A Virtuous Cycle

This was originally a guest post I did this past Summer for Wasabi Ventures, which is a great resource for entrepreneurs.  Finally getting around to re-posting here.

As an investor, what I seek more than anything is authenticity. Actually, simply as a person, that’s what I seek.

I mean a couple of things by this.

First, the smaller picture. To us at Merus Capital, the most critical element of a pitch for any type of startup is that it must come across as something that you are truly passionate about and really, sincerely want to see become a reality. No shortcuts, no BS, no quick flips, and no pretending that there aren’t massive challenges ahead.  Challenges are OK. Finding ways to overcome them is what we’re all trying to do. Otherwise, where’s the fun?

Second, the bigger picture. And this part is more personal to me than just my capacity as an investor. I would love to find startups that are building products and services that encourage, and allow for, greater authenticity. Authenticity of information, opinion and emotion. And hopefully in ways that *help* people–don’t just entertain me, rather allow me to be more productive, make more informed decisions, work or play smarter, be safer, save money, whatever it is that can improve lives personally and professionally. Certainly the social web is helping us get closer to the vision. As examples, I’ll look briefly at three well-known communication platforms through the lens of productive authenticity: Facebook, Twitter, and Quora.

Facebook may be the leader in this light but to me, it doesn’t go far enough. I don’t really have 250 close friends and for me, it isn’t a useful productivity tool. Entertainment and personal connection, yes, but productivity and all the things mentioned above, not really.

I find Twitter to be a better productivity tool than Facebook, and thus a much more integral part of my daily life. And while the ability of Twitter users to spread important and useful information worldwide instantaneously is a fundamental societal shift, the cynic in me would say that at times Twitter can be a self-promotor’s dream–a bazaar of false modesty, feigned exuberance and hollow praise.

Quora starts to get at the issue. Real people with real knowledge on certain topics and events sharing their perspectives. But it still suffers from much of the blatant self-promotion that other services do. No doubt they are working hard to reduce the noise in the signal.

But how about the next communication platform? Can we build one that promotes and preserves true authenticity, exploits deep personal and professional relationships and helps people in their daily lives? I would love to find out.

We’re excited to announce that Merus has invested in the online security company, Authentic8. Guest post by my partner Peter.  Originally posted here.

It’s a Big Idea
The web has become the primary vector for criminals to deliver malware to scam users. Since it’s the browser on your machine that downloads and runs code from the web, it’s impossible for you to know if the code that’s downloaded is secure and trustworthy each time you go online. What’s more, the criminals’ attack “surface area” is even broader than the browser–there’s URL redirection and other potential weak points all the way across the chain from the user’s machine to the web destination.

At the same time, tracking one’s passwords has grown increasingly unmanageable. It seems like each site has different password strength requirements, minimum (or maximum) password lengths, set of characters you’re allowed to use, etc. To deal with this complexity, people end up setting weak passwords, re-using them across sites, or storing them in unsafe places. As a result, online accounts are more easily compromised by criminals.

Dealing with online security is a major pain point for consumers and businesses of all sizes. Authentic8 turns the problem on its head: What if you could simply outsource the headache of keeping your browser secure and managing all of your passwords to a trusted and reliable party? Authentic8 delivers the Simply Safe browsing experience.

Real Software Solving Real Problems
How they solve this problem is quite novel. Each time you access the web, Authentic8 launches a Disposable Browser in the cloud. In essence, you’re surfing the web in real-time from Authentic8’s servers where they manage all security aspects on your behalf. It’s called a disposable browser because they’re “single-use”–Authentic8 gives you a fresh browser instance each time you access the web and discards it when you’re done, a bit like dental floss or latex gloves. The implication is quite powerful: Malware never touches your machine.

What’s more, once you’re using Authentic8’s service, they do all the hard work of validating the destination site you’re trying to reach, as well as securely and automatically submitting your login credentials. So there’s no need to remember any passwords or manually generate new ones, as some sites periodically require. The company precisely fits our goal of investing in entrepreneurs building real software solving real problems.

Exceptional Team
Perhaps what we like most about our investment in Authentic8 is that we get to work with the two exceptional founders again–Scott Petry and Ramesh Rajagopal. Scott and Ramesh worked together for several years at Postini, the company Scott founded in 1999, which was a pioneer in security-related SaaS, where Ramesh was VP of Corporate Development (Google acquired Postini for $625M in 2007–an acquisition sponsored by my two partners, Salman Ullah, who led Corporate Development at Google, and Sean Dempsey, who led the overall acquisition).

The three of us at Merus also had the privilege of working with Ramesh for several years when we were all part of Microsoft’s Corporate Development & Strategy team. We’re also excited to be partnering with Foundry Group, which recently announced their investment in Authentic8.

To be considered for Authentic8’s beta program or for more information on the company:
Click here to be put on the list of future beta invitees. For some great insights and discussion on Internet security (like this one: “Macs & Volvos: Where perception transcends reality“), check out Authentic8’s blog, OSMoSis.

Among many institutional investors who invest in the venture asset class, there is a perception that a “trickle down” effect is at work in venture.  By trickle down, I mean that a handful of well-known “top tier” venture firms see all the best deals, select the most promising opportunities for themselves, discard the others to the next set of firms who do likewise, until only the least promising ugly duckling deals are made available to lesser known venture investors.  Pity the firms at the end of the line who appear doomed by design.

Fortunately for firms who are still building a brand and the LPs looking to invest in such emerging firms, the trickle down theory doesn’t work in early stage venture.  And the primary reasons are personal networks and firm structure.

First, regarding personal networks.  Venture capital is very much a personal relationship driven business.  An entrepreneur looking to build a business will first talk to investors he or she knows and respects.  And the odds are good that most of these investors aren’t employed by the small number of firms that LPs often assume get to see “all the best deals first.”  So right off the bat, there is a mismatch with the trickle down theory.  Not to say that brand or firm reputation don’t matter, they do, or that entrepreneurs won’t also seek out well-known firms, they often will.  But the notion that dealflow follows a predictable pattern from well known to lesser known firm is false.  Case in point, the ability of the new class of super-angel funds to attract healthy deal flow should provide a good counter-example to the trickle down notion.

Quick aside: who’s to say what the “best” early stage investments look like anyway?  I like to say that while some opportunities can appear obviously inferior (utter lack of compelling product, seemingly hypercompetitive or tiny market, disorganized or untrustworthy team, or other admittedly subjective reasons), no deal appears obviously, and unanimously, good.  Yes, an investor may instantly like a pitch but there is always some challenge that the business must overcome and it’s the investor’s job to decide for themselves whether they believe it’s a hurdle that can be cleared and weigh this against the perceived reward.  What’s “best” may become a bit more evident in later stage investments when market traction–breakout user adoption, brand recognition, revenue growth–is more readily discernible.  Of course, valuations rise markedly when this is the case.

Second, firm structure.  In order to scale the firm and better manage partner time, larger firms hire junior partners, principals and associates.  While partners at the firm may have decades of venture and tech industry experience, the newer folks may be only a few years out of business school.  And when entrepreneurs show up to pitch these firms, who do you think they meet with?  Typically not the senior partners with whom LPs are most familiar.  Instead, it’s the job of the relative newbie to decide whether this first impression merits a follow up “partner meeting.”  So what’s wrong with this?  Early stage venture investing is a nuanced business.  A yes/no decision doesn’t hinge on quantifiable or structured data that can be quickly or easily communicated inside an investment partnership.  You need direct engagement.  At Merus Capital, we’ve invested in companies that we thought initially looked highly unpromising and we’ve passed on opportunities that seemed like great wins at first.  The point is that as an investor, you need to take the meeting.  You need to hear the pitch, ask the questions, read the body language.  The most interesting opportunities are usually in the gray areas that can only be fully understood through direct conversation, debate, and deep diligence.

And just as importantly, this works the other way too.  Coming out of this initial meeting, the entrepreneur’s impression of the firm is tied directly to the quality of that discussion.  Did this investor really understand my business and constructively challenge assumptions?  Do I think they could effectively sell the opportunity inside the firm?  Do they have any decision making power?  Is this person genuine or a bullshit artist?  Would I want this person on my board?  So even if an opportunity could be clearly communicated up the chain of command inside a firm, it doesn’t matter much if the entrepreneur left the initial meeting with a sour taste.

One answer to this structural problem is a small fund managed by equal partners with little or no supporting cast.  Each investment affects everyone equally and therefore each deal receives equal scrutiny before making the investment and equal help from all partners post-investment.  There is no chain of command problem or career risk issue because the decision makers hear pitches directly.  Entrepreneurs appreciate this principal-to-principal interaction right from the start and know how this can greatly accelerate the fundraising process.  This approach leads to better investment decisions and a strong rapport with entrepreneurs.  And isn’t this how top tier firms earned that reputation in the first place?

I did a brief Q&A with Josh Breinlinger, Director of Product at AdRoll.  I’ve re-posted it below or better yet, read it and (more importantly) far more interesting and insightful posts by the AdRoll team about the online ad market and retargeting on the AdRoll Blog!

We recently had the pleasure of sitting down with Sean Dempsey, Co-Founder at Merus Capital, to talk about venture capital, M & A activity, and online advertising trends. Sean brings 10+ years of experience in Corporate Development at Microsoft and Google to his role at Merus and to his role as Board Member at AdRoll. You can follow Sean on Twitter or read his blog.

Josh Breinlinger: Tell us a little about yourself.

Sean Dempsey: I’m a founding partner of Merus Capital, an early-stage venture firm. My two partners and I founded Merus in late 2007 to focus on software and Internet investing. The three of us worked together for about a decade at Microsoft and Google prior to starting Merus. My role at both companies was in Corporate Development, where we were responsible for all investments and acquisitions. I’ve been thinking about entering the venture business for about 15 years now, so it’s great to finally be doing it. On a personal note, I’m into trail running, skiing and tennis and think that besides the iPhone, the Sonos music system and the Garmin Forerunner 405 are the best consumer products in the last few years!

Josh: As an early stage VC, what are some trends you see in the types of companies that are getting started and getting funded?

Sean: There is certainly a lot of attention paid to consumer-focused startups. Even though it can be exceedingly difficult to predict consumer behavior, companies with breakout viral growth potential are always interesting to investors. With all the focus on consumer Internet startups, I think there is a tremendous opportunity to fund companies catering to the needs of other businesses, both large and small. Particularly where these companies can take advantage of the social nature of today’s web to rapidly build a brand, attract customers and get product and service feedback.

We also love seeing what I’d call “SaaS 2.0″ companies–whereas the first generation of software-as-a-service companies stored and reported on your company information and could tell you what you are doing, with the computing power economically available today coupled with the right algorithms, companies can take and process all that data and tell you what you should be doing.

Josh: What are the characteristics you look for in a startup before deciding to invest?

Sean: At Merus, we’re pretty focused on investing only where the business opportunity seems sufficiently large. The question we always ask ourselves is: “Is this the type of business that can generate $50 or $100 million in revenue at some point or are there structural constraints to this kind of growth?”  We try to “score” an opportunity along many dimensions–barriers to entry, customer impact, competitive intensity in the market, network effects, market size and ease of implementation among other metrics. And of course, we have to have full faith and trust in the team and they in us. A question we ask about the team is: “Do they strike the right balance of having a deep-seated belief in their vision and yet possess the flexibility to listen to customers and users to make informed course corrections?”

Josh: Let’s talk about the online advertising industry. With your background at Microsoft and Google and now as a VC, what trends do you see in this space and what type of M & A activity would you expect over the next couple years?

Sean: Well it’s hard to underestimate the importance of real-time bidding (RTB) in the online display industry. Though I like to call it IBB for impression-based bidding since that’s what we all care about–the ability to tailor advertising and content on a per impression basis.  The recent rise in retargeting is perhaps the first indicator of the power of IBB. There is still much to be done to increase liquidity–boosting inventory on exchanges and more broadly implementing real-time bidding–but the promises we’ve heard for the last few years are finally becoming real.

It will be fun to watch the M&A activity in this space over the next few years. All the ingredients are there to suggest a series of consolidations. Thematically speaking, I think we’ll see a couple things. The first is a flight to technology, by which I mean that networks and other inventory aggregators who don’t possess a highly scalable targeting and optimization platform will look to acquire that capability in order to serve a broader set of display advertisers. The second, which is already underway, is a consolidation of optimization capabilities–media + data + creative + landing page–in order to fully serve an advertiser’s needs and maximize ROI.

Josh: Question for you about data transparency and privacy concerns. Targeting technology is getting really powerful, but there are some privacy concerns out there as well. Do you see any major changes happening in this area?

Sean: Privacy will always be a concern on the web, though what tends to be forgotten is that marketers have long known a lot more about our real, offline lives than our online personas. The best, and perhaps simplest, thing to do is make users aware of how their data is being used. If people know more about what is happening in the background–what preference or historical data is being used, how it can be altered, and how to opt out–and this results in the display of highly relevant ads and content, then I think users will respond favorably. While some publishers and ad networks are starting to provide better transparency, I think an independently-managed “dashboard” to help users manage their personal data across sites and networks could be a very useful tool for cementing user trust and even improve targeting. What’s hard to predict are the actions of an overly aggressive market participant who broadly abuses user trust, sending us down a path of strict regulatory reform. I would hope we could avoid this through improved transparency and user controls.

Josh: Ok, now it’s time for a quick, shameless plug. As an investor in AdRoll, what do you see as the future for our company?

Sean: While Google’s introduction of remarketing has broadened awareness of general retargeting, we’re still in the early stages of what can be accomplished with more advanced retargeting techniques–customizing messages based on shopping, search and other intent-oriented behaviors, social connections, and individual preferences to name a few.

As the lead investor in AdRoll, I’m of course highly biased(!) but I’m really excited to see the company pushing the envelope on retargeting. And doing so in a way that is highly scalable and automated so that the benefits a large customer are also available to the broader base of display advertisers. Couple this with the site-targeted campaigns that AdRoll offers and it’s a very powerful yet simple way for advertisers of all sizes to benefit from display advertising. Companies like AdRoll will open the eyes of search marketers to the power and demonstrable ROI of display and help close the wide gap that exists today between the number of search marketers and those active in display.

Josh: Thanks Sean!