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what constitutes an attractive market?
sizing & validating market opportunities
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paul finke: follow the food chain

Iíll talk a little bit about change to begin with, and maybe hit some of the points the rest of the others talked about.

        Does anybody remember the optical equipment bubble? Well, I joined Yafo Networks right at the peak of that curve, when it was heading in the opposite direction. One of the things Jonathan said that I took to heart when I looked at different opportunities was the growth of the market. When I joined, it was going crazy. I just recently left, but was at Yafo for about 18 months during that roller coaster ride the other way. Itís about how you deal with change, and what you do when you are there.

        Yafo makes a product called a polarization mode dispersion (P&D) compensator. It is a mouthful, but as carriers upgrade their networks from one speed to another, they run up against a phenomenon that does not let them send the light over the fiber optic networks this far from point A to point B. In fact, as you increase the speed, the dispersion gets worse, and, in some cases, you can send the light one-fourth as far. What we did at Yafo is make a P&D compensator that allowed you to send it about four times further than normal as you upgraded the network.

        When I joined the company, the customer was very clear, very focused. We were going to make a subsystem that fit within a Ciena system or a Lucent system, but it was a smaller part of a larger transport product. The company was very focused on original equipment manufacturers (OEM) like Lucent, Ciena, or Nortel. How did we get those customers to buy our product? Well, in dealing with this change, we actually turned the scenario totally upside down and said, ďAll of those companies have laid off at least half their people over the course of the last 18 months. They have been bailing water and theyíre not listening to anybody about new technologies.Ē We went up the food chain. We went to that customerís customer, the carriers, and we said, ďOkay, we want to let you know about this phenomenon that is happening in your network and how to solve it.Ē By educating the carriers, the OEMs came to us and said, ďWe noticed that you are talking to our customers. They thought you had a good idea, and we would like to talk to you about it.Ē

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        We went even further than that. We created an educational program called P&D University. Itís not so easy to just dial up your local carrier, whether itís AT&T or Sprint or Deutsche Telecom, and say, ďIíd like to show up and present my product to you.Ē P&D University was crafted by several of our Ph.D. folks inside Yafo, and it essentially taught them what P&D was. Carriers, at least in this particular environment, always want to learn new things. They want to understand their networks better than they do today, so we taught them about P&D, then we taught them what they could do. They helped us get in touch with their customers, and we got a lot of traction in the market that way.

        In terms of understanding the market and how to size it, typical entrepreneurs, and I include myself in that group, start off with analystsí reports. By definition every forecast is wrong, so you get all the analystsí charts on the wall, and none of them converge. The best way to do it is to talk to customers. You go out and try to get somebody to say, ďIf you made this thing, I would buy it.Ē If you can get the customer to say that, then youíve got your start and you work in that direction.

        Different markets are different, of course. In the market that I have played in recently with Yafo, the carrier space, it takes one customer to make the company. If you go back a couple years and look at Ciena, it was Sprint that made Ciena. In our particular case, if you get one or two giant customers to say, ďAbsolutely, I would buy that product. My fiber plant looks like this, and I think your product would fit this way.Ē If you can sit down with them, understand their network, and where your product can fit, there is no better way to validate a market.

        Iíve been involved with six startups since 1985, and there are five key things that I have looked at in every one to try to figure out whether it made sense for me. Some are obvious as I talk about them, but theyíre not so obvious when you actually sit down and try to do them.

        The first and most important one is understanding the need. Who needs whatever it is youíre trying to do? Then as you figure out the need, how big is it? You have to get your arms around that.

        The second thing is the customer. Who is the customer, and how do you get to them? In the case of Yafo, the customer was an OEM, but we couldnít go to them. We had to go to their customer and educate those folks in order to entice them to get involved with us. Who is your customer and how do you really get there? It is not always as straightforward as you might think.

        The third thing is an overused phrase, but it is most important for any business plan that I look at: the value proposition. Itís tried and true, but itís something I find that in almost 95% of the startups nobody gets right. If itís done right, the value proposition is expressed in terms your customer understands. Forget about you and what youíre doing. If your customer is a carrier, you have to be able to present your value proposition in terms that the customer speaks and understands. The CFO of a carrier customer should say, ďYes, that is what we do here, and that is how we measure ROI. If you hit that ROI and your technology is okay, yes, weíll buy.Ē Itís a value proposition expressed in terms of your customer.

        Fourth, you have to figure out how to make a profit. You figure it out with your spreadsheets and do your prototypes, then the fifth thing is figuring out why it is hard to do what youíre doing. Can three boys and a dog in Sweden programming 24 hours a day duplicate what youíre trying to do?

        If you can get pretty good answers to those five questions, you usually have a fair business case. Itís the need, the customer, the value proposition, how you make money, and why it canít be duplicated.

Mr. Sherman: Great advice. As I was listening, I realized that if we had done this program two years ago, weíd probably have had a lot of discussion about ďfirst mover advantageĒ and ďfirst to marketĒ and how you get there ahead of everybody else. We havenít heard that mentioned once yet. In fact, itís been just the opposite. All of the advice so far, and Iím sure Tim will reinforce it, is about the best of the market and about understanding the market, not about the race to get there first. If  youíre there first, the likelihood of running into a bubble or failing is much higher.

        Tim?

tim meyers: better, cheaper, faster

Jonathan did a great job of describing the big picture. Iíll hit this from a little different perspective.

        At Updata Venture Partners we focus on software that gets sold to the Global 5000. The reason is that we believe about 80% of all technology developed gets sold into that group of companies. By definition, then, we look for companies that are selling to the people who are buying.

        In our opinion, there are two different types of companies. One type is the technology-defined company that has created a great new way of doing somethingóa bunch of engineers in a garage who have created an idea like ObjectVideo. The other is customer-defined, where customers have said, ďI have a great need for Product X. Can you help us create it?Ē You use that kind of white knight customer to help you get into that market. Both of them are legitimate directions. The customer direction is probably a little bit easier because you have a product that has been defined. Over the last couple of years, all of us, especially in the venture capital area, have seen situations where engineers created a product and said, ďThere will be a great need for this. Help us get there.Ē Today, the direction needs to be that you have a customer that has said, ďThis has got a strong ROI. It is going to help us do something better, cheaper, faster, or differently in our new business process.Ē

        Budgets today are very tight, so itís very difficult to get into some of these companies. You have to find somebody who has a tremendous need, like Clara has done at ObjectVideo. There are over 25 million cameras at various government installations with thousands of security guards looking at them, and there is no way they can watch every single video image that is coming across. There is a strong need to improve a process, and those are the kind of markets that need to be attacked.

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        In our opinion, there are two different types of markets. There is the bleeding-edge market that nobody has gone after before. Itís a new space and a new need, and there really arenít any established players, so I will violate your comment about first mover advantage, Andrew. There is a benefit in getting a product out into that market, but itís very, very important not to develop the product naked. Get customers to help you define what it is that they want, then move it forward. Weíve had the benefit of working with a number of those companies. We had one in Austin, Texas, that we just sold 16 months after they transitioned from a consulting firm. They had been in business for nine years as a profitable consulting firm and found a product that all their customers were looking for. It allows a customer to back up a server in 20 minutes or less on any platform, and back it up literally to the bare metal. They could lose a server and restore it in 20 minutes. We were able to push it through IBM and Tivoli and other channels, and the demand took off because of the channels that were built for it. There really hadnít been a product like it before, but it was built by people who had expertise in the field and had been working with their customers for nine years.

        On the other side of the coin, we were the lead investor in ObjectVideoís last round, and Clara has already explained the transition we saw within that company. It had some great technologists who were going after Real Networks and Microsoft. They thought they could use video compression for enterprise video conferencing on every desktop. It was a great concept, but, at the end of the day, nobody was really interested. A great concept that didnít have a high need. People are comfortable talking on cell and office phones, so, last spring, we decided it was time to transition the company. The founders had come out of the security field and werenít overly comfortable going back at the government with a security feature. By talking to 30 or 40 different customers, however, we found that there was a strong need for a product that could help their security departments do what they do better. We quickly transitioned the product and got the company to a point that when 9/11 occurred, we already had a solution that the market was demanding.

        Established markets are a little bit different. They are spaces where you can go through normal channels. There are a number of technology analysts which, unfortunately tend to put pie in the sky. They really donít have the benefit of being able to figure out where your product fits within that market. It takes going back to the grass roots and talking to people, asking, ďWhat is the market really looking for?Ē How easy is it going to be to displace Microsoft or IBM or another service provider in the market? Creating a product that can really go at an established market is very difficult, but, if your customers can define what the elements are that they require, it makes it a lot easier. Weíre looking at a product today that is going right after Microsoft, but itís in a space where most of the technology that people have is 15 years old. Theyíre going to do it better, faster, cheaper. That is a market space where we say, ďOkay, if you can do all those things and provide a solution to a customer that is a lot cheaper and better than the established players, itís worth the risk.Ē The market is $80 billion, so, if we capture .1% and we can do it in other countries, it may be worth the risk. Itís not always about avoiding the behemoths. You just have to make sure that what you have really does do it better, faster, cheaper.

        The technology analysts do define who the competitors are in a space, and the financial analysts are another breed. In the last two or three years, a lot of people have defined their companies based on what Merrill Lynch or Goldman Sachs or Morgan Stanley said about particular markets. People were saying that revenues really didnít matter, that a market was growing. Revenues do matter. Iím a big believer that chasing what the analysts are saying in a particular space is probably not the right direction to go. Define your markets by the people buying your products, not the ones who can take you public. A lot of the companies we talk to today tell us about their exit strategy. Well, what is your entry strategy? How do you get revenue? Today, there arenít any exit strategies, so how long can you survive? How many customers do you have? Our belief is that the first five customers are probably the hardest to get. If you can get from 5 to 20, itís a little bit easier. Each time youíre going to find that your company is changing significantly.

        We also agree with Jonathan that you canít take every single customer. A lot of customers will take you off your mission and direction. You might know that youíre one of the best players in a specific vertical. Donít go to a different vertical if you donít have the resources to be able to spread in that direction. Have it in your vision and be able to tell the world that youíre going to be the greatest at X, and that your next vertical is going to be Y, but focus on X and stay within that vertical as you continue to grow. As you get those 20 customers, then you can start thinking about the next sub-vertical youíre going after. When you get to 100 customers, itís a heck of a lot easier. Now you probably have a company that can start talking to the analysts about who you are, your competitors, and what might be an exit.

the audience: q&a

Mr. Sherman: Iíd like to summarize my four favorite comments from the presenters, then weíll go to Q&A.

        From Jonathan, hands down, it was ďnew versus betterĒ and the importance of incrementalism in sizing and validating your market share. Claraís story about competitors who are bigger than you with better products that theyíre offering for free, now that is a classic. Paulís five key elements I thought were excellent and very well presented. Tim had many good lines, but my favorite was a good piece of practical advice: Do not develop your products naked. Particularly those of you working with hazardous materials.

        We have a couple questions that were emailed in advance. Iíll introduce those as we go along, but letís start with the audience.

Q: Iím Gary Heurich, President of Old Heurich Brewing. We make Foggy Bottom Beer. How do we, as a craft brewer, project the practical maximum size of a given new market so that we can determine how much to spend for marketing and investment?

Mr. Silver: Iíll take a stab at it. In an earlier life I was an early investor in Brooklyn Beer and they faced a number of the same questions. For starters, you are going to begin by talking about demographics, which Iím sure you already know in great detail, including the profile of your current customer. Then you are going to extrapolate that into the new markets you want to enter. Try to identify the drinking and beverage purchase patterns demographically. Look at a geographic overlay of that. You are going to have to address the pricing questions, because pricing issues may or may not vary by demographic, geographic, or socioeconomic characteristics. In fact, there is almost a cookbook methodology to this, though I donít mean to downplay it. Andrew mentioned that Michael Porter wrote a book called Competitive Strategy, which I strongly encourage those of you in more traditional industries to read. It does a remarkably good job of listing in enormous detail the sets of characteristics in each of the five general areas that Paul referred to and some others that make sense.

        Youíre then going to roll out, I assume, on a test basis and go from there. Itís much better to test and revisit your assumptions than to just roll out. Having gone through this template analysis that Iíve just described, my one piece of advice would be to test the assumptions youíve built into that analysis in a piece of the new market youíre going into.

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Q: Whatís the relative investment interest in a ďbetter, faster, cheaperĒ opportunity versus one with an intellectual property component?

Mr. Meyers: The intellectual property is nice to have, and itís a must have if there are other people who have similar products with similar intellectual property protection. If you have a better, faster, cheaper product, we want to know that youíll have the ability to continue to sell it and that somebody canít come into the market and squish you because they have a patent or some other intellectual property protection. To the extent that you have the ability to protect your market, the intellectual property is nice to have, but not a must have. Thatís because even if you have a good product, and you just sit there, somebody will come along in a year or two with a better, faster, cheaper product. Youíve got to continue to upgrade and stay ahead of the market, and not just because you have a patent, but to be able to have a protected market. A patent doesnít give us a lot. What gives us a whole lot is the fact that you have customers who like your product and will buy it.

Mr. Sherman: One of my pet peeves is when I see an entrepreneur with a limited budget spending a lot of money protecting intellectual property without first figuring out what markets, products, or services could be developed around that intellectual property. If you head too far down that path, you end up with big legal bills and no products or markets.

Mr. Finke: I have been in that scenario where entrepreneurs get focused on patents. Everybody has to realize that it takes two years to get a patent issued. By the time your patent is issued, youíd better be a couple of technologies ahead in terms of what youíre selling to a customer. Patents arenít the be-all and end-all. They help, and, certainly, folks will invest in companies with patents, but your product has to be in the lead in what youíre doing.

Q: My name is Larry Ross, President of Ross Financial Services. We conduct acquisition and investigative intelligence for investors. So often we see these letters of reference where a potential buyer is endorsing a product. You have to make sure that these letters are worth more than the paper on which theyíre printed. Often we go in and ask the person who wrote the letter, ďDo you have a line item in your budget to acquire these widgets?Ē They say, ďWell, Paul was an awfully nice guy, and he took me to Mortonís. We had cigars and the investors paid for all of it, so I wrote him this letter. I am getting a promotion and moving to Los Angeles, and I donít think anybody is really interested in this product.Ē You have to make sure that your letter is going to stand up.

Mr. Finke: That is a good point. I donít know that letters are the best way to do your research. You have to talk to the people, and itís different in different markets. In the market that I just came from, the telecom carrier space, sometimes you have to talk to more than one person inside a particular carrier. They usually have an advanced technology team that looks four years out ahead of what is deployed in the network. You canít talk just to them because they are four years ahead. You have to talk to the people who are doing the deployments and find out what their need is. Nothing replaces the phone call.

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Mr. Meyers: A reference client doesnít necessarily mean somebody who wrote a letter. A reference client, especially in software, is somebody using the product with line people who can talk about it. There is a strong ROI that has already been built up in that particular company. Most people arenít going to buy $100,000 software without seeing the product in use in particular situations.

Mr. Silver: You want to do at least as much research the investors do, and we are talking to 20, 30, 40, 50 potential customers about your product. You ought to be doing at least the same.

Q: Jonathan, you mentioned interest in markets that are big and growing. Could you identify what some of those markets are and what types of services they might need?

Mr. Silver: Can I identify big successful markets and how you can make a million bucks in them? Well, turnarounds are a big market . . .

        That is a question that I canít answer for obvious reasons, but I can suggest some of the areas we are increasingly interested in. Clara and her team are working in the security space, which goes without saying was a large space before 9/11 and remains very substantial with the governmentís commitment of capital for the next couple of years. There is a lot of work being done in emerging markets now, although you have to understand that there is near-term emerging and long-term emerging. Investors like Updata and Core focus on near-term emerging, so, for example, you will hear a lot of talk about nanotechnology.  I think itís going to be an enormous business initiative and fundamentally change certain industries, but the question is, are those real companies in a two, three, or four-year time frame. Will a market have developed for them in that period of time? I donít know. I suppose somewhat shorter term are bioinformatics and genomics, particularly the data mining aspects look very attractive. Perhaps nearer term than nanotechnology would be something called MEMS technologies, which I wonít bore you with here. I think that despite the bubble, there still are significant opportunities going forward in the optical electronics space, particularly in quantum photonics.

        At the same time I want to make sure we donít lose sight of the fact that you can grow a huge business brewing craft beer. There are a lots of opportunities in very traditional, mainstream products and services. The answer to the question is that anything is an opportunity if youíve got a better product at a cheaper price.

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