Does Your Venture Have The Traits of a Winner?

What works? Hundreds of times a week, venture capitalist Ann Winblad asks herself that question. As a co-founder of Hummer Winblad Venture Partners, she is constantly on the lookout for the next big idea in computer technology, particularly in the fast-moving Internet arena.

By GEORGE ANDERS
Staff Reporter of The Wall Street Journal.

When Ms. Winblad spots a potential winner, she and her partners pounce. Their San Francisco venture firm has bankrolled more than 60 tiny start-ups since opening its doors in 1989. Among Hummer Winblad’s best-known winners are Liquid Audio Inc., NetGravity Inc. and AdForce Inc., all of which have gone public in the past 18 months.

But Ms. Winblad is hardly a naive booster of everything with a dot-com at the end of its name. For every company she finances, there are dozens she turns away. Her world is full of warning flags — companies that can’t connect clearly with customers, that can’t put together first-rate management teams, or that can’t master the intricacies of rapid-fire product development.

A native of Minnesota, Ms. Winblad makes a point of widening her horizons beyond the go-go world of Silicon Valley. Some of the best new businesses are being formed in Texas, Seattle, New York, Atlanta and Minneapolis, she says. And if other venture capitalists don’t want to stray too far from their comfortable northern California offices to find tomorrow’s winners, she is willing to get on a plane, visit the best candidates across the U.S., and make investments that her competitors might overlook.

In a recent interview with The Wall Street Journal, Ms. Winblad laid out her prescriptions for success. She also took stock of the volatile Internet sector today, and offered her forecasts of what the next few years might hold. "The risks are huge," she warns. But the opportunities, she adds, are even greater.

The End Is Not Near

The Wall Street Journal: Are you seeing any signs that the Internet boom for new companies is peaking? Or are you still getting plenty of exciting ideas coming in the door every week?

Ms. Winblad: The number of pitches is accelerating. The quality of deals is at an all-time high. You would expect that with a big increase in the number of proposals that quality would go down and you’d end up getting so much stuff that’s worthless. But that isn’t happening. There are still many sizable opportunities that are unclaimed. There’s so much money in the hands of venture capitalists, so many contenders and so much opportunity. But everything will be funded in a very short time frame.

New entrants include what people are calling the click-and-mortar companies. This new combination combines an Internet-based business with elements of the classic brick-and-mortar company — stores, warehouses and support functions like call centers. It has expanded the investing landscape. Large companies that haven’t been part of Silicon Valley now are calling venture capitalists saying: "We’ve got an idea that we’ve thought up within our existing company. Will you fund it as a new business?"

Last year I keynoted the Direct Marketing Association’s conference of catalog vendors. There were 1,200 attendees. It was disappointing how many people were hugging their catalogs. They didn’t understand that consumers wanted to order from the Web. That’s completely changed in less than a year’s time. As a result, huge segments of the economy that were hard for Internet entrepreneurs to access on their own are changing. With the right partner, it’s possible now to do something in every segment, from furniture to agriculture.

WSJ: There’s a stereotype that any smart college dropout with good computer programming skills can set up an Internet business on a shoestring and have a chance to become rich and famous. Is there still some truth to that? Or is it getting more expensive to compete on the Internet?

Ms. Winblad: No question, the price of admission is higher. If we look back at the first Internet investments in 1994-95, everything had to be hand-crafted. The tools were basically free. You could pile together a bunch of stuff with the right computer languages and tools — HTML and PERL scripts. You would bolt that onto a database. Even though it wasn’t scalable, it was a good enough start.

Today a new Internet company needs to make a substantial technology investment to have all the capabilities you need to be competitive. You need an e-commerce layer, a personalization layer and a database layer, a content-management layer, and on and on. That isn’t cheap. But the tools allow new entrants to build better sites and businesses than ever before. Very large markets are opening up quickly as the technology scales with the opportunities.

Customers’ expectations have also risen greatly. People expect that sites will be fast and easy to use. They expect that sites are deep and broad and personalized and that they won’t have to hop around to nine places to get something done. They also expect a lot of extras. If you use a site, you may expect to join a community to have access to message boards, to have free e-mail, as well as to have fresh content every day. That means it takes more to satisfy the customer. And that also accelerates the cost of entry for a new Internet company.

Picking the Winners

WSJ: What are the hallmarks of a really good Internet business proposition? What do you want to see before you write that first multimillion-dollar check to help a tiny company take off?

Ms. Winblad: We look for big markets and customer-driven business models. It doesn’t have to be a market where winner takes all, but the winner should win big. We can expect that every new opportunity will include many freshly funded start-ups, and competition will be intense. So we look for companies that get big faster than the competition.

Another big issue for us is people. They’re the engine that makes a business race ahead. Money is just the fuel that goes into the engine. Sometimes when we see a significant market opportunity, we can be very straightforward and say: "We’ll fund the opportunity, but it’s not going to be you who runs it. We need a different executive with a different set of skills." The company must also stand out in the way it reaches and delivers value to customers. The business has to be better than what exists today, not just in terms of economics but in terms of meeting customer needs. Last but not least are partners that are in place or can be secured for the company to be successful.

The ideas that win big aren’t the ones with years of advance planning. This isn’t a sector where people can write a term paper and then come in wearing nice suits, saying: "Here’s what we could do." The winners are already jumping in and doing things. They say: "There is such a strong penalty for not moving quickly that we’re just going to start now. We’re going to quit our jobs and start mocking up our Web site. We’re going to look for capital as we go along."

WSJ: When you see an idea that you like, how lavishly or cautiously will you fund it?

Ms. Winblad: Each company is different. But for the most part it does not pay to be cautious in the competitive Internet area. The real question is how much money does it take for a company to be a dominant winner in its market segment. Everyone is in a race for market space in the new economy. You can’t give a company a little money to get started, then take it a little further and give them a little more money. That approach to investing has gone away. Now you have to put a lot of money upfront.

We want a company to have adequate funding to compete with all the other entrants that will race into a new area. Companies may get going for a few million dollars. But that get-going period may be just 60 days. Then, if they’re a contender for a major area, the next step can easily take $10 million, or $30 million, or even $50 million. That means we have to convince venture capitalists and other investors to swing for the fences with you. The risks are huge, but the rewards are significant for owning the dominant position in a new area. We swing for the fences when we see the potential for a winner.

WSJ: Are established companies serious competition to your start-ups?

Ms. Winblad: Actually, just the opposite. Many of the large brick-and-mortar companies are important strategic partners for us. Our portfolio company, Works.com, is a procurement site for small businesses. Works.com sells office supplies that come from J.B. Richards and provides financial services that come from Merrill Lynch. Other companies in our portfolio have wide-ranging partnerships with companies such as QVC and Fingerhut, which have been the backbone of the direct-marketing industry.

I don’t think anyone is trying to say we’re going to throw out yesterday completely. We’ll say: "What holes are there in large markets, where we could connect customers in different ways and build more-efficient businesses within the best parts of an existing industry?" We benefit from thinking like a software company, finding leverage wherever we can and having minimal fixed costs. Where can we find leverage? Why build it yourself and assume fixed costs if you can leverage a relationship with someone else? Are we going to build pick-pack-and-ship operations for all of our companies? No. Are we going to build it for some? Yes.

There are sectors where big companies dominate, which makes it challenging to create an Internet-commerce opportunity. Look at high-end cosmetics. Most of the top brands belong to the Lauder companies. They dominate customer buying for prestige cosmetics. They have their own sites. They aren’t willing to be the supplier to any prestige-cosmetics Internet site. They’ve decided to go it alone.

Advice for Big Companies

WSJ: What would you tell big companies wanting to be more competitive on the Internet?

Ms. Winblad: My first piece of advice is: Don’t be a prisoner of Wall Street. Some people are letting their accounting models drive their business models. Our accounting system was invented several hundred years ago. Income statements and balance sheets were invented to help us dissolve businesses and count the assets. It’s very punishing for an established public company to describe its business differently to the Street.

Second, if companies don’t build an entrepreneurial environment, they will lose all their employee entrepreneurs to start-ups. There will be more start-ups funded in this next year than there were in the past four years. There’s a growing belief that the risks involved in joining these start-ups aren’t so bad after all, so more and more people are willing to join start-ups. If their company doesn’t look like it’s going to stay on the map, they will cross borders. That’s a benefit to us as venture capitalists. We get an excellent flow of resumes.

Big companies should also be willing to get close to the customer. Internet commerce companies touch their customers millions of times a day and adapt in real time to the customer.

WSJ: Figuring out what determines success on the Internet is a mysterious thing. But it’s clear that brand visibility counts for a lot — both in selling to consumers and even in reaching the business market. How do you think companies should get their brands known and understood?

Ms. Winblad: Internet companies need to attract customers early and fast. That means reaching a big audience and achieving stickiness — keeping visitors at your site once they come. Those two goals drive the Internet branding process.

A good example is the start-up of eHow.com one of our portfolio companies. EHow.com provides step-by-step information on how to get things done. If you wish, it lets you buy the goods or contract for the services needed to complete the task. They’ll tell you how to set a table for entertaining or how to make a Halloween costume. It doesn’t have a huge marketing budget, but it has done a lot of very imaginative things to build an Internet identity and reach its customers.

First, even before the site was fully established, the entrepreneurs who started it went to 1,000 of their friends to talk about the site. Then those 1,000 told others. Even during eHow’s test period, it had 16,000 people come to the site. The willingness of customers to tell other customers was a key test before launch.

After that, eHow bartered for a billboard on Highway 101 in the heart of Silicon Valley. They bought spot radio in only four key markets. They rented a window on Market Street in downtown San Francisco, where three days a week they performed "how-tos." They did two U.S. press tours in four weeks. The company was just a few months old when it launched, but in the first week it had 90,000 unique visitors to the site.

The lesson is: You can’t just put your product team in a back room, create something and then outspend your competition with what you believe is an effective marketing pitch. This doesn’t work on the Internet. You can’t prepackage and shove it down the customer’s throat. You have to make sure you can define your spot in the market and that you reach customers who will stick to your site and tell others as well. You need to communicate your reason for existence on the market map to analysts and journalists. By the time you launch you have already built an identity and have supporters, partners and customers who want you to win. If you can’t do that, no matter how much money you spend, you won’t get a place on the market map.

The Internet has turned over the steering wheel to customers. Some companies ignore that. They just think they should be spending more vs. letting the customer drive the site. They say: "This site is working great." But it may have everything except customers. Well, hello!

How Big a Loss Is Too Much?

WSJ: A lot of Internet companies are running sizable losses as they spend heavily to recruit new customers. How do you control that process? What guides your thinking in deciding how far into the red your companies should go?

Ms. Winblad: Reach and stickiness are paramount to any Internet business, and this does cost money. Our companies work on a very excruciating, bottoms-up model. We tell CEOs that before they go out to raise a substantial financing round, they need to be able to answer the question: How long will this cash last? Is it the last cash in? What are the key assumptions that drive this business, and how ultimately will revenue exceed expenses?

I was fortunate early in my career to work with a former General Electric executive, who had worked with [GE Chief Executive] Jack Welch. He taught me that you need to put your experience into a small set of assumptions that you look at frequently and how to tune your business in real time. This is even more true for Internet companies that have many fast-moving parts to their model.

We’ve turned down some very big market opportunities when we discovered that the economics were tough even on the Internet. An example of a segment we passed on was the Internet hardware store — tools, electrical supplies, paint etc. There were very small gross profit margins on the top-selling items. The distribution channel of that sector was pretty tightly connected so it was challenging to improve these margins. The slim margins in this sector aren’t big enough to build the infrastructure that you need for an Internet business, and to do everything you need to meet customer expectations.

But we continue to watch this sector in the event some entrepreneur has an inventive solution to the economics of the corner hardware store or there are major changes in the distributor relationships.

WSJ: What’s the most you’re willing to spend on a company’s URL — the uniform resource locator that amounts to its business name on the Web?

Ms. Winblad: Someone offered me my own name for $25,000. They said they had another bidder. Since I’m not building a business around my name, I said, "Congratulations. What a jackpot you’ve hit. Go sell it." Some of these names are extremely valuable, and there are many people that just register them to sell them. There is a hostage situation right now, where people may have to pay a lot to get the URL that they need.

Pets.com, for example, is a very valuable URL, very easy to remember and straightforward as to the business. It was part of the start-up we funded. Some URLs are move inventive, such as http://www.liquidaudio.com. Our companies have had to buy some URLs. Sometimes they just pay for someone’s cost of changing their business name. Sometimes they pay a lot. We haven’t paid more than $100,000. Others have. It doesn’t mean that these URLs are worth that much. But decisions have to be made rapidly on your identity as a company.

The question should be: What’s a bad URL? Some companies need to know when they’ve got one that doesn’t work. They don’t symbolize the product well, or they are hard to remember, or they are just hard to type. Check the site for Hammacher Schlemmer & Co., a famous name. There’s a tough one. What do you do for the URL?

WSJ: You go to eToys instead.

Ms. Winblad: Exactly. Some of the existing names roll off your tongue, but not off your fingers. I went to high-school spelling bees, so I do fairly well at this. But not most people.

It’s important to remember, though, that technology is changing. URLs are important today because that’s how we find Web sites. It’s hard to jump into the Inter-net ocean and find what you want. But that is changing rapidly. Search engines and browsers are evolving so that people can find what they want with a simple, natural-language query.

The Importance of Looks

WSJ: How important are Web-site aesthetics? Is the battle for customers won and lost in the first minute or two when someone comes to a Web site and either says: "This is great!" or "Good heavens, I can’t find my way around?"

Ms. Winblad: Redecorating a Web site is easy to do. Getting a good customer experience is harder, but not impossible. Getting the right supplier relationships is absolutely crucial. Without that, you’re nowhere. We’re contemplating an investment in an area that I won’t name, because we haven’t done it yet. The company has one of the ugliest Web sites I’ve ever seen. But that can be fixed. Meanwhile, customers are spending hundreds of thousands of dollars a week at this site, because they can’t get the products anywhere else and the services offered by the company are great.

In this case, we’re likely to go ahead based on the business opportunity and customer satisfaction. If you asked us to invest based just on our reaction to the Web site’s appearance, we would have puked all over this deal.

WSJ: What are some of the Internet-oriented investments that you didn’t make — and wish you had? Or that have fared much better than you ever expected?

Ms. Winblad: We wish we had a piece of Amazon.com. We met with Amazon’s CEO, Jeff Bezos, early on. It didn’t take much convincing to see the potential there. But another venture-capital firm, Kleiner Perkins Caufield & Byers, got that deal. It was a competition for the deal — and Kleiner won.

Still, we’ve built a great relationship with Amazon. They are investors in some of our companies.

The "free-everything" area is another area that’s intriguing. Free e-mail. Free personal computers. We’re not investors there. The verdict is still out about how well these ideas will work. Whether they can stand alone and become real businesses is unclear. But other venture firms have made investments here. They’ve made money, mostly by turning these companies into acquisition candidates that are valued for their big reservoirs of users.

Does the First Win?

WSJ: Many people say that in the Internet economy, it’s absolutely crucial to be the first mover in a new area. Pioneers supposedly grab dominant market share, while everyone else fights for the crumbs. Does that square with your experience, or do you have a different view?

Ms. Winblad: In general, the first movers do have an advantage, if they build customer loyalty. Then customers want you to win. They’ll stand by you during outages. They’ll tell you how to improve. But you take on quite a burden in the more technical markets to be first. You have to invent a lot of things. If you don’t win big, you may just end up polluting the pond. And in the consumer markets, you take on huge visibility to be first. People notice if you belly-flop.

Charles Schwab is the leader today in Internet trading. But it wasn’t the first. Or let me give you another example. We’re investors in Net Perceptions, which helps other Web-site operators provide personalization services for their users. It wasn’t first in the category. Firefly.com was first and attracted a huge amount of publicity. But it ended up being sold to Microsoft for just $30 million, and it had only a handful of customers at the time.

If we had been worried about not being the first mover, we never would have done Net Perceptions — and it has ended up being a great success.

WSJ: If you read everyone’s press releases, though, it sounds as if the pioneers never stumble.

Ms. Winblad: We’re in an environment where companies need to declare victory early on. That’s fine, but companies have to realize that it isn’t enough to stand proud and say they’re the winner. They actually have to go out and win the game. It’s really hard to grapple with all these levels of technology. But if you look carefully, sometimes the question isn’t: "Who is the first mover?" It’s a matter of: "Who is the first loser?"

We constantly remind our companies: You must sprint to first place but still pace for a marathon. We’re early in the Internet-commerce marathon.

WSJ: There’s a tremendous amount of money in the venture-capital community. Does that create an investing frenzy, in which you can’t invest in a promising company unless you accept a crazy valuation?

Ms. Winblad: You have to make sure that you aren’t just looking at the runts of the litter and picking the best runt. But I think we’re still being selective. We feel good about the quality of our deal flow. We do have to make decisions very quickly We have to think ahead.

And we need to have our existing companies tell people: "I’m so happy we picked Hummer Winblad. I never regretted it." Just having a $500 million fund or a $1 billion fund isn’t enough.

WSJ: What’s the fastest you’ve ever gone from hearing a company’s first pitch to making a firm commitment to finance the deal?

Ms. Winblad: We’ve told a company right after a pitch: "We want to do the deal." We’ve shown up with a term sheet the next day. It helps to know some sectors well. I like to get on my StairMaster every evening and read business plans. I can read a lot of plans in 45 minutes. It gets my adrenaline rising. And it helps prepare me for spotting good investment areas.

You have to like these entrepreneurs. You have to be that trusted coach that can help when things aren’t going perfectly. You’re going to be working with them for a long time.

Mr. Anders, a staff reporter in The Wall Street Journal’s San Francisco bureau, served as contributing editor of this report.

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