Why Every Startup Should Create Its Own New Category

Category leaders capture the majority of the available profit pool, and investors seek to find future category leaders. Peter Thiel’s ‘Zero to One’ book is about how to build companies that create new things and eventually become a monopoly. Investors also look for new categories because it is virtually impossible for a startup to unseat a current category leader.

But how to create a new category?

Founders should look for a net new problem and they should devise a net new solution. The only way to find this new problem is by talking to customers.

Category creation requires developing a concept and planting a story in people's brains. Customers may not understand that they have a problem and therefore may not have a budget. A new point of view replaces the current customer point of view. And customers may be puzzled because they haven't thought about it. In fact, there may not be any easily identifiable customers and the ultimate act of category creation results in a new role in a company. Box's Aaron Levy said 'you need to find a demographic and a customer that no other software company is paying attention to in a modern way, and your job is to make them be heroes.'  

The solution has to be not only better, but different and unique. Being different comes from proprietary insight and can be based on technology differentiation, network effects, or a structural competitive advantage. Peter Thiel asks founders one key question: ‘What important truth do very few people agree with you on?’

The existence of a band aided solution at the customer is a good sign that there is a category waiting to be productized. And a sufficiently large number of these cases is evidence that now is the perfect time for the category to be created.

Talking to existing channels is unlikely to generate new insights since they serve current solutions and address known problems and customers.Advisory firms such as Gartner and others will only validate new software categories when a category has become large enough for their own customers and competitors are emerging.

Qualtrics realized that their customers started to tweak the software and use it as a customer experience and employee experience solution; the original market research use case dropped to the third rank. CMO Kylan Lundeen said 'We realized we were not in the survey business, we were in the business of helping people manage the experience they provide to their most important stakeholders.' Qualtrics was acquired for $8 billion by SAP in 2018.

The best categories have no or few competitors. There is little noise and there are no preexisting notions and once a new category has been identified the work only starts. The new category needs to be positioned and an ecosystem around it has to be created. The message needs to be authentic at scale for the users and customers to evangelize it. Leadership of this movement has to extend beyond the company and include the competition.

Peter Thiel has said ‘... the single most powerful pattern I have noticed is that successful people find value in unexpected places, and they do this by thinking about business from first principles instead of formulas’.

2018 in Review - Category Kings Rule

A new year’s beginning is the customary yet arbitrary time to review last year’s market movements and portfolio developments. The main theme for decacorns, unicorns, and my own portfolio companies was category leadership; .

The undiminished power of that leadership in SaaS was again on display when Qualtrics decided to sell itself for $8 billion to SAP. Shopify, Veeva and Twilio are examples of these category leaders that have already reached or surpassed $10+ billion valuations and continue to go strong.

Picture credit: Forbes

Public markets and private tech startups

The longest bull market in history may be coming to an end. The DJII started at 25,461.70 and finished the year 5.8% lower at 23327.46 points; the Nasdaq Composite lost 4.6%. Cloud software stocks were still doing well though and massively outperformed the overall stock market where the Bessemer Nasdaq Emerging Cloud index rose by 37% from 621 to 851.

It pays to be a thunder lizard and create a new category. The plethora of tech IPOs continued and was led by some notable SaaS leaders such as Anaplan, Elastic, Docusign, Eventbrite, Pivotal, Zuora, and Dropbox. Even Domo made it out in time, although they raised a ton of red flags when they announced that they would have to IPO or go through a major restructuring.

SurveyMonkey debuted on September 26 and is trading at a market cap of $1.4 billion at the time of writing. Their IPO was soon  overshadowed by SAP’s announced $8 billion acquisition of Qualtrics on November 11. Also worthwhile mentioning is Plangrid’s $875 million sale to Autodesk. Plangrid was first introduced to the public at the Y Combinator day in March 2012 and raised a Series A not until 2015. I saw the team at the demo day and liked them, but did not pursue an investment in this vertical SaaS startup that set out to revolutionize workflows on construction sites.

Relayr was the only notable SaaS exit in Germany. Getting to a $300 million exit in five years is great by any measure, and growing into a full fledged unicorn in the IIoT space would have required a lot more capital to expand more aggressively and internationally.

Venture capital continued to flow freely according to PwC’s Q3 Moneytree report.  Late stage unicorn funding rounds drove up dollars invested in the U.S., but deal activity declined for the first time since Q4’17. In addition, seed-stage deals continued to decline, and early stage deals only increased very slightly and for the first time since Q4’17. The U.S. median seed stage deals cost $1.5m, down from the previous quarters but still very high based on historical figures. Historically, all these are signs that the funding market is a the end of the cycle.

Total investments in startups in Germany increased by 7% to reach 4.6 billion Euros, and the number of financing rounds increased by 21% to reach 615. European startups raised a median $1.2 million in Q3 for seed stage deals, less than in the U.S., but the money lasts a lot longer when taking into account the lower salaries compared to Silicon Valley.

The year started with Initial Coin Offerings (ICO) being all the rage, but the SEC quickly cooled buyer interest in the U.S. and subpoenaed 80 cryptocurrency firms in April. Global activity seemed to come to a complete halt shortly thereafter, tet Andreessen, USV and others invested $12 million in the inventors of the Cryptokiddies in March. Steem.it announced it had to lay off 70% of its employees in late November, and one of the more interesting experiments clearly is in deep trouble.

My portfolio

2018 began with 17 active investments and the value of the portfolio rose significantly due to the follow-on rounds in Wandelbots and in Kreatize.

There were 13 transactions in total: Two exits, two warrant deals, three bridges, three follow-on equity financings, and three new deals.

• Exits: Practice Fusion sold to Allscripts for $100 million in cash and Savvy was sold to Global English
  
• Follow-on financings: Truevault raised a venture venture round in August. Wandelbots continued to receive strong customer interest and raised €6 million from Paua Ventures and EQT in December. Kreatize changed their business model to provide a turnkey service for the sourcing of custom made parts and have been on a tear since January 2018. I participated in a bridge round in May, and in December they raised €5.5 million from Earlybird VC.

New investments

Some of my 2017 resolutions were continue to look for differentiated opportunities in enterprise SW in Europe - and in Germany in particular- , bet on contrarian outliers in Silicon Valley, and dive deeper into Blockchain and tokens. I did end up investing in two Germany based companies and in one enterprise SaaS company located in San Francisco.

• The AIPark team led by Julian and Johannes provides predictive parking information just based on data and without owning sensors.  Traditional parking is evolving as cities, drivers, and other stakeholders will need to rethink the curb as ride sharing services proliferate and self driving cars appear on the horizon. I helped the team sharpen their pitch and made introductions to VCs. As in most of my investments, I was the first money in, together with Atlantic Labs, Jens Lapinski and other angel investors. 
• I first talked Jan-Philipp from Hashplay in late 2017.They are building an AI powered business intelligence platform to translate operational data into digital twins and are garnering great interest from multiple verticals in a space which Gartner terms immersive analytics. The team is based in Hamburg and in San Francisco, with development resources in East Asia. 
• I got to know Oomnitza’s CEO Arthur when he raised an initial seed round in 2014. Oomnitza builds a connected, automated, and visualized Thing Management that tracks everything that makes a business run.  I was more than happy to join the bridge round in December.

I also deeply looked into two startups that planned to use tokens as an incentive mechanism for their respective market places. But the ICO market collapsed, and the collateral damage is that most token markets will likely remain frozen for a while. My other activities were concentrated on coaching and mentoring and helping fundraise some of my existing investments, and growing the deal pipeline of B2B SaaS startups  in Germany.

Observations and pontifications

The tech sector is continuing to go through seminal changes at every level of the tech stack and in every aspect of the business model.

• The Iaas market is growing in excess of 35% CAGR. Enterprises are finally moving their production environments to the cloud and to the multiple cloud providers. AWS and Azure are in the lead, with Google Cloud investing heavily to differentiate via AI and AliCloud staking their claim in China. These hyperscalers will to continue to move up the stack via acquisitions to better serve the needs of large enterprise customers and achieve customer lock-in.  
• Kubernetes fundamentally changes how complex SW is being developed. Again Google has disrupted the market with open sourcing their SW, and as a result, startups in the ecosystem are in the crosshairs of these hyperscalers. Heptio and CoreOs have already been acquired, and Docker and Mesosphere are going through massive changes to reposition themselves in this environment. 
• AI has matured from algorithms to the life cycle management of training models. But data and models are customer specific, and scaling these solutions creates challenges far more complex than for bread-and-butter SaaS solutions. In turn, this will lead to more activities in automating data labeling, model scaling and other areas which are not addressed by Tensorflow and other AI libraries.
• Tokens hold great promise in removing friction in marketplaces, and provide incentives for buyers and sellers. The market for security tokens crashed completely in 2018 and all tokens seem to be in the phase that Gartner calls the ‘trough of disillusionment’.
• IIoT customers understand the value delivered by SaaS ‘products’, but they are still expecting a full solution. On top of that, larger buyers in that segment are not yet used to paying recurring revenues. Industrial IoT (IIoT) startups need to be super disciplined about the engagement cycle from first contact to demo/proof of concept and then to pilot and to recurring revenue. Relimetrics and Amper have templated this approach and are preparing to reach escape velocity.

2019 outlook

Dark clouds? R.I.P. Good times? It pays to be prepared, although the VC guns are still loaded and there is plenty of money to go around.

The probability of a downturn becomes more imminent the longer the bull market continues. GM’s announcement of a significant streamlining of their operations notably implied an expected economic slowdown in 2019.

The time to get back into investing in Silicon Valley startups will be when seed stage and bridge valuations become more reasonable. In the meantime, lower valuations and great technical talent can be found in continental Europe. Celonis and Signavio are already category leaders in their respective segments, and Kreatize, Relimetrics and Wandelbots in my own portfolio hold great promise.

The importance of the Relayr exit for IIoT startups, and for startups in Germany

The Industrial IoT (IIoT) startup Relayr recently sold for a reported $300 million. While it is not a unicorn type exit with a billion Euro valuation, it is a very significant exit for a startup in the IIoT space and for a startup based in Germany.

The importance for IIoT

Germany is a great place for an IIoT startup to engage with industrial customers: There are about 2000 so called Hidden Champions in Germany, and most are located in the south of the country. These ‘hidden champions’ are global players, and startups serving these customers should expect to scale globally very quickly.

Relayr has had to develop four basic approaches in order to scale:

1. Make sure that there is a business outcome and the vertical market understands the value proposition

Relayr’s core products is a horizontal solution, a middleware in the cloud which acts a data broker. They started with a horizontal go-to-market approach, but that value proposition turned out to be too complex to communicate, and the customers did not have the  know-how to connect Operational Technology (OT) and IT.

Relayr then focused on use cases in a four specific verticals - manufacturing, energy, transportation, and retail - and developed prepackaged products for each use case and vertical.

The business outcomes of the use cases were either opex minimization or creating new revenue streams. Predictive maintenance is such a business outcome that results in opex minimization.

2. Know your buying center

Selling IIoT requires executive sponsorship, in particular when wanting to change business outcomes. CIOs typically cannot change these outcomes, and Relayr ends up selling to the CEO as the buying center. At the CEO level, they try to position themselves as one of the key providers vis-a-vis competitors such as Cisco and GE.

3. Make sure that your product connects well with the surrounding ecosystem

Industrial environments require high quality systems and the ability to exchange data with others. In addition, most environments are hybrid on premise and cloud deployments, and the product architecture needs to be designed with that in mind.

Relayr offers six prepackaged products with OEM partners based on the Relayr routing gateways. The gateway has an open ecosystem with other vendors for hardware, software, security and connectivity.

4. Have a structured GTM approach with clearly defined deliverables

Relayr receives many leads from partners, but the customer requests tend to be very unspecific. In response, they have built structured and templated roll-out process for their GTM and devised the following ‘5-4-3’ schema:

• Firstly, a five day discovery session to identify the low hanging fruit impact use cases. This compresses the consulting sales cycle from months to one week.
  
  
  
• Secondly, a four week prototyping phase
  
  
  
• Thirdly, a three month roll-out plan. Some of these roll outs were global from day one and required zero touch deployments.

The Relayr business model is to drive services revenues for enablement until SaaS revenues kicks in. The services revenues are a means to an end and cost neutral. The SaaS pricing started by charging per device per year for small projects, but Relayr quickly realized that this pricing metric was unrelated to a business outcome. Their goal is to grow strategically with a customer, and hence churn tends to be low.

The SaaS sales cycle depends on the complexity of the sale. For a single machine the cycle is six months; for others that are more complex up to one year but in both cases, the key is to provide the customer with a clearly defined environment. In addition, they are offering insurance of a business outcome as a unique selling point, e.g. a performance outcome from energy management. Guaranteeing this business outcome helps accelerate the sales cycle.

A complex environment requires sales discipline. Junior sales people did not work out for Relayr. Instead, Relayr went through engagements with consulting companies such as McKinsey , EY, and Accenture to establish credibility. In addition, the open platform for developers provided a sandbox environment which resulted in 50% of projects being industry initiated.

The importance of the exit

Getting to a $300 million valuation in five years is a great outcome by any startup measure. Given where the company revenue generation after five years and given the complexity of the IIoT space, growing into a fully fledged unicorn valuation would have likely been difficult. It would have required taking on more capital - likely from large international investors -, and expanding more aggressively internationally.

Relayr raised $66.8 million in six rounds from the likes of KPCB,  Munich Re, Deutsche Telekom and others. CEO Josef Brunner has stated that they were intentionally looking for US investor early on to push their thinking and for the brand when approaching customers and indeed, KPCB is one of few US VCs who have invested in a European startup early on.

Founders and early stage investors likely had a nice exit, but it was not a fund returning exit for KPCB, and it is unlikely that Deutsche Telekom made a lot of money after their last investment just a few months prior to the sale.

The buyer Munich Re/HBS is an insurance company that is using IIoT to offer risk services. A sign for more IIoT acquisitions to come from competing insurance providers?

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Further reading (in German):

https://www.deutsche-startups.de/2017/02/08/will-relayr-die-boomende-iot-welt-aufmischen/

https://www.gruenderszene.de/allgemein/telekom-investition-relayr-iot-30-mio

https://www.digitalkompakt.de/uebersicht/josef-brunner-relayr-fehler/

https://t3n.de/news/relayr-josef-brunner-859448/3/

Why Software Startups Should Sell Their Product But Not Their Company to German Mittelstand Companies

Or

There Are Buyers of Products, And There Are Buyers of Companies And They Are Different.

A recent article detailed two well-known Berlin startups which had just been acquired by Mittelstand companies.

This begs the question why there aren’t more of these types of exits. Can the German Mittelstand companies be startup acquirers at a larger scale?

The majority of startups are building Software as a Service (SaaS) companies with high gross margins. In a SaaS world where growth is directly correlated with enterprise value a founder’s is to grow as quickly as possible to build an important and material software company and to maximize the company value. The highest valued SaaS companies have annual growth rates in excess of 75 per cent.

As a reminder, Mittelstand companies are "highly focused medium sized companies, achieving unprecedented efficiencies by designing a business model with a razor-thin focus and learning to do the one thing really well. They are typically privately, family owned". Many of them are in the automotive and mechanical engineering sectors and are focused on hardware and systems integration. Medium size Mittelstand companies have revenues on the order of a hundred million Euros with relatively narrow margins. They tend to grow with the GDP of their major export markets. In the past years of low interest rates they have been significantly credit financed.

Will these companies be able to pay the expected acquisition prices? Does their balance sheet provide enough room to pay cash? Do they understand the mechanics of a software business? Does their ownership structure allow them to agree on a deal ? Are they willing to take significant risk?

The answer to these questions is obvious and seems like bad news: The majority of Mittelstand companies are unlikely to be potential acquirers.

The good news is that the Mittelstand companies can be great customers and fantastic early adopters: They have fewer hierarchy levels and can make decisions quickly. They want to co- develop the Minimum Viable Product to get results. They tend to be very international and they will want to deploy products globally right from the start. In contrast, big industrials and automotive OEMs are much slower moving, and their many hierarchies and lack of true urgency will likely kill a startup. Many of their innovation outposts and labs are clueless and powerless.

For successful exits, SaaS startups need to understand the software ecosystem. The same companies that are competitors can be potential buyers. In the manufacturing and Industrial Internet of Things (IIoT) spaces, CAD and PLM companies like Dassault, Autodesk, Siemens, PTC, SAP, Oracle, Infor, and Ansys are some of the key  players. These companies make acquisitions routinely using their cash and stock, and their investors understand the need for growth.

The German Mittelstand companies can be great customers, but they are an unlikely buyer of startups. In fact, they are not really an exit option unless a startup is willing to sell very early or has essentially failed.

Angel Investing in 2017 - Looking For Value in New Places

I did not make any predictions for 2017, following Winston Churchill’s quip about the politician ‘who needs the ability to foretell what is going to happen tomorrow, next week, next month, and next year. And to have the ability afterwards to explain why it didn't happen.’ Here is what was noteworthy in my eyes.

Picture credit: Nasdaq

Public markets and private tech startups

Who could have imagined that the value of the DJII would increase a whopping 25% and go from 19762.60 to 24719.22, and that the Bessemer Venture Partner Cloud index would increase by 49.9% in the same period?

There were only 14 Tech IPOs, and the majority were in the consumer/retail space. The Stitch Fix IPO was noteworthy for delivering massive returns to investors. Meal kit providers Blue Apron and Hello Fresh both managed to go public but then followed two very separate trajectories, illustrating the importance of understanding the unit economics and LTV, but also the difference between the investors in their respective markets.

In the venture capital space, 109 mega rounds of $100+ million were evidence of the massive amounts of capital wanting to be invested. 22 new unicorns were minted while this was more than in 2016, it was only about half of 2014 and 2015 numbers.The pipeline of unicorns was still growing, yet many of the unicorn valuations took significant hits. The most prominent and public example was Softbank’s investment in Uber.

Seed investing activity in the U.S. declined to reach a two year low, and yet a median seed stage deal size of $2.0 million remained astonishingly high. International investments were strong: In Germany alone, €4.3 billion were invested in 507 deals with Berlin leading the way by a wide margin. The number of deals and the investment volume in Germany could be best compared to New England, but was significantly smaller than in San Francisco, Silicon Valley, or New York.  

It would have been easy to speculate about how technology trends like Blockchain, the Internet of Things and Artificial Intelligence will to disrupt everything. And yet, as Peter Thiel reminded us a few years ago, the biggest secrets are about people and not about nature. Susan Fowler’s courageous reflections in February about her very, very strange year at Uber surfaced biases of the worst kind. And subsequent revelations forced us to examine our daily interactions and whether we treat others like we wanted to be treated ourselves, with dignity and respect. A few years back I had penned a somewhat admiring post about Harvey Weinstein, and in hindsight it became clear his professional and personal behavior were inseparably intertwined.

At the same time, I met Tammy and Grace from BetterBrave, and they deserve a big shoutout for tackling a topic that defies easy answers and yet is so crucial for society.

My existing portfolio

I entered 2017 with thirteen active angel investments. Compared to 2016, the value of my portfolio stayed flat: Four companies raised additional funding, and I participated in two of these. There was one significant markup, one down round to half the value, and one recap that effectively wiped out the existing investors. There were no exits and no final death notices.

Special shout out to 3ten8.ai for getting the first large telco PoC, and to 3DprinterOS on closing the first OEM deal with Dremel.

New investments

It turned out to be the year of investing in Industrial IoT (IIoT) and in German startups; the result of 18 months of research in and search for enterprise software startups in Germany. Much of it was self sourced by attending pitch events all over the country, founder networking and mentoring, and outreach to VCs.

• I met Simon of Kreatize and invested in the first round together with Atlantic Labs and with other angel investors. Simon and Daniel are building a SaaS network to order custom manufactured parts and allow for seamless collaboration between manufacturers and suppliers. They are headquartered in Berlin with strong roots in the industrial southwest of Germany.
• I mentored Akshat and the Amper team through the Alchemist Accelerator program. Amper is helping manufacturers increase efficiency and productivity through real-time machine and factory monitoring, and they are based in Chicago. My initial investment was followed by Slow Ventures.
  
• Kemal, the CEO of Relimetrics, was referred to me in December 2016. Kemal and Juergen have developed a low-cost imaging technology to inspect and monitor material shape, deformation and reliability across different phases of the engineering lifecycle. Relimetrics went on to raise a seed round from Silicon Valley, German and French investors in December 2017, and they are based in Berlin and in Silicon Valley.

• Atlantic Labs graciously referred me to Wandelbots. Christian and the team have built software and hardware to teach industrial robots with wearables, making programming robots available for everyone. They are based in Dresden.

There also were five startups that I spent significant time working with but did not invest in. The number of blog posts collapsed from 11 to 2 as deal sourcing and founder mentoring took precedence.

2018 resolutions

Organizations and experts who are ostensibly more qualified than I regularly fail at making predictions, Instead, I will rather focus on a few key resolutions: Continue to look for differentiated opportunities in enterprise SW in Europe - and in Germany in particular- , bet on contrarian outliers in Silicon Valley, and dive deeper into the Blockchain and tokens.

The Three Types Of Seed Investing Strategies

In early seed stage investing, there are thousands of startups, few early breakout performers, and little data that can be analyzed. But early stage investing can be highly profitable, and three distinct strategies have evolved: boutique firms, index funds, and hedge funds.

A boutique seed approach best describes the typical angel investors. They make few investments, and try to leverage some special insight to increase the probability of success. The underlying assumption of a small fund is that the investor can pick the top of the seed stage startups. In private markets, that seems like a very tall task. In fact, the vast majority of angels lose money using that approach, just like most VCs don’t make money for their investors.

Superangels, seed investors and small incubators fall between the boutique seed approach and an index fund. They invest in about 10-20 startups every year and over time create a portfolio that is large enough to increase the likelihood of having one or more outsize winners.  

The seed investing index funds are represented by accelerators and incubators such as Y Combinator, 500 Startups, Alchemist Accelerator and others. By investing in a large and broad number of early stage startups, they are increasing the likelihood of having outsize winners in their portfolio. If the number of startups is large enough and the investor is a decent picker of talent, there will likely be some outsized returns in the portfolio. Y Combinator is a perfect example for that approach.

Dave McClure of 500Startups and others postulate that a portfolio of 100 companies is required to capture the outliers that generate 50X returns. The good news is that unicorns are not even required to generate returns for a seed stage fund: Exits on the order of  $100 million are enough. An exceptionally well connected angel investor such as SV Angel has 16 unicorns among their 628 investments.

Traditional angel investors make an initial investment only. Some are putting money aside for follow-on rounds, but the increased capital requirements limit the ability to participate.

An alternate approach has been pioneered by Chris Sacca: The hedge fund. After making an initial investment in Twitter, Sacca realized that the company was a rocketship on the way to unicorn status. Initially he took the typical super angel path of raising a small fund, but when he had the opportunity to buy $400 million worth of Twitter shares in a secondary sale he realized he wanted to play in the bigger leagues. Within 30 days we was able to raise commitments from institutional investors and put in place vehicles for successive investments . By the time Twitter filed for its IPO, entities affiliated with Sacca held the largest positions in the company. As Jim Collins wrote in From Good to Great: “The most effective investment strategy is a highly un-diversified portfolio when you are right.”

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All three seed investment strategies assume that an investor gets into the right deals. Even the index fund investment strategy requires 1 out of 50 investments to end up in a $100+ million exit. But an investor will not ‘see’ all startups with that exit potential in their deal flow, and may not recognize them. Attractive deals may be oversubscribed and the investor may not be able to participate. So regardless of the strategy, an investor needs to attract the ‘best deal’.

Picture credits: Time Inc, Money Q&A, Forbes