, she fought so hard that she had nothing left to fight with when her body came down with an infection.

When I heard the news, I went through the normal reactions that most people do.  I couldn’t believe it.  It took some time to process.  Some time to settle in.  Then I became angry.  Why Andrea?  This isn’t fair.  Selfishly, I was mad that I didn’t get to see her again.  That I didn’t get to say goodbye.

It was very hard to make sense of such grave circumstances.  I didn’t know what to do.  I  remembered that Andrea had been using Facebook to receive support from hundreds of her family and friends.  They would frequently tell her how much they loved her.  I didn’t know what to expect since death isn’t an easy thing to deal with, but I went to her Facebook page when I woke up the next morning — what I found was an outpouring of love.  People were using Facebook to tell Andrea once more how much they loved her and as a way to support each other through a very tough time.

It’s funny that it takes mortality to compel us to tell someone how much we love them.  It’s normally a gift we only receive once, and just before we die.  I was hoping Andrea would be one of the few people to  experience this wonderful gift more than once, like the woman below — but  I am happy that she experienced this love when she did.

Two days after her death, I was driving in the car and started to recount some of my memories of Andrea.  They were such happy memories and I started to cry.  I missed Andrea.  That’s when it struck me.  We can all share those wonderful memories we had with her.  And they should be shared.

This is exactly the idea of a site called 1000memories.  1000memories was created by some of my friends — Brett Hunnycutt, Jonathan Good and Rudy Adler — to allow everyone to remember the life of a loved one, with a space to share photos, stories, and memories with family and friends.  This is a site to celebrate a life.  I have begun a space for Andrea with one of my fondest memories.  I hope that you will share some of yours.

My memory of Andrea is called The Regulator.  To read my memory please go to Andrea’s space here.  And please share some of your own.  I can’t wait to read them.

November 29, 2010 / Michael Klein

Why Superangels are a Godsend for Entrepreneurs

“I have ways of making money that you know nothing of.” – John D. Rockefeller, Oil Magnate

Every day we hear more about the rise of the angel investor – from Ron Conway’s iconic status rivaling Chuck Norris, to Super Angel v VC Smackdown on par with WWF, to Dave McClure’s superangel manifesto.  The ascent of the superangel is the topic du jour.  There has even been scandal – do superangels wield the same power as the robber barons?  One would think Barack Obama is just a step away from adding a position to his cabinet titled Angel Czar to revitalize America (perhaps not entirely a bad idea).

So what gives?  Although angel investments may still be fairly small compared to VC, they play a critical role by funding startups at the earliest stage of development, giving them life.  Also, the economics of early stage investing in consumer internet companies is going through a significant transition, as evidenced by the following:

  • The barriers to entry have been reduced by cloud computing and crowdsourcing.  These computing techniques allow startups to defer upfront capital expenditures, and provide a more sophisticated and flexible architecture allowing them to focus on their core competency and product differentiation
  • Increased distribution channels and emerging platforms such as iPhone/Android, Facebook, Twitter, etc.  have given startups more options for reaching and engaging with their customers/users
  • Viral/Word-of-mouth marketing enhanced by social product design has allowed startups to acquire massive user bases on very little marketing spend
  • Business models with attractive unit economics and revenue from day one (e.g. Zynga, Groupon, Zoosk, Chegg, AirBNB).  Once these companies figure out their customer lifetime value, they can turn on the marketing firehose to acquire customers

All of this means that the cost of failure for a consumer internet startup is much less than it used to be.  Entrepreneurs can easily and quickly put a live product into market and begin receiving feedback and iterating on product/design.  Some of these startups may even begin producing significant revenue before raising large sums of capital, although scaling businesses still requires capital.  These trends have not been as pronounced in other areas of technology like enterprise software, semiconductors, etc.

This also means that the universe of angel investors is expanding.  Historically, angel investing was a sport reserved for the wealthiest individuals – successful entrepreneurs like Bill Joy and Andy Bechtolsheim.  But now with a burgeoning angel community, proliferating consumer internet entrepreneurs and smaller check sizes, more individuals can become angels.

Although these trends are secular and should indeed alter investment strategies, there will likely be an equilibration as with all markets.  We don’t know what the right size for the angel industry is, but we do know that there has been a significant increase in capital and number of startups getting funded.  Holding all else constant, this spells trouble for returns and follow-on financing.   Some angel investors with enough capital will be able to mitigate this effect by doubling and tripling down on their good investments in follow-on financing.  Another troubling trend is startups that are overleveraged with convertible debt.  Most troubling is that angel investing has now become “fashionable.”  You know it’s a stock market bubble when your cab driver starts giving you stock picks.

This might be bad news for angel investors and returns, but on the whole, it will be good for VCs and great for entrepreneurs.  VCs will get to see more entrepreneurs with better developed products, and entrepreneurs will have more access to capital for building their businesses.

Canaan has seen these trends shape our investment strategy over the past several funds.  In 2004, we began an active seed investing program.  This program has grown in each successive fund and has never been more active than in Canaan VIII.  Since 2004, the firm has made 20 technology seed investments and the pace is accelerating.  Some of the seed investments made only a few years ago have gone on to become leaders such as Blurb, Cardlytics, and Kabam.  The latter was started by Kevin Chou out of my current office.  We recently made a seed investment in Bartek Ringwelski’s startup SkillSlate along with First Round Capital – Bartek was previously a Canaan analyst in NYC.  Between Kevin and Bartek, there is obviously no pressure on me!  As the angel industry evolves, and perhaps thanks to Dave McClure calling for the bloodshed of VCs, I expect VCs to become more active in this market.

Given these trends, it is more important to have a relationship with the angel community.  I am now on an online matchmaking service for angel investors and entrepreneurs called AngelList.  For someone who loves web services and investing, AngelList is the perfect service for me.  It also significantly increases the efficiency and transparency of the angel funding process, and gives access to high quality investors for high quality entrepreneurs and vice versa.

AngelList is an innovative service, yet a lot more can be done to help improve access to capital for entrepreneurs and small businesses.   This is an issue near and dear to my heart, and I find myself often thinking about potential solutions.  For the dedicated and passionate entrepreneurs I speak with regularly, many have trouble understanding why raising capital is such an arduous process.  I think there are several things that hold back potential solutions:

  1. Not every entrepreneur with an idea should get funded (this seems obvious, but isn’t always).  Mechanisms that increase the efficiency of the fundraising process and allow good entrepreneurs to rise to the top are therefore invaluable
  2. Early stage venture capital is risk capital.  Most investments will ultimately fail.  And even the good ones are often illiquid.  This means they are not suited for everyone.    Investors need to have an investment strategy and a means for diversification
  3. Debt is (often) not the right security for an early stage tech company.  Startups don’t have assets or collateral – they have talented people.  Businesses burn cash at the early stages of the company.  Investors hope to invest in something worth nothing today and grow it into something of value
  4. “Social proof” is hugely important.  Especially in Silicon Valley.  Low barriers to entry in consumer internet mean literally anyone can start a company, but few will succeed.  For early stage investing there are few signals, but who else is investing is an important one.  At this stage the investor is largely betting on the person, and perhaps the market, but the idea will likely change.  Having a strong relationship between the investor and entrepreneur is critical
  5. Starting a company is hard.  Money simply isn’t enough.  Getting the right investors that can help grow your business is important.  Although that investor will vary by industry and business, there are only so many of these investors with only so much time

We believe early stage investing is in fact risk capital.  That’s why we choose to invest with a price and straightforward equity terms.  The costs for a preferred equity round are not as high as some will lead you to believe.  The structure and costs of legal fees should not be part of the investment thesis.

I am excited to play a role in the vibrant and developing angel community.  And I am thrilled that more entrepreneurs will be funded because it.  Superangels might still need to spread their wings, but in the meantime, they should be a godsend for entrepreneurs.

November 15, 2010 / Michael Klein

Why the Mobile Opportunity is Different and Bigger than the Web

“Mobile will be a larger business than the PC-Web.” – Eric Schmidt, CEO, Google

I think most of us are pretty familiar with the explosion that has happened in mobile over the past couple years – the growth in smartphones, apps and data usage –  driven by the growth in iPhone/smartphones, a subsidized Android OS, application ecosystems, flat rate data plans, and the carriers relinquishing some control to Apple and Google.  I believe this has laid the foundation for a whole new class of technology companies to be created.

For the first time we have a distributed infrastructure of mobile computers that are with us at all times.  This network 1) has mainstream adoption 2) has high computer processing power and 3) is connected to the cloud and other data networks in real-time.  This network is in many ways analogous to the platforms that were created by both the PC and the internet.  We are all familiar with the innovation and business successes that followed those platforms.  First PC applications like word processing, spreadsheets, etc.  Then email.  Then web companies like Yahoo, eBay, Amazon, Google, etc.  And the list goes on and on.

When I think about what’s going on in mobile today, I get very excited about the possibilities.  I am also frustrated that there aren’t already big successes to point to (save Apple).  However, I believe we are on the precipice of a new level of innovation in mobile that will breed a host of successful technology companies.  Fred Wilson hinted at this when he wrote about Mobile First Web Second.  Evan Williams recently noted that “46 percent of active users make mobile a regular part of their Twitter experience.”  I think we will see many more companies that are mobile first web second and where the majority of usage and engagement is on mobile.  The infrastructure is there.  The distribution may not be perfect, but more than anything, it requires entrepreneurs to innovate on top of it.

The entrepreneurs that do will be able to capitalize on some very big opportunities.  It is true that mobile innovation is benefitting from the innovation that has gone before it such as the PC (processing power) and internet (connectivity).  But it is also inherently different, and that is for the better.  There are simply things you can’t do on a computer that you can do on a mobile device.  Things like a ‘check in’ to a local venue or seeing what is happening nearby right now.  Mobile has the potential to become a digital bridge for everything in the offline world.  It has the capability of being a “digital remote control” and in the process digitize everything.  You can liken this network of mobile devices to a central nervous system for the planet.  The big winners in mobile will utilize these new, unique capabilities.

This may be somewhat vague and high level, but at this stage the possibilities are endless.  We don’t have any idea what kinds of companies and services will be created.  Could anyone have predicted Google 10 years ago?  Facebook 5 years ago?  The possibilities are just too vast.  Although there are a couple of companies that highlight some of these new capabilities (this is not an exhaustive list at all).  These companies may be early, but it presages some of the things that are possible.

A better known example is OpenTable.  OpenTable is a real-time inventory management system for restaurant reservations.  OpenTable creates significant ROI for local restaurants by filling excess capacity and providing a real-time booking solution for consumers.  This value proposition for both parties is significantly enhanced by mobile.  The restaurant has a number of fixed costs regardless of whether they fill every seat or not.  The incremental value of filling an empty seat is tremendous.  Now, a consumer can logon, see what restaurant has availability nearby, and book that empty seat in real-time on their mobile device.  OpenTable’s mobile app has now generated over a quarter billion in sales for restaurants and the pace is accelerating.  I think this is part of the reason investors are paying such a high multiple for OpenTable because 1) there are very few ways to play the growth of mobile in the public market and 2) mobile has the potential to significantly accelerate adoption of OpenTable’s service and revenue.  What’s interesting is that some of OpenTable‘s functionality could now be replicated on a mobile device for the restaurant, which would reduce the infrastructure and cost of installing an electronic reservation management system.

Another example is Uber (formerly UberCab), which realized there weren’t enough cabs in San Francisco and mobile was a perfect solution to remedy that.  Without getting into the politics (I can personally attest to the problem of not enough cabs and bad service), Uber realized the logistics system and customer service platform for cabs can now be completely replaced by an iPhone (or other smartphone) and an app.  If you haven’t tried it yet, I would recommend setting up an account and giving it a try when you can’t get a cab.  The app is plain simple – you choose your location on a map and click a button to request a pick-up.  That request is sent out to a network of black towncars, and based on location/availability, one is chosen and dispatched immediately.  The driver receives your coordinates and information on their phone/app.  As soon as the driver is on the way, you receive a notification along with the driver’s name and ETA.  In fact, you can watch the driver en route to pick you up on the map.  When the driver arrives, you receive a notification and you are on your way.  At the end of the ride, you simply say goodbye, and Uber handles the billing process so no money is exchanged nor any credit card  swiped.  An email with a receipt is in your inbox in minutes.  It’s simply just a better way.

Another example is DriveMeCrazy , which allows individuals to report bad drivers (and flirt with ‘good’ drivers).  When you are in your car and you see someone driving dangerously, you can report them by saying the license plate number into your phone via the app.  The driver is tagged and the report is processed.  Historically, this information has been very hard to get for insurance companies that depend on it for their risk models.  In fact, most incidences of bad driving go unreported.  Instead, the insurance companies are dependent upon costly and delayed information from the DMV.  The data are so scarce that they often rely on other correlated, but non-causal data such as education/grades, credit score, etc.  You can easily envision a crowdsourced system that is redundant (for data quality) and whereby citizen reporters are incentivized by discounts on their car insurance.  Now that there is a mobile device in everyone’s pocket, there might just be a better way for the insurance industry.

These are just several examples of how mobile is opening up new possibilities, which I believe are vast and many of which haven’t even been considered.  And that gets me excited.  The innovation that will be unleashed by mobile will be staggering.  And it won’t just be one company (as it wasn’t just one company on the PC/Web) and it will be more than media and marketing/advertising.  There will be big winners.  I can’t wait to speak with the visionary entrepreneurs that are dreaming up this new innovative, mobile future.

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