<img height=”150″ src=”/vcj/images/Febcover.jpg” width=”120″ align=”right” border=”0″>Walking through the crisp offices of Accel Partners, it would be easy to confuse Managing Partner Jim Breyer with a college intern. The 41-year-old seems to have inherited the Dick Clark gene, but the boyish-looking venture capitalist has compiled a track record that is nothing short of astonishing: He’s created about $1 billion in wealth (according to a source close to the firm) through 25-plus exits, including such notable IPOs as Foundry Networks, MacroMedia and Synopsis. That may explain why some of his younger peers refer to him as one of the “old guard.”
As part of our 03 predictions coverage, we were looking for a single venture capitalist who could present a well-rounded perspective. Breyer was an obvious choice. He’s been a venture capitalist for the past 15 years, he has visibility into overseas venture capital through Accel’s European fund, he has perspective on the buyout market through Accel’s partnership with KKR, and he has sat on the board of Wal-Mart Stores since 2001, which gives him a window into the public markets. Plus, he has personally dealt with hot-button issues, like cutting fund size.
We met at Accel’s glass-walled offices, four stories above University Ave., a pretty, tree-lined street that runs through the downtown of upscale Palo Alto, Calif. The conversation lasted long after my Mocha coffee drink went cold, and Breyer had to get a second bottle of Calistoga for the second half. By the time we finished, the scenic view to our left had changed from wispy treetops to twinkling lights set against the winter darkness.
<font color=”#0000a0″>VCJ: VCs used to say that macroeconomics weren’t really a huge factor in what they do. But we’ve been in this rut for the past couple of years and, coincidentally, so has venture capital. So, I’m wondering whether the economy really is a factor and how you see that playing out in 2003.</font>
Breyer: Well, I think the really important thing for us as venture capital investors is to have a view of where we are on the playing field. And there is a Silicon Valley technology macroeconomic set of issues that has been negative for the past couple of years. From a corporate purchasing and consumer purchasing perspective, I don’t expect anything to get much better in 2003. On the consumer side, the most important insights I have would come from the Wal-Mart Stores board. We view 2002 and 2003 to be difficult years. The 2002 holiday season was clearly one of the most difficult in decades, and 2003 is likely to be very difficult as well, from a consumer spending point of view. These macroeconomic trends, both domestically and internationally, do have an effect on the health of the venture capital business.
<font color=”#0000a0″>I can understand how cutbacks in corporate IT spending can affect a whole bunch of startups, but what kind of perspective do you get from the whole Wal-Mart experience and what consumers are doing? How do you relate that to VC?</font>
There are two issues that come out of the Wal-Mart experience. One, from a consumer spending point of view, watching what’s happening relative to how consumers are choosing to spend discretionary money has an impact on many of the consumer-oriented software technology businesses we’re involved in, such as RealNetworks, MacroMedia and others. From a corporate purchasing perspective, Wal-Mart is obviously one of the largest corporate spenders on IT.
In many ways it’s been very instructive to watch how the purchasing behavior for strategic technology projects has evolved. We’re seeing both at Wal-Mart, as well as a number of other Global 1000 to 2000 companies, a very significant change in terms of the initial license price they’re willing to sign off on. Two years ago a $500,000 deal took one signature and three to six months, but today there are a number of deals in the 100K to 500K range that take eight to 10 signatures and nine to 12 months to close. That has a very significant impact on how we’re building software and communications infrastructure business models. If we as venture capitalists and software and networking CEOs don’t have a view on what these kinds of underlying purchasing trends look like, it’s very hard to build appropriate operating and burn-rate plans for 2003.
<font color=”#0000a0″>When I was reading your piece earlier (see piece), I was really blown away by how much you believe it costs to start a successful software company. How many VCs really understand the fundamental decision-making process as you’ve outlined it and understand the number of signatures and price points?</font>
I can’t speak for the venture business. I know that we and a number of other venture capital partners and firms that we co-invest with a lot are spending a good deal of time with the most enlightened CIOs and chief technology officers at the large companies. We are trying to understand in as much detail as possible what the budgets look like for 2003 as they’re being put together, so that we can provide appropriate input to our companies. Conventional wisdom has suggested that the budgets are flat year over year. I see it being much worse than that in 2003, and we felt it would be much worse than that in 2002 for the kinds of startups that we invest in.
Much of the IT spending is simply around maintenance, and there was an absolutely dramatic pullback relative to the spending on new technology infrastructure or applications. In addition, the metric that has changed quite dramatically is what the annual savings target might be for justification of a six- or seven-figure deal. It used to be that 2x, or 3x annual savings was enough to justify a significant expenditure on new software. In fact in many cases, it wasn’t justified by savings; it was justified by strategic revenue enhancement.
Today, if someone can’t justify at least a 10x annual savings two to three years after deployment of the technology, in many cases it won’t make it through the final purchasing approval process. That is quite dramatic for our portfolio companies. If we’re trying to get a million-dollar deal in one of our companies, we have to be prepared to be able to show a $10 million annual savings to that corporate customer as they look to justify that large P.O.
<font color=”#0000a0″>It almost sounds like the bar is too high now. There is only so much a product can do, and then it’s an issue of reducing the purchase price if you expect someone to buy it.</font>
I think that’s the world we’re in. The margins that we saw in both the software and enterprise networking businesses over the past couple of years are going to evaporate. People simply got used to extraordinary license and service margins that are not sustainable. The good news is that we can still build really fast-growing, profitable businesses with lower gross-operating margin structures and still have successful investments.
However, the models that we saw in the second half of the 90s from the enterprise software vendors and enterprise data communications companies aren’t sustainable. In many cases, most of the investments that we saw getting made in the networking business had 60% to 70% projected gross margins, and companies in our portfolio, such as Foundry Networks, have achieved those sorts of gross margins.
At the same time, as we look at markets going forward and where the power is in the value chain, the power has absolutely shifted to the large corporations, and those kinds of margins are going to come under enormous pressure.
<font color=”#0000a0″>Where are margins right now for successful software makers?</font>
In software the most relevant margin is pretax. We like to see the ability to achieve 20% pretax margins for software companies. A couple of years ago, we saw 30% pretax margins, with a significant margin on the licensing side and on the information services or consulting side. Those margins are under enormous pressure, too. On the communications equipment side of the business, historically we’ve looked for 50% to 70% gross margins, but today our assumption is that 40% to 50% gross margins are what will be most sustainable.
<font color=”#0000a0″>What are you looking for in a company that’s pitching you or has sent you a business plan?</font>
We received 10,000 business plans last year that were logged in. There’s no shortage of business plans, but at the same time we’re in the business of trying to help entrepreneurs build large, standalone public companies. We absolutely don’t make any money-whether it’s a software company or a networking company-when we back something that we plan to sell to Cisco or Microsoft or Dell.
In many cases that will be the outcome, but there has to be a large standalone opportunity, which means several hundred million dollars in revenue. Therefore, we need to see a company that is not only solving a very defined tactical problem in a way that’s better than anyone else out there, but solving that problem should lead to other products and services that lead to significant growth.
For example, Datasweep is a private company in our portfolio focused on product lifecycle management. In 1999 it attracted very little interest in the venture community or in the general financial community simply because people were much more focused on consumer businesses. They’re thriving in this environment. They work very closely with [publicly traded] Agile Software, which is a former portfolio company, and they solve a very tactical defined problem in terms of allowing shop floors to operate very effectively in the supply chain.
We believe that is a core strategic position that can lead to other products and services that allow it to broaden into true product lifecycle management applications, where the license deals can be six and seven figures. That’s the kind of model that we really like to see with new software investments.
Something that might look nichey and perhaps too small from an initial market opportunity standpoint at first blush but is very defensible. If it has those characteristics, but then we see significant leverage in add-on products and services around that core application or technology, those are the kinds of deals that have historically done extremely well for us.
<font color=”#0000a0″>In the column you wrote for this issue, you make the argument that in most cases it takes about $20 million to $30 million to build a successful software company. But as fund sizes have come down, I hear over and over that you just can’t put large dollar amounts to work in a single deal. Do you think there has been an oversimplification of what’s happened with the reduction of fund sizes?</font>
First of all, I think that the trend line that started in 2002 will continue-that smaller funds will be raised by the firms that we work with and by us. My prediction for when we raise Accel IX is that it will be a significantly smaller fund than Accel XIII. If I had to predict the ideal fund in the year 2004 for a firm like us, $400-or-so million seems to be the sweet spot. At the same time, there is over-simplification occurring, because based on the input of our most knowledgeable and best entrepreneurs, we can’t see how to create across the board a number of new software companies for $5 million to $10 million of paid in capital before they become profitable and have the ability to achieve $100 million in annual revenue five years out. In some cases, good entrepreneurs will find ways to do that, but they will be the exception. We also don’t believe that companies should need more than $30 million to $40 million over their first four or five years to get to cash-flow positive.
<font color=”#0000a0″>With regard to a $400 million fund, how many deals would you do with a fund of that size?</font>
Historically we’ve averaged 30 to 40 deals per fund. The more recent funds will have more deals not only because the funds were larger but also because there were write-offs. For an early-stage venture capital fund of $400 million doing 40 or so deals, you’d have five to seven general partners doing one to two deals per year actively.
<font color=”#0000a0″>Circling back to fund reductions, GPs handed back more than $5 billion last year. Are we pretty much done with that?</font>
No, I think we’ll see more of it in 2003. What I don’t have a sense for is the total number of venture firms and how many actually have decided to reduce their funds or reduce their commitments. As a percentage, it would be an interesting question, but I don’t think it’s as high a percentage as I would have thought. I think there are a number of firms that have done it, but of the total universe not that many funds had to reduce their fund size because they never raised large funds. That’s certainly a positive. For us, we raised too much money in 2000 and therefore needed to address it.
<font color=”#0000a0″>What are you hearing from LPs about this year and how is it going to differ from last year?</font>
In many cases what we’re hearing from our investors is a continuation of what we’ve heard for the past year or so. A key question is, “What is the lineup for the next fund when it occurs?” There is going to be a very justifiable set of due diligence around the historical track record of firms as well as the individuals within the firms. That’s a very good thing.
Just as we do due diligence on the management teams we back, both individually and collectively, I think that’s an extremely healthy trend. We’re seeing long-term interest in venture capital as an asset class, but at the same time lots of concerns around what is the right fundamental model. And are there enough opportunities in the software and communications space going forward?
<font color=”#0000a0″>What do you mean by the right model? Are you talking about the mix of investments?</font>
Many of our limiteds like the early-stage model and want us to remain aggressive around early-stage investing. That’s consistent with what we’ve done for a long time-early-stage software and networking investing.
Therefore, if someone doesn’t believe in long-term opportunities around early-stage software and networking investing over the next five to 10 years, we’re not the place to be because we’re going to continue to stick to our core. At the same time, I can totally understand and fully respect someone who believes there may be fewer software and networking investments that provide breakout opportunity, and I have a very healthy disagreement with them.
The other question that comes up again and again is the capital intensity model. I’m pleased that there is a great deal of debate around the question: “What should the very best software and networking companies consume in terms of capital to get to cash-flow break even and to build highly scaleable models. If we all had the same view in the venture business, we would have the over-funding, me-too phenomenon that we had in the late 90s and early 2000.
<font color=”#0000a0″>You’re hearing that from LPs? It seems like they haven’t been as involved in trying to set the tone or have some kind of influence on investments.</font>
We have 125 investors and 15 or so on our advisory board. Obviously the returns for the funds that were in the early and mid-90s for us were strong and the late 90s and 2000 funds will be really challenged. The capital efficiency of the underlying portfolio companies is something that has received renewed focus in the last year or two, but it was always a focus previous to 1997 and 98.
What most likely happened-and venture capitalists are guilty first and foremost-is the fund sizes got larger, the returns were going well, the public market was booming, and we stopped being as capital efficient as board members in our portfolio companies as we should have been. It’s as simple as that. When I sit down over drinks with software and networking CEOs, many of whom have built very successful public companies, we kick ourselves when we talk about some of the dollars we “wasted” around activities that didn’t generate as much ROI as we would have liked.
<font color=”#0000a0″>In addition to going “back to basics,” everyone is talking about being “opportunistic.” Which means: If we can make money by selling cars, we’ll do that. There are a number of cases of early-stage firms getting involved in buyouts or other areas that aren’t their primary focus and making quick money. Do you think we’ll see more of that? And is there a danger there?</font>
Yes, I think there is a danger. If there isn’t long-term consistency and strategic focus, a lot of the benefits of what we do-in terms of the networks of entrepreneurs and a deep understanding of the technologies-become less relevant. If an organization believes that for several years there simply aren’t any good early-stage technology investments, that’s a good question about whether they should shift or not.
We happen to believe that no matter how difficult the current environment is-which is brutal-long term these are still really interesting places to be investing. Changing the focus is very dangerous. That being said, there are some investors out there who are exceptional and they could invest in gas stations and probably make a lot money. Don Valentine [of Sequoia] could invest in whatever he wants to. And yet Sequoia is a firm that remains true to a consistent focus.
<font color=”#0000a0″>Another phenomenon we’re starting to see in addition to funds being right-sized is teams being right-sized. Will there be more scrutiny of individual performance in addition to firm performance in 2003? And will the number of firms start to decrease?</font>
The key checkpoints will be when venture firms raise their next funds. There should be very significant scrutiny around who are the good investors, how are they working together as a team, who are the moneymakers? That level of due diligence can and should occur in a very detailed fashion. If I had to crystal ball it, there will be fewer firms and fewer individuals in the venture business a year from now than there are today, and there will be even fewer two years from now and even fewer three years from now, before it bottoms out and starts going the other way.
I believe we’ll see fewer venture partners and less general partners at firms like Accel. I believe we’ll see fewer venture consultants. And there will be more than ever a premium on the starting team of investing general partners. Thinking of the Boston Celtics [Breyer is a minority owner], it’s the starting five that is critical. And it’s both individually and collectively how that starting five is working together. At the same time you need a bench. So many people are saying that there is a group of first-time venture funds that were created in the late 90s or year 2000 that are all going to go out of business. Or there were so many people who joined the venture business around that time and most joined for the wrong reasons. I don’t see that. I see some of the best instincts I’ve ever seen in the venture business being demonstrated by individuals in their early 30s who are prepared to take a very long-term view of the business and are doing it because they like doing it.
<font color=”#0000a0″>I think you are going against the grain on that one, because I think that we will see some of these guys who made a very big splash with large funds that just haven’t had the track record. And when they go out to raise that new fund, the LPs will say …</font>
Investment track record really matters…
There’s a lot of luck involved in our business, but over a period of time we know we can tell within Accel who’s able to work through really tough situations and recover capital. At the same time, can that individual achieve a 10x or better return on certain deals? Are they a magnet for new deals? All of those issues are due diligence items that should and have to come up as limited partners evaluate which individuals and venture firms to back over the next couple of years.
<font color=”#0000a0″>I was talking to a VC recently and he said he wants to be realistic, so he’s looking at opportunities that will produce 1x or 2x his money. Sounds overly conservative.</font>
We won’t invest in a company where we think it’s going to be a 2x outcome. In a lot of our existing investments, we’d be thrilled with a 2x outcome [laugh], but going in we need to feel that there is an opportunity under realistic conditions to make 10 times our money five years out. Therefore, it has to be highly capital efficient, the pre-money valuation should be single digit and the market size should be large enough to generate the right exit value.
<font color=”#0000a0″>Jumping back to the macro level, I’d like to get your predictions about some big topics. For example, what kind of impact would a war have on the venture business?</font>
I strongly believe we’re going to war, but I have absolutely no idea what kind of impact it would have on the venture business. I’m very comfortable saying I just don’t know.
<font color=”#0000a0″>On the issue of venture-backed IPOs, do you see the window opening up this year or do you think we’ll have another down year like 2002?</font>
I don’t see a fundamental change in the IPO market. I also don’t see many companies with four to five quarters of profitability behind them and are growing dramatically. That really is what a good model would be from a public market perspective, certainly from a software perspective.
I would also say that being on public boards is no picnic, and for a company to go public everything needs to be in place, including the management team and the board. There also needs to be real visibility and scalability around both the margin model and the revenue growth rates. Once a company is public, the flexibility is greatly hindered, and it is very difficult right now to recruit exceptional executives to public company boards.
One of the real headaches I have and one of the things that keeps me awake at night is how we’re going to build world-class boards for many of our late-stage private companies, as well as to continue to build boards on our public companies. In many ways there is no rational reason for someone to join a public company technology board in this kind of environment.
<font color=”#0000a0″>Are there some factors that could make the IPO market open up in 03? For instance, the Bush Administration is talking about cutting the tax on dividends.</font>
I have to say that I just don’t see a thriving technology public market environment in 2003. And I even question the first half of 2004. I don’t think that’s a bad thing. I think that’s the reality as I see it, and that’s how we’re managing our portfolio companies. There are a couple of private companies that I’m involved with that are generating $50 million to $100 million in annual revenue and are profitable. In many environments, they could tap the public markets, but my advice is: Let’s wait and continue to build the business and be smart about building real defensibility, so that post-public offering there is an optimized chance of building a highly successful company.
<font color=”#0000a0″>So, if you were going to be overly aggressive, you could probably get those companies public?</font>
Yes. There are two cases, specifically, where leading investment bankers have told us that we should be going public, given the software position, the revenue run rate and the profitability. We’ve also turned down a couple of potential acquisitions where we could have made 2x or 3x, but we’re going to play a little bit more of a long ball. In some cases we would dearly love to make 2 times our money because we think we’re going to have a write-off. But in other cases, we have companies with tens of millions of dollars in revenue, they’re growing at 50% a year, they’re profitable and have deep defensibility, and those are valuable companies. And we believe, over time, that they can return more than 2x or 3x.
We want to make sure we’re building companies that matter and at the end of the day are worth as much as possible. There is no rush to liquidity. That’s not to say that recent funds aren’t in need of some big positive returns [laugh]. We could use that, but the way we have historically generated good long-term returns is through building good public companies, particularly on the software side.
<font color=”#0000a0″>Given how things are, it seems that if there were any opportunity to make a decent return there would be a rush to liquidity. “Let’s get that off the books and move on to the next one.” That’s not happening at Accel. Do you think that’s generally true at other firms?</font>
I don’t see a real push toward having to achieve liquidity or forcing it unnaturally. I see very healthy, positive dynamics relative to liquidity.
<font color=”#0000a0″>Is there anything this year that could improve the M&A market? There’s still a ton of cash out there.</font>
No. I think companies will continue to focus more on upside opportunities, and it will be gradual. Some of the best public companies-whether it’s PeopleSoft, SAP, Microsoft, Intel or Cisco-all of those are likely to become more acquisitive. But from a valuation perspective, we still don’t have the appropriate resetting of valuations with our portfolio companies. Entrepreneurs still aren’t yet ready to accept the fact that they may only be worth 20 times earnings or 2 times revenue. It’s moving in the right direction, but I don’t believe there has been enough rationality injected into the private company marketplace to lead to fundamental changes in M&A.
<font color=”#0000a0″>After last year, you’d think that people would be more grounded.</font>
It’s like the venture community, where every venture capitalist believes their companies will succeed. It’s getting better, but it’s not where I believe it will be a year from now. It’s better today from a year ago and it will be even more rational six to 12 months from now, because I expect a very difficult year ahead. I think we have 12 very difficult months in 2003, in terms of what growth rates look like and what margins look like in the software and networking business.
<font color=”#0000a0″>What will be the toughest thing in ’03 for Accel and for the overall VC business?</font>
From a VC point of view, there are a lot of issues facing us, to put it mildly. The issues that I think are very challenging in 2003 and 2004 are generational transition within venture firms. It’s really hard…
<font color=”#0000a0″>You’re not planning to retire at 41 are you [laugh]?</font>
No, I’m not planning to retire [laugh]. … There’s a constant challenge around empowering the best next-generation venture capitalists and at the same time having the experience become part of internal fabric of how we’re evaluating businesses. You have to have the aggressiveness, the creativity, the technical understanding of where these markets are going and at the same time having a historical perspective is very powerful. That balance is really important. In my view there is a tremendous advantage to bringing all that together in a firm, but it’s also very complex because most venture capitalists believe they’re pretty good. So the generational challenge, whether it’s Accel or other venture firms, is ongoing and we’ll see more of it in 2003, 2004 and 2005.
On a similar note: What is the appropriate compensation within venture firms? The venture business is going to contract in a very substantial fashion, but we and other firms would love to hire another superstar or two. Therefore we want to be sure we’re putting in place highly rewarding long-term compensation structures that are aligned with who’s going to generate very successful results over the next five to 10 years.
Also, are the young partners who are doing really great work-even if they don’t have significant returns-being appropriately rewarded? I think that’s something that’s very important as firms continue to try to build vibrant organizations. The next generation of venture capitalists is going to have a profound impact not just on the industry but also on how well we as a firm do. Therefore over-investing early in the very best next-generation venture capitalists is a real positive. Within Accel we named Peter Fenton a general partner in 2002. He’s 30 years old, he’s doing a great job and he has enormous long-term potential.
<font color=”#0000a0″>Do you expect to see some competition for talent in 2003, like the bidding wars we see with sports teams?</font>
It’s generally not competition around compensation. But I’m aware of over 20 current software partner searchers in the venture business [including one by Accel]. The competition is most often with having that individual get comfortable about leaving a Siebel, an Oracle or a Microsoft, as opposed to Accel competing with Sequoia, although we’ve had lots of overlap in certain situations.
<font style=”BACKGROUND-COLOR: #ffffff” color=”#0000a0″>Getting back to challenges for venture firms, what else is top of mind?</font>
The salary structure in existing portfolio companies is a tremendous challenge facing the venture capital business in our capacity as board members. There was a salary structure that existed in 1999 and 2000 that is completely out of whack with what software and networking salary structures looked like in the mid-90s or what they should look like today as startups: Those companies where the CEO was recruited and given 10% of the company and is receiving $400,000 to $500,000 a year in salary instead of the $200,000 or $300,000 that is the norm. Those bloated salary structures need to be addressed. We’re still working through that. We’re about halfway or three-quarters through it, but it’s still a very significant issue.
There are also CEOs and other senior executives who are very talented and may have left the Ciscos and Oracles in 2000 who had expectations of moderately quick hits. They tend to be in their mid- to late 40s, they realize they may only have one more shot, and they might be getting tired. In our portfolio and in other venture-backed companies where we’re considering a new investment, we’re seeing some tired CEOs who are talented but just don’t have the fire because they realize it’s going to be three or four years of guerilla warfare. It’s: “Do I want to work 78 hours a week and take three to four years to build this for a payoff that is nothing close to what I had hoped for?”
<font color=”#0000a0″>How about a final prediction?</font>
What we might see in the next couple of years is a couple of new firms formed, where highly talented younger partners leave established firms and decide they want to create their own firm. I think that would be quite healthy. I think we’ll also some of the very established blue-chip firms continue to thrive, but I would be surprised if there aren’t a couple of new firms created. That would be exciting.
<font color=”#0000a0″>How open would LPs be to that?</font>
Breyer: If it’s just the right team focused on the right segment, I’ve got to believe they would be able to raise some good money. I think four to five partners raising $200 million and going at it with real vibrancy, aggressiveness and thoughtfulness would be good for the industry.
Email <!–a href=”mailto:firstname.lastname@example.org”>Lawrence Aragon</a–>