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If the average Venture Capitalist was asked to run a startup, would he/she be successful?

YES. The average VC would do a good job as CEO of a startup.

NO. VC's are investors, not operating executives, and would mess things up if they tried to run a business day to day.

Venture Profile: Mike Kwatinetz, Azure Capital Partners

By Angel Mehta, Managing Director, Sterling-Hoffman Executive Search

Formerly one of Wall Street’s top technology analysts, Mike Kwatinetz built his investment strategy around a seemingly unique approach in the world of high tech investing: The use of facts and rationality. Angel Mehta, Managing Director of Sterling-Hoffman, chats with Mike Kwatinetz about his once controversial take on Apple, the value of ignoring other people’s opinions, and the importance of forgetting the past in venture capital investing.

Angel Mehta: You were at one point ranked as the #1 stock picker on Wall Street…skill or luck?

Mike Kwatinetz: A bit of both, inevitably. I had Dell and Microsoft as companies I was covering, and happened to like them before most people – this was probably around 1990. So I rode them and got all these Wall Street accolades as the #1 hardware analyst and the #2 software. So I suppose liking those stocks before other people did, that was skill. But at the same time, if I were covering the steel industry, I would not have been the #1 stock picker on Wall Street. It’s definitely a function of getting assigned to the right space.

Angel Mehta: Warren Buffet always talked about cultivating the right temperament for investing and using rationality. But he always seemed to imply, the way I read it, that learning to invest the way he does was easy. Other people say that the ‘correct temperament’ for investing is in the blood. What do you think?

Mike Kwatinetz: I’m not sure if it’s in the blood or learned, but I can tell you that I felt the most important thing was ‘Do your own research’ and ‘Come to your own conclusion’. When I picked up the software space, I never read anybody else’s report as I felt it would taint my thinking. I was very lucky in that the first firm I worked for was Sanford Bernstein & Co. They were very research-oriented and they gave almost a year to do the report. That was a very big competitive advantage over other firms where analysts had to launch within a couple of months.
A combination of running a computer software company and having a very strong accounting background helped me in understanding finance and technology very well. I also had my mathematical modeling background, so I was good at abstracting information. I concluded from my research that very few people really look at evidence as a basis of conclusion. Many people tend to let their prejudices influence the way they treat the evidence. If the evidence contradicts their thinking they just discard it. My attitude was that I may have some prejudices but I had to let the evidence guide me. This kind of approach was in my nature…I did a Ph. D in mathematical modeling, an area of logic.

Angel Mehta: I understand that you considered Apple to be problematic. Almost everyone at the time loved it; what caused you to go against the grain?

Mike Kwatinetz: I looked at the PC industry and especially at the model of the Wintel space. At that time, it wasn’t called Wintel, but IBM Compatible. The model was a vertical integration but I believed it would shift to a horizontal market where Intel would supply the processor and Microsoft would supply the OS. Apple, along with others, stayed on the old model and that presented a problem because they didn’t have a strong set of companies that were allied with them. That would cause their share to decrease, which in turn meant economics was going to go against them. Nobody else bothered to really calculate the true cost of Apple’s OS. Compaq was getting the OS from Microsoft for less than it cost Apple to produce it on a per unit basis. If you took 100,000 units of Mac at $10 million a year, then that meant they were spending $100/per unit on R&D. Compaq was paying Microsoft $20 for DOS and $50 for Windows, half of Apple’s costs. So I had a different way of looking at the industry: Diagnosing the economics.

Also, Microsoft and Intel worked very hard at getting a large base of support. That meant they had more shelf space in the stores and there was more software being created for their products. There were more peripherals created, more hardware vendors creating different variations of the product, so that customers that went to the Wintel side had a much richer set of choices even though Apple worked better because it was a very closed-in solution. Customers who went to Windows got a much richer set of options, but gave up a better user experience compared to Apple.

By the way, Microsoft gets criticized a lot in the press because Windows has more glitches. Nobody seems to pay attention to the fact that it’s because there are around 6 million different combinations of hardware that it has to work on while Mac only works on 15. I’m exaggerating, of course, but you see the problem of conceptually testing products when you’re not even sure what combinations of hardware will exist versus testing a product where you could completely control the combination.

Anyway, at the time, I felt economics was against Apple, as they didn’t have the right set of partnerships or enough of them. They didn’t have a sufficient shelf space or many software products; then as the Wintel platform grew, the economics would get even more compelling versus Apple, so that was the concern I had with Apple. If you followed the seven-year period when I recommended Dell versus Apple, Dell stock went up about 10,000% and Apple’s was down 20%. The thesis worked better than one could have imagined at the onset because you don’t know that it’s going to holdup for that length of time. Every year, a company has to keep executing, and it’s a new set of challenges so you can’t predict with certainty that a company 10 years out is going to be a Dell. I did have a couple of years of visibility where they had an economic advantage versus their competitors.

There are three areas that I strongly believe must be looked at: The business model, not just technology; the evidence and letting that guide you; 5 year trends, along with the economics and changes in use associated with those trends. At Azure, our thinking is centered on those three areas and we wind up doing investments that are different than other firms because of that.

Angel Mehta: What about the public market today? Are there any key areas that you see going against the grain?

Mike Kwatinetz: In a public market, things change much faster. I think the biggest thing is people look backwards instead of forwards. In the mid-‘90s, the Web was very successful, so in the late ’90s, everybody wanted to invest in the Web, and that drove a lot of the valuations to absurd levels. After the collapse, people looked back and said “We’ve got to stay out of Web stock,” but there were opportunities to buy companies like eBay and Amazon at very reasonable prices. Looking back over the prior two years, most investors said, “I don’t want to invest in Amazon because it’s down 80%,” but that’s when I bought Amazon for my own portfolio saying, “Gee, Amazon’s cheap now and it still has a great business model.” So I think the biggest mistake people make is they look at the last two years backwards instead of the next five years forwards.

Angel Mehta: What’s your take on the next 5 years?

Mike Kwatinetz: It has to do as much with what you should short as what you should long for. Communication is changing and voice-over IP looks like it’s going to take over a bigger chunk. It’s at a lower cost model that, if the existing players want to compete, they have to keep driving their prices down. Retail through the Web is increasing at a decent rate every year but the Web is still only about a 5% share. I would predict fiercely that 10 years from now it will be 20%. Consider what that means in the growth of Web retail. There’s going to be a HUGE amount of opportunity in Web retailing, and it also means existing players who don’t compete as well on the Web are going to lose share and that’s pretty astronomical.

What about all the equipment that’s needed to support the number of people and the number of transactions, etc. that will be involved with that transition? What about the transition of advertising from TV? Many people use TIVO and how many ads do you see? None. Companies will be looking for a place to put millions of dollars of freed up advertising. For example, if you have watched the show “24”, there was a huge Cisco payment because the Cisco networking is visible on the last five or 10 episodes. That is a clear product placement situation. You will also have advertising moving to other vehicles, and certainly the Web is going to pick up a substantial amount. Google primarily, but also Yahoo and Microsoft appear to be well positioned.

So we’re talking about a complete change in the advertising model, communications and then there’s the music and video industry. The percentage of music that’s now being bought on the Web as opposed to that in a music store is pretty significant. Record stores will go out of business as brick and mortar stores, and I think Blockbuster is also feeling the effects in a heavy way right now. The music labels don’t mind because they could actually have as much or more profit from the Web as they had for the traditional vehicle. That’s because they’re dealing with royalties, and they’re not involved in the manufacturing business to the same extent when it goes through the Web, so that’s pretty interesting

Angel Mehta: How do you feel about software, in general? Would you be buying public software companies right now?

Mike Kwatinetz: Software is a big driver of some of the trends I just talked about, so we’re very interested. What’s interesting is software can be a tool to allow a company to compete in a traditional business. One company we invested in, I4 Commerce, is quite interesting. It’s both a software company and a credit card company. The credit card (called “Bill me later”) is virtual, and you never get a physical card. When you’re at the merchant, you apply online. You select us and essentially that’s the credit application. We ask you for 10 digits of information, which is half as much as your credit card number and we’re able to do all the credit checking in a very thorough manner. We have better fraud checking because we know a lot more about the transaction than Visa does. We can tell if it’s being shipped to a suspect place. We keep very good technology and databases on what would be a more likely fraudulent transaction.

Angel Mehta: And that translates into less risk for the company?

Mike Kwatinetz: Less risk in terms of the transaction but think of how much cost we’ve removed from the equation. Traditionally to get credit, you fill out the two-page form, send it to the credit card company and they get it back to you in about one or two weeks. Also we don’t send out a hundred mailers to get customers, they come to us. So there’s a lot of software and technology and database-tapping involved.

Angel Mehta: Is this what is called “Web 2.0”?

Mike Kwatinetz: Yes. The early phase of the Web, referred to as “Web 1,” is mostly about many users being able to connect to a single site. The second phase of the Web is improving the user interface and letting users connect to multiple sites. So our application is not restricted to a single site but it’s a composite application that can go to other places on the Web and it’s essentially instantaneous. For instance, you go to Overstock to buy something. You use your credit card and you perform this complicated task in one and a half seconds going out to 10 different places. That just wasn’t possible five or six years ago on the Web.

So that’s the next level of sophistication on the Web. There’s going to be a lot of software involved in getting to that level because we’re just scratching its surface now. We’re very strong believers in this trend and our credit card company is doing unbelievably well. We’re up to 85 sites that have the card at the Tier 1 level and our rate of growth resembles a Google-like play. We now have critical mass and the rate of growth is actually accelerating. We launched on Wal*Mart in March. We’re on Overstock, Continental Airlines, America West Airlines, 1-800-Flowers, Lego. We’re getting very big merchants, and within two years, it’s going to be pervasive around the Web.

Angel Mehta: I want to shift the topic a little. Why do you think venture investors fail?

Mike Kwatinetz: A few reasons could be – bad deal flow, deals without good fundamentals, overpaying for the deal and having a huge amount of competition in the space. I’d say most of the failures circle around those criteria.

We have to divide the deal flow into two categories. First, why does a new venture firm fail versus somebody who’s hired by an existing firm that is well-known? If you don’t have good deal flow either as a firm or as an individual partner within a firm, then you’ll probably have a smaller group of companies from which to select. If you’re anxious to do investments and are not patient enough, then you’ll make investments out of a small group and the number game works against you. If you have smaller groups to select from and they’re not necessarily the highest quality deals, then the chance of you failing is higher. So the first step in being successful as a venture firm is to have a good flow of deals and to be very selective and analytical about the deals you do. I think that’s absolutely important. A lot of people coming into venture don’t necessarily have a background of picking investments. Many are ex-operators and potentially have great skill sets in helping the company, but only after they have invested in them. But, as you know, if you have bad grapes you don’t get good wine.

The selection process is the second very important item and having the flow is the starting point in the process. If you're anxious to do the hot deals, especially deals in the spaces that everybody else wants to invest in, by definition, you’re probably going to overpay and have more competition. Some of those deals may be super successful; if you’re really great at how you build that company, maybe you’ll beat out the other 30 guys who did a deal in the same space, but it makes it a little bit harder.

Angel Mehta:
Do you think it’s fair to criticize venture investors when so much appears outside their control?

Mike Kwatinetz: When I was on Wall Street, I was good at figuring out strategies for companies, but they never listened to me. I even put in print what they had to do but they didn’t do it and it was too late when they tried to reconsider my point of view. Palm is a great example. I wrote about them in ’98 that they should tackle e-mail and they waited about five years before they did it. If they did it in ’98, they could have been RIM. At that time, they were the dominant players but they didn’t understand that e-mail was the most important app for handhelds. You have to understand when you’re in venture that exactly what you have is ‘influence’. If you try to run the company, I don’t think you’ll be successful.

Angel Mehta: So what do you look for in a company?

Mike Kwatinetz: People. You must have the right people, especially those who will listen to options, and hopefully if you have some good thoughts on strategies, they’ll adopt those thoughts.

Angel Mehta: Do you have a bias when evaluating other partners who potentially will join Azure? Would you prefer those from equity research and public market investing or experienced entrepreneurs?

Mike Kwatinetz: We like both kinds of people and strive to have a blend in our firm. We’ve hired venture partners with operating backgrounds, so they’ll either become a GP or run one of our companies. Larry Augustine (one of our venture partners) built VA Linux starting in his living room, to a $250-million revenue company. That’s not shabby. He was with us for about two and a half years and decided to run one of our companies.

You must have both skill sets helping the company. Many of the best deals are with entrepreneurs who know how to run their company. They have been highly successful entrepreneurs and now they’re doing their second or third company. We’ve been able to help with many areas that are very incremental, such as strategy, the financial model, more accurate forecasting and, on the networking side, how to get additional customers. If we’re investing in a firm where the entrepreneur is less experienced and we don’t have somebody internal that is suited to help them on the operation side, then we try to get somebody on the Board or another venture firm that has that experience. The Board and the investing group should have multiple skill sets amongst them and the ones they need vary depending on the particular deal involved.

Mike Kwatinetz is a founding General Partner with Azure Capital Partners where he specializes in software and related infrastructure technologies. His current board memberships are i4 Commerce, Jacent Technologies, Knowledge Adventure, Medsphere, OQO, Rooftop Comedy and ROME. Prior to Azure, Mike was Group Head of Technology Research, a Managing Director and the senior software and hardware analyst at several major investment banks, including Credit Suisse First Boston, Deutsche Bank Securities and PaineWebber. For article feedback, contact Mike at mike.kwatinetz@azurecap.com 

Angel Mehta is Managing Director of Sterling-Hoffman, a retained executive search firm focused on VP Sales, VP Marketing, and CEO searches for enterprise software companies and lead investor in
www.softwaresalesjobs.com, the #1 site for software sales jobs. Angel can be reached for feedback at amehta@sterlinghoffman.net 

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