A VC endorses JUPM, but is he right?

by: David Jackson

Paul Allen, managing partner of VC firm Infobase Ventures, published a strong endorsement of products from Jupitermedia (ticker: JUPM), WebSideStory (ticker: WSSI), ValueClick (ticker: VCLK) and Linkshare (part-owned by Internet Capital Group, ticker: ICGE). But his assumptions are rejected by another entrepreneur, and require careful thought:

In The 5 Most Valuable Services Most Entrepreneurs Can't Afford, Paul Allen describes his experience as founder and director of Ancestry.com. After Ancestry.com raised $75 million, Allen writes, "we could afford virtually any technology or service", and "I found a number of ultra-valuable resources that very few entrepreneurs that I know have ever had the benefit of even trying, let alone using day after day." He then makes the following recommendation to CEOs:

...as your internet company grows, you should plan to invest in some or all of these services in order to improve your intellectual capital, your efficiency, and maximize your business potential. Used appropriately, these services can generate an incredible ROI and give a company a tremendous competitive advantage over companies that aren't using them.

The list that follows endorses the products of four publicly-traded Internet companies:

  1. Market research from Jupiter (ticker: JUPM);
  2. Web analytics
    software (hosted) from WebSideStory (ticker: WSSI);
  3. Affiliate advertising services from
    ValueClick (ticker: VCLK) and...
  4. ...LinkShare (part owned by Internet Capital
    Group, ticker: ICGE).

Paul Allen's article - which is well-worth reading - was published days before a controversial essay by programmer and entrepreneur Paul Graham.

Graham's entertaining essay, A Unified Theory of VC Suckage, argues that because VCs are paid a percentage of the funds they manage as an annual fee (usually about 2%), they are incentivized to raise more capital than they can efficiently manage, which leads them to invest too much in each deal. Graham suggests that VC-backed companies therefore take too much funding, spend inefficiently, and end up being worse run than companies with tighter funding constraints.

Graham's article throws into question the very premise behind Allen's article, which touts the benefits of expensive services only affordable by well-funded companies. Which is correct?

Graham probably misjudges the incentive structure for VC funds. Like hedge fund managers, VCs usually charge "2 and 20" - a 2% annual asset-based fee plus 20% of the fund's profits. When asset-based fees dominate performance-based fees, they misallign money managers' incentives with those of their limited partners.

But most VC and hedge funds should (and many do) charge an asset-based fee that covers only the funds' operating costs without generating profits.  Profits should come from the performance-based fees, at least in theory. If the fees are structured correctly, VCs should care most about the return on capital from their investments (since that's what generates profits and their performance fee), and should therefore be strongly discouraging of inefficient spending by their portfolio companies.

Yet I wonder about VC-funded Internet companies today. Probably the most significant difference between today and the dot com bubble business environment for Internet companies is the spread of performance-based and consumption-based services. The dramatic growth of pay-per-click (NYSE:PPC) and affiliate advertising means that companies' marketing budgets should be closely tied to revenue generation and profitability. By "closely tied", I mean not only that the relationship is demonstrable but that it occurs within a remarkably short time period. In many cases, companies know their advertising return on investment within hours.

Similarly, the web analytics software that Paul Allen endorses is now hosted. Hosted, or "On Demand" software, obviates the need for companies to invest heavily before reaping the benefits of the software they purchase.

The growth of performance-based and consumption-based services should drastically reduce Internet start-ups' requirement for up-front capital. We should see many more "boot-strapped" companies that can generate enough cash flow to fund growth, thanks to today's tighter correlation between the growth of expenses and revenue. So Graham might well be right that many companies are now over-funded, but not for the reason he claims.

Against that background, Paul Allen's list is an unusual mixture. Affiliate marketing services from ValueClick and Linkshare are not unaffordable for most Internet start-ups, because the cost of the service is closely tied to revenue generation. Similarly, WebSideStory's hosted web analytics software should not require significant up-front spending, and should rapidly improve web sites' revenue generation.

The only service that Allen endorses that isn't closely tied to revenue generation, and may therefore require up-front spending, is research from Jupitermedia. And here, I must admit, my experience as a director of start-up, "on-demand" e-learning and human resource management company CyberU clouds my view. "Industry research" from firms like Jupitermedia is so conflicted that it makes pre-Spitzer equity research look idyllic. (Full disclosure: I was a pre-Spitzer sell-side analyst.)

Small private companies pay for research because the analyst won't talk to them otherwise. On receiving a handsome check, the analyst includes them in industry reports and briefings that go to potential customers. Yet, as far as I know, there are no disclosures of conflict and the recipients of the research are unaware of the risk of bias. At CyberU, we regard spending on industry research as an advertising expense, not a business-planning expense.

Jupiter research may be a highly beneficial service that many companies can't afford, as Allen asserts. But that's not because "their projections...  and their reports... told dot com executives what to plan for and what to build". Rather, it's because for start-ups Jupiter research is a form of (non-performance-based) advertising.

A few other quick comments:

  • Allen gave honorable mention went to Web site performance
    measurement from Keynote Systems (ticker: KEYN). Also tied to revenue generation, but less closely than web analytics or affiliate marketing.
  • A commenter endorsed "an unlimited Monster (ticker: MNST) subscription to search for
    resumes relevant to your industry [as] a great way to build an advisory
    board and management team".
  • Alan Meckler, CEO of Jupitermedia, just wrote that "Jupiter Research is thriving! Synidcated research clients hit 297 the other day (up from 241 at this time last year). Contract value renewals have climbed to close to 100%. JR is now profitable and we expect healthy financial growth this year."
  • A question for VCs: if Internet companies' capital requirements fall due to the rise of on-demand software and performance-based advertising, what will happen to VCs' return on capital? Smaller funds with higher returns or large funds and wasteful spending?

JUPM chart below.