Milestone Matters Newsletter
Fall 2006

“The traditional venture model seems to us to be broken.” Steve Dow, General Partner of VC firm, Sevin Rosen, The New York Times, October 7, 2006.
 

Dear Friends, Investors and Associates:

I was startled the other day upon reading the New York Times article which included Mr. Dow’s remarks noted above. The headline read, “A Kink in Venture Capital’s Gold Chain.” The story described the decision of the prominent venture firm, Sevin Rosen, to abort its tenth venture fund and to cancel $300 million in commitments from putative investors. This unnatural act was unprecedented. Periodically, venture managers have moaned and groaned about the daunting challenges of the business, and have limited the size of funds but they have never been so despondent as to reject the proffered money in toto. Among other things, this development casts doubt on the often heard institutional investor assertion that the only way to make money in the venture sector is to invest in the old brand name funds.

By way of explaining the firm’s momentous decision to return capital and cancel the prospective fund, Mr. Steve Dow, a general partner of the venerable firm, which can point to Compaq, Lotus and Cypress Semiconductor among its many successful investments, opined that too much money was chasing too few opportunities.

This shibboleth drives me to distraction because it is neither provable or refutable and therefore intellectually mischievous. No one has ever been able to model what the right number of available opportunities and the optimal amount of capital would be within the context of the incredibly rich and complex U.S. economy. Furthermore, it is totally inconsistent with our experience at Milestone and clearly doesn’t apply to some distinguished firms such as Sequoia which has provided financing for, among others, Google and YouTube.

The fact is that monolithic characterizations of the venture business are not illuminating because the VC community has become much more variegated than twenty years ago when generalities were more applicable. Today there are multiple strategies focused on companies at various stages of development in many different business segments and sometimes focused on specific geographical catchments. In addition, some firms apply financial engineering while some utilize pure equity. Some take control positions while others hold minority stakes and operate in a more detached fashion. Some are huge and some small and therefore make, respectively, very large and very small bets.

At one point, Mr. Dow dismisses the huge success of YouTube as essentially an outlier. This is specious because a number of firms that utilize early stage, high risk, high reward strategies recognize that their approach remains one where one or two huge winners have a disproportionate impact on portfolio performance. It is the ability of certain fund managers to more frequently uncover and finance these opportunities that separates them from the pack.

Mr. Dow also notes that the IPO market has been sluggish of late thereby hindering a popular route to liquidity for successful venture-backed portfolio companies. This is certainly true but the merger and acquisition market - the other principal route to realized profits - has been very active. In addition, hedge funds and large private equity investors have emerged as buyers of maturing venture-backed companies.

Of greater importance, and more disturbing, is the report that Sevin Rosen’s pessimism is based primarily on their negative view of where the IPO market will be “in five or more years.” I doubt that any financial seer, let alone Sevin Rosen, has the ability to predict what initial public offering conditions will be in five years.

It is certainly true that the perfect model for VCs is to have a robust IPO market available five to six years subsequent to the launching of one’s fund and arguably this is likely to be a major variable influencing a fund’s performance. However, we also believe that without exception, all economic environments present opportunities for the venture investor but strategies must be tailored to meet the times. For example, at Milestone, we are not unmindful of the current sluggish IPO climate. Accordingly, we stress low entry-level pricing and modest investment amounts targeted at rapidly growing capital efficient companies. This should allow us to achieve attractive returns within an M & A market which values companies predominantly in the range of $50 to $100 million. Should the IPO market prove hospitable to more issues and higher pricing over time, this will only enhance prospects for profitable exits.

During my thirty-two years in the business, the only constant in the investing climate has been change. At Milestone, we believe in settling on a strategy which focuses on known variables and then working hard on execution. In the last analysis, identifying, financing and nurturing quality companies will generate attractive returns. There is nothing fundamentally wrong with this VC model.

We look forward to having turkey at the coming holidays and having had a good year, to avoid eating crow.

With best wishes for the holiday season,

Edwin A. Goodman
General Partner
 

In September 2006, MVP III invested $750,000 in New York City-based M5 Networks. The financing represents the first investment of Milestone’s newest fund (MVP III) which had its first closing in April 2006. M5 Networks provides VOIP (Voice Over Internet Protocol) telephone service to small to medium size enterprises, primarily 10 to 100 employees). By outsourcing to M5 instead of buying a traditional phone system and securing local, long distance and Internet service separately, businesses save time and money. M5 customers substantially reduce their initial capital investment, forgo internal system maintenance responsibilities and are able to take advantage of the powerful functionalities offered by VOIP.

Milestone invested alongside Edison Venture Partners and Greycroft Partners in this $7.7 million financing round. Edwin Goodman will serve as board observer.

MVP III invested in SmartAnalyst in mid-September, marking the new Fund’s second investment. MVP III invested $800,000 in the New York City-based company. SmartAnalyst provides outsourced custom research products and services, primarily to the life sciences, financial services and consumer/marketing industries. The Company is a leader in the emerging segment of the outsourcing market known as Knowledge Process Outsourcing (“KPO”).

Milestone co-led this $3.75 million financing round with Edison Venture Fund. Todd Pietri has assumed a seat on SmartAnalyst’s board of directors.

By Todd Pietri

In October, I was fortunate to make my first trip to India to meet employees of our New York-headquartered portfolio company, SmartAnalyst.  SmartAnalyst has operations just outside Delhi with approximately 100 India-based employees. The Company provides outsourced custom research products and services, primarily to the life sciences, financial services and consumer/marketing industries.  During the trip, I was exposed to the impressive intelligence, skill, and entrepreneurial spirit of our employees in India, which reinforced my conviction that SmartAnalyst is well-positioned to become a large and valuable next generation information services business.

Companies like SmartAnalyst are fueling India’s leadership of the outsourced services revolution, which was made possible by the dramatic economic reforms India enacted in 1991.  The results speak for themselves.  GDP rose 7.5% per annum between 2002 and 2006, and 6% between 1980 and 2002.  In terms of overall economic output (purchasing power parity– PPP basis), India’s economy will soon surpass Japan’s.  If India grows at even the post 1980 rate, it will be as rich as the U.S. in 60 years in terms of GDP per capita (PPP basis).  Finally, analysts predict India’s population will exceed China’s in 25 years, and will have a much younger average age.

Indian companies are becoming major players in their own right. There are over 100 Indian companies with a market capitalization in excess of $1 billion.  Additionally, 125 companies in the Fortune 500 have already established R&D bases in India.

Visiting and doing business in a thriving developing country offered me the opportunity to determine if the tenor of my experience “on the ground” matched the academic facts.  Without question I found the energy, excitement, and activity of the Indian business environment congruent with the bullish sentiments I regularly see in the U.S. media.  Unexpectedly, I witnessed a great deal of warmth and friendliness for Americans.  This is consistent with a recent Pew Global Attitudes survey in which 71% of respondents had a positive view of the U.S., which was up from 54% in 2002.

However, as a first time visitor, the risks and challenges inherent in the India growth story were magnified for me to an even greater extent.  While in general there were very few topics where I could ascertain a consensus view, there was one area where there was a universally held opinion: the government is not getting the job done.

No matter to whom I talked or where I went, the story was the same; entrepreneurs and businesses are succeeding in spite of the Indian government. Unlike China, where the state is creating the infrastructure to meet demand, Indian infrastructure is developing slowly. Complicated regulations, atavistic laws, and a bureaucracy prone to procrastination, are holding back new airports, decent roads (traffic was awful), reliable electricity (lights flickered constantly), potable water, decent healthcare, and adequate education.

So what does the government’s shortcomings mean for India’s future? This is where I had a hard time gaining a consensus view.  For example, Indian property prices are increasing at an alarming rate. In Gurgaon, where SmartAnalyst is located, rents have increased 100% in the last six months!  Some people think property prices will continue to rise because the government isn’t laying infrastructure fast enough to permit new, large scale developments.  Others think there is a real estate bubble which will burst soon enough.

India’s services-driven economy also needs a growing pool of educated workers.  Unfortunately, the government gets poor marks again.  India’s literacy rate is perhaps 60% (China’s is north of 80%).  Duke University published an interesting study on the annual number of engineers graduating in the U.S., India and China. It found that after normalizing the data, China was producing 350,000, while the U.S. was out-producing India (137,000 to 112,000).  The elite Indian Institute of Technology is only producing 3,500 graduates per year.  NASSCOM, the Indian software trade organization, projects India will be short 500,000 technology workers by 2010.

Given the tremendous demand for employable English-speaking professionals, salaries are rising well in excess of 10% per year.  For entry-level BPO workers, it is not uncommon for  attrition to run 30% to 60% per year.  Mid-level managers are also in very short supply.  Due to these labor challenges, the best run software and services companies like Infosys are, by default, entering the education and training business on a large scale.  The results of these efforts are nascent, but many people I spoke with were confident that India will produce, one way or another, enough workers to meet demand.

Despite these big challenges and contradictory viewpoints, I shouldn’t obscure the obvious: most businesses I encountered are growing rapidly and making lots of money.  Although there will no doubt be painful corrections from time to time, I think India will continue to create remarkable wealth and project increasing power around the globe for many decades to come.
 

About Milestone Venture Partners

Milestone is an early stage venture capital fund with $42 million under management. We focus on technology-enhanced service businesses in the New York metropolitan area. Companies that we find attractive possess the nucleus of an exceptional management team, an attractive business model, and a compelling market opportunity.

Milestone Venture Partners
551 Madison Avenue, 7th Floor
New York, NY 10022 
V: [212] 223 7400
F: [212] 223 0315
www.milestonevp.com

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