The Leaders: Omniture, HBX (WebSideStory), WebTrends, CoreMetrics

Image Gallery: These screenshots show the latest Web/data analytics software from Visual Sciences.

Firm would not be surprised if management had relatively strong visibility into Q1 targets, given that the Q4 results were announced late in February (vs. instead of in late January) and given that firm's checks suggest that Q1 was off to a good start. They're aware of a large Visual Sciences deal with a new customer and also some other opportunities which were closed early in Q1, which drives their comfort levels with their targets (which are slightly ahead of street estimates).

Online ad spending continues to be healthy (especially with increased interest in online video advertising or mobile ads and ramping credibility of Yahoo search), although any mild slow down in online ad spending could potentially be positive news for web analytics vendors: In fact, firm wouldn't be surprised to see organizations shift some focus to improving online measurement and optimization in order to drive increased funding for online advertising programs in the intermediate term. Given that web analytics is a key enabler of online site measurement and optimization, they expect that overall interest in web analytics and related customer targeting (search, bid management) continues to grow nicely.

TRANSCRIPT SPONSOR

WebSideStory, Inc. (WSSI)
Q4 2006 Earnings Call
February 26, 2007 4:30 pm ET

Executives

WebSideStory, Inc. (WSSI)
Q2 2006 Earnings Conference Call
August 4, 2006 9:00 am ET

H-P to Buy Mercury for $4.5 Billion In CEO Hurd's First Big Purchase

J. CREW GROUP (NYSE: JCG)

What We Like: We think WebSide's web site tracking services compliment the boom in industry white papers and reports on Internet trends. WSSI's top line is on steroids: sales jumped nearly 100% to $40M in 2005. Four weeks ago, the firm's key product, HBX Analytics, won a major industry award for its excellent reporting, e-commerce capabilities, technical support and project management. Six weeks ago, WSSI unveiled Search 4.0, the first site search solution to integrate site search and behavioral data. While the market for e-commerce performance gauging is still in its nascency, there is no doubt that the internet's astronomical rise and global household penetration means that companies are more and more interested in pin-pointing the efficacy of online marketing campaigns. The demand for the type of service WebSide proffers is unmistakably there. If WSSI can't execute, the company will surely be snapped up: from a competitor's vantage point, WebSide's customer base is a market-share-grabbin' layup.

Valuation: Analysts expect a 35% jump in earnings from 2006 to 2007. Right now, shares are going for less than that -- 19.4 x 2007 numbers. Given the intense competition in the Web analytics space (there are several smaller, private players on the field), we understand investors[' concerns. However, WSSI weathered the tech bubble burst better than most of its peers (ahem, it survived) and the company is coughing up 25% gross margins, a debt free balance sheet, and heavy insider ownership. Most importantly, WSSI's rivals have less access to capital. With just 7M shares in flotation, WebSide Story is not without its risks, so make sure you kick the tires once or twice before putting the stock in your retirement account.

WebSideStory, Inc. (WSSI)
Q1 2006 Earnings Conference Call
May 10, 2006 9:00 a.m. EST

Overview: WSSI provides on-demand web analytics solutions for over 1,100 customers in the US. These web analytics solutions enable organizations to understand how Internet users respond to website design and content, online marketing campaigns and e-commerce offerings. We think that WebSide's web site tracking services compliment the boom in industry white papers and reports on Internet trends. WSSI's top line is on steroids: sales jumped nearly 100% to $40M in 2005. Last week, the firm's key product, HBX Analytics, won a major industry award for its excellent reporting, e-commerce capabilities, technical support and project management. Just a week before that, WSSI unveiled Search 4.0, the first site search solution to integrate site search and behavioral data. So far, we like what we see. On a pullback, we'd definitely like to get to know the stock better.

WebSideStory Inc. (WSSI)
Q4 2005 Earnings Conference Call
February 1st 2006, 4:30 PM.

"In the long run, every time companies increase the value of their online businesses, they end up handing over all that added value to the search engines. Any gain is temporary; once competing sites improve their profit-per-visitor enough to increase their search bids, they'll drive up everybody's cost of traffic.

… By the end of the year we will have doubled our core R&D capacity by establishing an offshore development center using the same management talent I used at my previous company, TogetherSoft, to revolutionize the software development tools market. So this is a known team to me and we're real excited about what we're doing over there. There's a massive amount of innovation going on in digital marketing right now, as everyone knows, and we need to be able to invest aggressively in R&D to continue to be a driver of that advancement.

• Piper Jaffray Internet analyst Safa Rashtchy initiated coverage on WebSideStory (ticker: WSSI) with an "Outperform" rating and $22 price target. He argued that WSSI "has a number of attractive investment characteristics including a strong market position in Web analytics, a highly predictable revenue model, increasing operating margins, and an expanding addressable market in site search, bid management, and content management."
• Yahoo (ticker: YHOO) CEO Terry Semel explained in an interview with Bambi Francisco why Yahoo acquired a stake in Chinese search company Alibaba instead of in Baidu (ticker: BIDU): "Alibaba brought [commerce] to the equation. Yahoo's going to bring communication and search. Technology in search will be a big factor down the road for the new entity". But when asked explicitly whether he tried to negotiate with Baidu, he said "Over the last year, we met with many different companies".
• Google (ticker: GOOG) purchased ad space in various print magazines to resell to its advertiser customers, in a move to become a one-stop-shop for both online and offline advertising. Forbes commented: "...Schmidt's firm [Google] said, "This limited test is part of Google's continuing effort to develop new ways to provide effective and useful advertising to advertisers, publishers and users." One translation of this statement might be: The firm doesn't wish to be seen as vulnerable to fluctuations in Internet advertising."
• Meanwhile, Google is facing challenges managing ads billed on a page-view basis (rather than a per click basis), according to Marketing Vox.
• Online jewelry retailer Odimo (ticker: ODMO) switched auditors. Switching auditors used to ring alarm bells for investors, but small publicly-traded companies are increasingly finding the costs of Sarbanes-Oxley and the higher fees of the largest accounting firms too much to bear. Odimo filed a letter from its outgoing auditor stating that there had been no disagreements with the firm. That followed the example of another small, publicly-traded Internet company, Hollywood Media (ticker: HOLL).
• eBay (ticker: EBAY) closed its acquisition of comparison shopping site Shopping.com (ticker: ODMO). eBay paid $21 per share in cash, totalling $634 million. Since Shopping.com had $148 million of cash, the net acquisition price was $486 million.
• Chinese Internet company Tom Online (ticker: TOMO) announced a partnership with (privately-held) instant messaging and voice-over-IP company Skype. More on this later. Skype CEO Niklas Zennstrom meanwhile denied a report that Hutchison Whampoa had acquired a 5% stake in his company.

Full disclosure: at the time of writing I'm long HOLL.

In site search, our main competitors are Verity and Deka (ph) and Google Appliance…

Some software solution providers are… giving away their site search solution... But they don't solve the in-house resource problem … customers feel good about paying a fair but relatively small amount to get the service levels and feature functionality they need to improve site conversions …

In bid management, we are launching this product this quarter…many small players and many companies… offer full-service campaign management. We believe our offering will be clearly differentiated by its integration with Web analytics. It is noteworthy that most other Web analytics providers are also building bid management modules because of the same opportunity. We have shown our solution to our customers and anticipate strong demand upon rollout. With about 1,000 customers to sell into and a nice pipeline for adding customers, we're optimistic as to our prospects with Bid.

The PPC networks are also offering strong bid management tools themselves, but these only cover one customer acquisition endpoint. Any sophisticated online operation is bidding across multiple endpoints and is thus in need of tools such as Bid to effectively manage their campaigns.

(Quotes are from the CCBN StreetEvents transcript.)

]]> Wed, 03 Aug 2005 00:02:00 -0400 David Jackson WebSideStory (ticker: WSSI) CEO Jeff Lunsford devoted part of his prepared remarks on WSSI's Q2 conference call to describing the competitive landscape for site search and pay-per-click ad bid management. These topics - particularly bid management - are important not only for WSSI but for the major search companies as well. Excerpts from Mr Lunsford's comments:

In site search, our main competitors are Verity and Deka (ph) and Google Appliance…

Some software solution providers are… giving away their site search solution... But they don't solve the in-house resource problem … customers feel good about paying a fair but relatively small amount to get the service levels and feature functionality they need to improve site conversions …

In bid management, we are launching this product this quarter…many small players and many companies… offer full-service campaign management. We believe our offering will be clearly differentiated by its integration with Web analytics. It is noteworthy that most other Web analytics providers are also building bid management modules because of the same opportunity. We have shown our solution to our customers and anticipate strong demand upon rollout. With about 1,000 customers to sell into and a nice pipeline for adding customers, we're optimistic as to our prospects with Bid.

The PPC networks are also offering strong bid management tools themselves, but these only cover one customer acquisition endpoint. Any sophisticated online operation is bidding across multiple endpoints and is thus in need of tools such as Bid to effectively manage their campaigns.

(Quotes are from the CCBN StreetEvents transcript.)

Complete Story »]]> WSSI David Jackson http://seekingalpha.com/article/1532-websidestory-meets-consensus-guides-in-line-wssi-2q05-earnings-results?source=feed 1532 Website analytics firm WebSideStory (ticker: WSSI) reported Q2 2005 earnings results that met both revenue and EPS estimates. Key stats:

Q2 Results
(all percentage changes and comparisons are year on year, unless stated otherwise)

• Revenue rose 77.8% to $9.4 million slightly above consensus of $9.29 million.
• Subscription revenue rose 70.9% to $9.0 million.
• Ad revenue rose 1,245.2% to $417,000.
• Gross margin was 83.0% versus 85.0%.
• Operating expenses rose 53.2% to $6.6 million.
• Sales and marketing expenses rose 53.3% to $3.5 million.
• Technology development expenses rose 14.2% to $1.1 million.
• G&A expenses rose 70.0% to $1.4 million.
• Operating income rose 570.2% to $1.2 million.
• Operating margin was 12.7% versus 3.4%.
• Net income was $1.3 million versus a loss of $272,000.
• Diluted EPS of $0.07 versus a loss of $0.06.
• Pro-forma non-GAAP diluted EPS of $0.10 versus a loss of $0.01, and versus consensus estimate of $0.10.

Balance Sheet

• Cash and equivalents of $13.4 million as of June 30, 2005.

Q3 2005 Guidance

• Revenue of $11.0 - $11.3 million versus consensus of $11.18 million.
• Pro-forma non-GAAP EPS of $0.11 - $0.12 versus consensus of $0.12.
• GAAP EPS of $0.08 - $0.09.

Q4 2005 Guidance

• Revenue of $11.9 – $12.3 million.
• Pro-forma non-GAAP EPS of $0.13 - $0.14 versus consensus of $0.13.
• GAAP EPS of $0.10 - $0.11.

Q1 2006 Guidance

• Revenue of $12.7 – $13.5 million.

WSSI chart.

Not subscribed to The Internet Stock Blog? You can get updated headlines for free by adding The Internet Stock Blog to your My Yahoo page. Just log into your My Yahoo
page, then go to The Internet Stock Blog and click on the "+ My Yahoo"
button on the top right of your screen. You can do the same for other sites, such as The China Stock Blog, ETF Investor, Radical Guides and Seeking Alpha.

]]> Fri, 29 Jul 2005 13:47:00 -0400 David Jackson Website analytics firm WebSideStory (ticker: WSSI) reported Q2 2005 earnings results that met both revenue and EPS estimates. Key stats:

Q2 Results
(all percentage changes and comparisons are year on year, unless stated otherwise)

• Revenue rose 77.8% to $9.4 million slightly above consensus of $9.29 million.
• Subscription revenue rose 70.9% to $9.0 million.
• Ad revenue rose 1,245.2% to $417,000.
• Gross margin was 83.0% versus 85.0%.
• Operating expenses rose 53.2% to $6.6 million.
• Sales and marketing expenses rose 53.3% to $3.5 million.
• Technology development expenses rose 14.2% to $1.1 million.
• G&A expenses rose 70.0% to $1.4 million.
• Operating income rose 570.2% to $1.2 million.
• Operating margin was 12.7% versus 3.4%.
• Net income was $1.3 million versus a loss of $272,000.
• Diluted EPS of $0.07 versus a loss of $0.06.
• Pro-forma non-GAAP diluted EPS of $0.10 versus a loss of $0.01, and versus consensus estimate of $0.10.

Balance Sheet

• Cash and equivalents of $13.4 million as of June 30, 2005.

Q3 2005 Guidance

• Revenue of $11.0 - $11.3 million versus consensus of $11.18 million.
• Pro-forma non-GAAP EPS of $0.11 - $0.12 versus consensus of $0.12.
• GAAP EPS of $0.08 - $0.09.

Q4 2005 Guidance

• Revenue of $11.9 – $12.3 million.
• Pro-forma non-GAAP EPS of $0.13 - $0.14 versus consensus of $0.13.
• GAAP EPS of $0.10 - $0.11.

Q1 2006 Guidance

• Revenue of $12.7 – $13.5 million.

WSSI chart.

Not subscribed to The Internet Stock Blog? You can get updated headlines for free by adding The Internet Stock Blog to your My Yahoo page. Just log into your My Yahoo
page, then go to The Internet Stock Blog and click on the "+ My Yahoo"
button on the top right of your screen. You can do the same for other sites, such as The China Stock Blog, ETF Investor, Radical Guides and Seeking Alpha.

Complete Story »]]> WSSI David Jackson http://seekingalpha.com/article/1218-websidestory-bounced-around-by-google-acquisition?source=feed 1218 WebSideStory's stock (ticker: WSSI) has bounced around over the last couple of days in reaction to Google's (ticker: GOOG) acquisition of web analytics firm Urchin Software. Does the Google purchase validate WSSI's business or dramatically increase competition?

Key points on GOOG's acquisition of Urchin Software:

• Urchin Software provides two web analytics products: an on-demand solution for $495 per month, and a non-hosted solution for $895 that can handle analytics for up to 100 web sites.
• Urchin is privately-held.
• Terms of the deal not disclosed.

Key Urchin Software product features:

• allows web masters to view metrics overlaid directly onto links so they can see the popularity and effectiveness of each link;
• allows web masters to eliminate bottlenecks in checkout and conversion
  processes and reduce abandonment by pinpointing where visitors leave
  where they go;
• customer segmentation by geographic location, new versus returning visitors.
• tracking of visitor behavior, conversion metrics, and trends for individuals or groups of visitors.
• performance summaries.
• geographical targetting: discover where best customers are located, where visitors come from and which markets are the most lucrative. Compare conversion metrics and visitor value for geographic locations.

1. Why does Google want to be a provider of web analystics?

Because the value of an ad to a merchant is defined by:

(1) how many people click on it,
(2) the rate of conversion to sale, and
(3) the value of a sale.

As online merchants become better at converting site visitors to actual purchasers, their return on investment on keyword ads rises and they are therefore willing to pay more for keyword ads. This explains why keyword prices are likely to rise in the long-term, and why it's in Google's interest to help merchants improve their conversion-to-sales rates by providing web analytics software.

Google's purchase of Urchin therefore validates the web analytics market. But did WSSI need that validation? Not really, given the strength of its recent performance.

Google has said nothing about changing the price of Urchin's product. Current price for the hosted solution is $495 per month. But in the long term, Google can make more money by giving away the software (assuming extremely low marginal cost to Google) to fuel increases in keyword ad prices. That's potentially bad news for WebSideStory and other providers of web analytics.

Bundling of web analytics is good news for merchants. True, in the long run it will lead to an increase in the price of online ads. But the overall improvement in conversion-to-sales rates will improve the profitability of e-tailers and improve their competitive position relative to offline vendors.

]]> Wed, 30 Mar 2005 10:57:26 -0500 David Jackson WebSideStory's stock (ticker: WSSI) has bounced around over the last couple of days in reaction to Google's (ticker: GOOG) acquisition of web analytics firm Urchin Software. Does the Google purchase validate WSSI's business or dramatically increase competition?

Key points on GOOG's acquisition of Urchin Software:

• Urchin Software provides two web analytics products: an on-demand solution for $495 per month, and a non-hosted solution for $895 that can handle analytics for up to 100 web sites.
• Urchin is privately-held.
• Terms of the deal not disclosed.

Key Urchin Software product features:

• allows web masters to view metrics overlaid directly onto links so they can see the popularity and effectiveness of each link;
• allows web masters to eliminate bottlenecks in checkout and conversion
  processes and reduce abandonment by pinpointing where visitors leave
  where they go;
• customer segmentation by geographic location, new versus returning visitors.
• tracking of visitor behavior, conversion metrics, and trends for individuals or groups of visitors.
• performance summaries.
• geographical targetting: discover where best customers are located, where visitors come from and which markets are the most lucrative. Compare conversion metrics and visitor value for geographic locations.

1. Why does Google want to be a provider of web analystics?

Because the value of an ad to a merchant is defined by:

(1) how many people click on it,
(2) the rate of conversion to sale, and
(3) the value of a sale.

As online merchants become better at converting site visitors to actual purchasers, their return on investment on keyword ads rises and they are therefore willing to pay more for keyword ads. This explains why keyword prices are likely to rise in the long-term, and why it's in Google's interest to help merchants improve their conversion-to-sales rates by providing web analytics software.

Google's purchase of Urchin therefore validates the web analytics market. But did WSSI need that validation? Not really, given the strength of its recent performance.

Google has said nothing about changing the price of Urchin's product. Current price for the hosted solution is $495 per month. But in the long term, Google can make more money by giving away the software (assuming extremely low marginal cost to Google) to fuel increases in keyword ad prices. That's potentially bad news for WebSideStory and other providers of web analytics.

Bundling of web analytics is good news for merchants. True, in the long run it will lead to an increase in the price of online ads. But the overall improvement in conversion-to-sales rates will improve the profitability of e-tailers and improve their competitive position relative to offline vendors.

Complete Story »]]> GOOG WSSI David Jackson http://seekingalpha.com/article/1187-a-vc-endorses-jupm-but-is-he-right?source=feed 1187 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.

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 (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.

]]> Mon, 21 Mar 2005 07:10:00 -0500 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.

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 (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.

Complete Story »]]> ICGE JUPM KEYN WSSI David Jackson