As the Internet continues to evolve at a fast pace, a new generation of fascinating companies is developing. Some of these companies are having a huge impact on our daily lives and further fueling the evolution of the Internet. Among the many factors contributing to this trend is a strong interest by investors to fund promising companies in this space. In today’s interview, Tod Francis of Shasta Ventures talks about the state of the industry, his investments, the service model, teams and more. Tod’s investment focus is in the consumer space, services, Internet technology enabled businesses, and advertising models.

Wondering about the cost of office space in the San Francisco region? Garrett Kruger of Aegis Realty gives an update on commercial real estate in the Bay Area, including average lease rates, vacancy rates, and tips for start-up entrepreneurs who are contemplating an office lease.

As always, I welcome your feedback.

To YOUR Venture’s success,

Tod Francis

Anthony: Please tell us about Shasta Ventures, your investment focus, and how you got involved with venture capital. 

Tod: Shasta Ventures invests in early stage technology companies that serve consumers and enterprises. The firm was formed on the basis of combining technology and marketing expertise in helping build companies. My background is consumer marketing. I spent 10 years in operating roles as a marketing manager, starting with Johnson & Johnson, and 10 years at Trinity Ventures where I invested in consumer-based businesses. Originally these were traditional consumer businesses, then I started working on Internet consumer businesses in 1995. We did quite well in this sector and then the market for consumer Internet businesses suffered a severe market adjustment around 2001-2002, and Trinity exited the space at the time. I felt strongly about continuing to invest in the consumer Internet sector so I left Trinity to build a new firm. And that was the beginning of Shasta Ventures.

I teamed up with Robert Coneybeer, who was a core technology investor with a strong track record from NEA. Our vision was to put together marketing and technology, as that’s going to be the powerful combination in businesses going forward. We also believed that end users would become the largest consumers of technology and create a great opportunity as they came online. We wanted to build a firm that would be structured to work with the new technology business models. We then added Ravi Mohan who was a software investor out of Battery Ventures. The three of us went out and raised capital. We have a $200 million fund that we started investing at the beginning of 2005.

To summarize, I focus on the consumer space, services, Internet technology enabled businesses, and advertising models. Rob focuses on core technologies, and Ravi on software.

Anthony: What recent investments have you made, and what was it about these companies that compelled you to invest?

Tod: We’ve made seven investments as a firm. I invested in LogoWorks, which provides graphic design services online. It’s a fascinating model, because if you’re a small business (which is LogoWorks’ primary target), you have a couple of options to get your design done. You can go to a local agency that will charge $3,000-$5,000 and take about a month. Or you can use LogoWorks, where you can manage your project online. We have a team of designers around the country to complete the design elements of projects. LogoWorks will put three designers on a typical project, not just one. You get back a group of design concepts, and LogoWorks will complete the design in about one week, and for around $500. So it’s a dramatically better and less expensive process. The business is doing very well and has served over 40,000 customers, so it’s ramping very nicely. We co-invested in it with Benchmark. LogoWorks is our first investment in the consumer space. We made it because we believe it’s a very significant opportunity to provide outsourced services. The first wave of the Internet was information, and the second was products. Now we’re moving into what I call intangible services. It works as a great model to manage distributed workforces.

We also made an investment in an innovative company called Flock, which is building a new browser. Their goal is to provide a superior browsing experience on the web, and facilitate the user’s experience by integrating with new, next generation web businesses. So those are two examples of consumer based internet businesses in our portfolio. We have invested in other companies in this sector that I cannot discuss, unfortunately, as they are in a more confidential mode.

Outside the consumer space, we’ve done a couple of investments in software: Right 90 and Zenprise. Right 90 delivers software and services solutions that enhance profitability of manufacturing companies, and Zenprise provides service-management software that delivers real-time, automated diagnosis and resolution of problems across the Microsoft Exchange environment.

In general, we look at the market the company is targeting, their product vision, and the quality of the team. The team and its ability to attract good people is the greatest determinant of success. So when we move into a company, we really look for a combination of those things coming together. Typically, we get involved with companies that are still figuring out parts of their business model, or still building their team.  

Anthony: How did LogoWorks structure their service business model to achieve VC-grade financial returns?

Tod: LogoWorks has built an efficient business model that provides a superior product to the customer in a profitable manner to the company. LogoWorks uses software to manage the projects, and the Internet to acquire customers very efficiently. Contract and free-lance designers are important service providers. This combination provides a very efficient business model with good profitability. And it’s really the combination of those things that makes it special.

Anthony: Do you foresee a growing adoption of service models by Internet companies?

Tod: I do. I think it’s the next opportunity. As I said before, originally the Internet was all about factual or recognizable products and information. Now people are comfortable enough to start trying services. The basic analogy is if you’re in Oklahoma, you may not have a service provider there that matches your needs as well as a service provider in Arkansas can. So we’re big believers in having the Internet be a great matching mechanism to find service providers. 

Anthony: There are many interpretations of the meaning of Web 2.0. What is yours?

Tod:  We think we are in a second generation of web businesses and customer perceptions driven by a more stable Internet platform, widespread internet access and increased consumer confidence in web based businesses.  With the increase of broadband, internet services are more available with a higher service level.  Quality web businesses have built a reputation of offering good products, good services, and are trustworthy. They’re responsive, have real infrastructure, and are trying to be real businesses.  This creates an environment where consumers are more willing to turn to the web for their communication, commerce and entertainment services.  We are looking for companies that offer a product or service that is good enough to generate a strong business model.  This is typically the result of building a deep relationship with the customer. 

Anthony: How do you characterize the new attitude of consumers towards the Internet?

Tod: In 1996-2000, consumers were apprehensive. We saw early adopters willing to try it, doing dial-up to buy groceries through Safeway or Peapod, or trying out Amazon. There were also great doubters. People were worried about their credit cards online. They didn’t know if they’d get products. Going online was painful because you had to take over the phone line, and it would keep dropping. So the original customer was someone who was willing to go through a lot of pain and agony, and had a lot of trust that it would work. But most people weren’t in that category.

Now, the new customer of the Internet is the mass market. That’s because broadband is always on, which is critical. Also, as people have good experiences, they trust the Internet and are willing to try something new. Until they get burned by somebody else, they’ll probably keep trying, and experimenting deeper and deeper. And that sums up the new customer attitude.

As far as the new consumer, I think what you might be referring to is the younger generation that’s growing up with the Internet. They’re using the Internet throughout their lives. It’s completely natural to them. I don’t imagine they even think about the Internet as a novel idea. A good analogy is if you travel today and go to a hotel, you certainly are not impressed that they provide electricity to your hotel room. I think the younger generation feels the same way about the Internet. They expect it to be there. They socialize through it and have trust in it. They even keep their most personal feelings and beliefs there, which may end up being a challenge. For them, the Internet is second nature.

Anthony: You place a very high importance on the team. Can you describe the characteristics of an ideal team? 

Tod: There’s no perfect team, but here are some generalizations. My favorite team combination starts with a passionate founder who had a unique experience, which gave him or her a vision for a product concept. They’re either a user of a product or supplier of a product. They saw an intense pain point, came up with a new idea, and a solution. That’s the passionate founder. Often, the passionate founder who comes up with the product idea is not a manager. So I like to see the passionate founder teamed up with a manager who can execute. That’s someone who’s been there before and who’s seen the movie. And then the ultimate combination is when that group is good enough to hire great people, because you never have the whole team in place when you go into a young company. If you have a great product idea, you’re in a good market, and you have people that others want to work for, things will often work out because you built a great team. If you have a culture or a team that is difficult to work for, that’s a huge barrier to success. So what we look for is product insight, domain expertise, and that ability to recruit teams and be leaders. But that’s rarely in place when we invest, so we look for nuggets that can enable it.

We’re deeply involved in every company we’re working with on thinking through team building and team dynamics, working with recruiters, and trying to place people. This is absolutely a huge part of what we do. I’d say team building is probably the most significant contribution venture people make in companies. Because if you put the right people in, you shouldn’t be worried about the details in the company. If you don’t have the right people, then the Board must worry about the details. It’s a very simple balance.

Anthony: What is your experience with trying to successfully "adjust" teams?

Tod: I have yet to see the perfect team the day we invest. So you’re often making adjustments, which is normal. Certain people just might not be the right fit. Others may not have the capacity to keep up with the company. But you might be asking, what about changing the CEO? That is something a lot of a people have different views on. If you go into a company and you know you have to change the CEO because there’s a problem with the current one, that’s a challenging situation where you have to change the culture of the company. We would prefer to go into a company where the founder and the current CEO can have a long-term role. It may not be as CEO. But the belief is that they’ve created a culture and they have a certain operating style that others have embraced to join them. Therefore, we’d rather let those people have a possible role in the company that we add to, rather than do a complete overhaul and replacement. Often the overhaul and replacement strategy can consume a lot of energy and time in the company and can be very disruptive. While it can be done successfully, I’d much rather build on the original team and move pieces around rather than do a complete change over.

Anthony: We've recently seen transactions with exceptionally high valuations that did not bear a direct correlation with revenues (ie. Skype and MySpace). Are these warning signs of the next Internet bubble?

Tod: That’s a tricky question, because what those companies brought was a very large franchise to platforms that can leverage them. So eBay has hundreds of millions of users who are trying to communicate with others more efficiently, and perhaps they can make Skype a very productive acquisition. Just like Paypal was a very productive acquisition. And the same goes for Fox and MySpace. They needed a foothold in the Internet and they acquired one of the biggest franchises. Now they have a huge volume and it’s up to them to figure out if they can make it work. So you got to be careful when you say: what is that business worth by itself and why did they pay so much? One should look at what that business is worth to the combined entity.

So yes they were very high prices. And it’s more a signal that those franchises that acquired these companies had a high enough valuation to pay those prices and still absorb them. Those transactions have fueled a lot of energy, money and financing by venture capitalists hoping they can get a similar transaction. And that’s the problem that’s being created today. Too much money is going into these companies because they see these very high priced outcomes. And you can’t assume that you’ll always have that much synergy with a company to get that kind of valuation. So we’re definitely in a bubble 2.0 in the venture environment. The difference is that the first bubble had very high exit valuations on a large volume of companies.  And today, we do not see that. You see very few outcomes. You see the MySpace and Skype outcomes, but that’s only 2 companies. Yet, there are thousands of companies being funded each year.

So I think the challenge we’re in today is that there is a lot of money going into companies on the front end, but very little validity for exit value on the back end. That’s squeezing the potential returns and increasing competition for every start-up. For every start-up you hear about, there are 10 more that have been funded. So we’re in a very delicate time right now. High priced outcomes do contribute to a challenging financing environment as this can drive too much money into the business and it will drive too many competitors, making it difficult for players in the industry to do well. 

Anthony: Would you invest in an Internet company that derives its revenues solely from advertising?

Tod: We would if it was a clear business model. We would have to have a reason to believe that the customer relationship would deliver an important advertising relationship. So yes, we absolutely would do it, but we would have to see a real validation that it could happen.

I think advertising models are hard to do. The bar is very high. You also have to realize that there are tons of business models out there competing for ad dollars. Therefore, you have to have a very tight customer relationship that can be the basis for revenue. If it’s another surfing site, we would not be interested. Where we’re more inclined to invest is in a lead generation model providing a deep relationship with the customer that can be of value to others. And that would be more interesting.     

Anthony: Looking back at investments you’ve made, and others you haven't, are there things you would have done differently?

Tod:   With full 20/20 hindsight, I would do a lot differently. Hindsight is a wonderful vision. You learn from every company.

I wish we had invested in more early stage Internet companies back in 1995-1996, because it was really an exciting time to build initial franchises in the evolution of the Internet.

The second thing I would have done (unfortunately I was unable to do it given my circumstances), is invested in more companies in 2001-2002 when everyone had given up on the space. That’s because I believed very strongly in the consumer Internet space when very few people did. And there could have been great businesses built in the ashes of the downturn. These could have been new start-ups, or companies that had already been started with a decent franchise, but that were struggling with a cash squeeze and lacked investor interest.

The third thing is that during the bubble, we knew it was a bubble. We should have paid attention to that and stopped. And I did make one or two investments later in the cycle that I wish I had not made.

Lastly, I would have done anything I could have possibly done to have gotten into Google. I think Google is such a fantastic platform to build businesses and to reach customers. I’m also a believer that others will have great businesses in that space. The world has proven that no one can ever dominate a sector forever. Google will be a phenomenal business and there will be other great businesses in that space too.

Anthony: Can you share a success story?

Tod: I’d like to talk about one that I’m particularly proud of -- Blue Nile. We funded it when I was at Trinity and were the first round of funders. It was then called Internet Diamonds, with just two founders and a business plan. So we assisted in the management team build-out, and watched the company change its brand platform, change its name to Blue Nile, and hire a great marketing team. I am most proud of how they were always focused on their customer and on doing what they did well: great service, great product, great pricing. We had eight competitors when we started, and were the only one to be successful. That’s because our management executed better than everybody else. What I am also particularly proud about is that in 2001, there was a down round that had to be done. The company presented to over 50 venture firms and no one would touch it. So we led the inside round, and rallied the rest of the investors to get involved. That round turned out to be the most profitable in the company’s financing history. It’s great to have been part of the beginning, to have stayed with the company and to have supported it through the toughest times. Currently Blue Nile has a market cap of around $700M. It’s a phenomenal company.

Anthony: Can you talk about exits: IPO vs. acquisition?

Tod: The IPO market is so tough today. And with the regulatory requirements, you have to be realistic. We hope every company we go into has a chance to be a standalone successful company. But we’re realistic that maybe the companies we’re building would be a great partner for a larger platform. So we’re very open to both.

Across venture capital, one third of the companies end up doing well and two thirds don’t. Out of that third, one third (or 10% of the original) will do really well. So this is highly skewed around big winners. And that very well could be an IPO or a big M&A. It’s very much of a challenging business. Anyone who thinks it’s an easy business is fooling themselves. There’s too much capital. And there are a lot of competitors on the venture side and the start-up side. There are very few exits today, and exit valuations are more rational. So you’ve got to be great to win and have a successful outcome.

Anthony: What is your advice to today's entrepreneur with respect to building successful companies and raising capital?

Tod: First thing, get great people to help you and focus on the team. That’s the most important thing. I think the big flaw is when people think they can do it all themselves. You should hire the best people and give them positions that empower them to execute.  Hire people who are better than you. It only takes three or four people and they’ll take care of the rest. Second, make sure you’re building a real business instead of just a feature. It’s not a gold rush anymore. This isn’t easy money. So a great team with a great product in a real market can lead to success.

As far as raising capital, I have a number of points of advice. When you go out to raise capital, figure out what business you’re in and target those people who have a positive experience in that space. Don’t try to raise money from people who don’t have domain expertise because a) they probably won’t be interested in your business, and b) they wouldn’t give you good advice if they were. So target people who have domain expertise, approach them through an introduction to the right person, and be very precise in the way you communicate what your business is. You’ll have a better chance of finding the right partner.

The next thing is to make sure you do your homework on the partners. These are long-term relationships. Get people who provide real value, who stick with their companies, who make good decisions, and give good advice. And treat the fundraising experience as a very important part of your company’s potential outcome.

Finally, don’t be too focused on valuation in the early rounds. Get the right partner and go from there. The right partner will drive a fair deal. If you have a good partner and a fair deal, you have a much better chance of success. Don’t be worried about the last 10% on the valuation because it doesn’t matter in the long run. The founder who has a 20% ownership of something that’s worth $3M is not in as good of a position as a founder with a 10% ownership in something that’s worth $300M. So it’s much more important to build a great company than it is to worry about the last dollar of valuation.

At Venture Momentum, Inc., we work with start-up entrepreneurs who wrestle with finance and accounting. We help you put together the pieces of your financial puzzle by providing a solid foundation from which to successfully raise capital, manage growth and achieve liquidity. To learn more, give me a call at 1.415.897.0195 or visit http://www.venturemomentum.com.