A new model for semiconductor investing

There was an interesting post on Techcrunch this afternoon, called “The Revival of Semiconductor Investing”. The title alone touched a nerve. It states something that I would very much like to believe is true, yet fear deep down inside is not.  The author, Ilgiz Ahkmetshin, is a venture investor at SK Telecom (a South Korean operator) in their incubator. More than that, he actually crunched some data. What he showed is that even though the number of semiconductor-related venture investments has fallen sharply, in the past few years, the number of investments in new semiconductor companies has started to grow again.

This seemingly defies common “Valley wisdom”. Most VCs I know find the idea of investing in a semiconductor company deeply unattractive, if not downright laughable. Now that I am considering my next career steps, I have been watching such investment trends closely. Speak to most people in the semiconductor industry and there is a clear sense that we have entered a new age, one with little room for new, small chip companies.

For several years, I have been suggesting that there is a great need for chip start-ups, but the funding model has to change.

This is how I see the problem.

Designing hardware is much harder than designing software, and by ‘hard’ I really mean expensive. If you design a web site, the whole product can be built around the idea of iteration. The first version will not work perfectly, so plan for that, and fix it in upgrades. And upgrades on the web or in the cloud are very easy. In hardware, everything has to be right before you ship the product. And not just before you ship, but really before you even start to build it. Returns are prohibitively expensive, and hardware cannot be readily fixed on the fly or in the field. This problem is even more acute in semiconductors. First, those chips have to get designed into other things, and that means even longer preparation times. Secondly, the complexity of the semiconductor manufacturing process are hard for the human mind to grasp. The industry requires incredibly tight specifications, as you can imagine for circuits many times smaller than a human hair.

In terms of investment dollars, this has meant that the cost to go from ‘good idea’ to revenue-generating product is very large. There are several private chip companies out there that have raised north of $200 million and never shipped a product much less gotten to profitability. So if you are a venture investor, you can roll the dice on that kind of prospect or launch a photo-sharing messaging, cloud storage app which gets to revenue in hours. Not much of a choice, except there are already a lot of those apps out there, and a growing shortage in semiconductor innovation.

I have been arguing for years, that the problem is one of expectations and funds raised. Too often, chip companies were funded on the premise that they need to get to the point where they are shipping product. This has meant that companies needed to build a relatively large operation. WhatsApp did fairly well with something like 30 employees, most of whom focused on the core app and user experience. By contrast, for a chip company to get to revenue, they need to build a big operations team that can take clever designs and walk them through the all the steps needed to get manufactured. They need a large sales force. They need incredibly expensive design tools.  The list goes on, and adds up to a lot of people and a lot of expense.

It is unclear what can replace that model. I think a better approach would be to break up the whole system and allow for some abstraction. VCs should fund promising chip designers, not on the expectation that they will get the product all the way to shipment, but to proof of concept, when the investment will be handed over to a company that specializes in transforming designs into prototypes. I think there is also room for clever incubators which pool some of the more expensive elements of chip design like software tools. This sort of ecosystem may be starting to emerge, but is still far from maturity. And none of this is easy. For chip designers to merely prove a concept, they would essentially be selling IP, and the market has not been that kind to IP companies like this. At their very worst, they end up becoming companies with more lawyers than engineers.

Nonetheless, I think a new model is starting to emerge. Many design tools are now becoming available on Software as a Service (SaaS), pay-as-you-go models. There are a few companies out there that can handle many of the complexities of translating designs into shippable products.

One of the paradoxes of the modern semiconductor market is that while starting a new chip company from scratch has only gotten more expensive, the cost of building a chip have generally come down meaningfully.  I do not mean the physical costs of manufacturing, that’s a topic for a different day, but the upfront costs have come down in many areas. This is the reason that the big web companies like Google and probably Facebook, are now designing their own chips. I am working on another post which lays out the math behind Google building its own server chips, and it turns out that this is a pretty easy investment choice for them to make. Part of the reason for this has been the rise of ARM Holdings, which designs and licenses a key piece of chip IP. So in many areas, the abstraction process has already started, with a dramatic impact of chip design costs.

Now ARM designs only work for certain chip applications. There are many more areas which have little or no abstraction available, and some where it is not even possible. Nonetheless, I think there is room for a new model to emerge that would greatly reduce the upfront costs of starting a chip company.

So I am encouraged to see posts like Ahkmetshin’s with tangible proof that investments may be picking up in this space. We still have a years to go, but maybe there will be a day when Venture investments in semiconductors once again make sense.

In which, the cause of the author’s absence is revealed

Some of you may have noticed that I have not been writing as frequently over the past few months.

Today’s news should explain that. I have been a little busy.

When I write, I tend to write about things that I have observed firsthand, and unfortunately for my writing (considerably more fortunate for my other aspects) there has been little that I have observed firsthand this year that I could share. I cannot really discuss any of the details of the transaction, but suffice it to say it would make for an interesting book…

Now that the deal has been announced, I should be able to write more freely about things I see. So I hope that I will resume my intended pace of 500 words a day. Come to think of it, I now have an awful lot of free time on my hands, and probably nothing but free time in a few months. So stay tuned, and stay in touch.

 

The Changing Structure of Financing Companies

A few weeks back, I read a post on Mark Suster’s Blog Both Sides of the Table called “The Changing Structure of the VC Industry”. It evoked a very strong response in me and I have been struggling since then to put my thoughts on his post on paper.

Put simply, I agree with many of his conclusions. The piece is one of the most thought-out, best researched pieces I have seen on Venture investing in some time (including this one). His basic premise is that even though everyone bemoans the decline in venture investing, the numbers actually paint a different picture. Professional Venture investors are not being overrun by Angels, nor is there a wholesale decline in the number of VCs out there. Instead, he argues, the boundaries are blurring (my word) between investment stages. Large VCs are increasing their late stage investing. Many old shops are closing down, but their numbers are being more than offset by new funds emerging. This is almost a changing of the guard as we transition from Web 1.0 successes and failures to Web 2.0’s new crop of hits.

Suster seems to draw two conclusions from his data. First, that the VC industry is undergoing transition but remains fundamentally healthy. He makes a very good case for this, and I agree with it. However, he closes his piece with the idea that the public funds who have been dabbling in VC (mutual and hedge funds) will eventually exit the market and go back to doing what they do best, namely trading public stocks. Admittedly, this is a side argument for his piece, but it got me thinking.

He argues that the traditional divisions among VC funds is blurring with the staging of funds changing as their sizes grow. It occurred to me that the public funds are no different. We hear similar comments from time to time in the public fund universe as well.

I think this blurring will continue, and we will see a steady shift to a new structure for the whole capital raising industry.

The distinction between and a public and a private company is entirely arbitrary. It is an artifact of habit and adaptation to regulation, but there is no ‘natural’ reason to draw the line where we do. Set aside the regulatory regime for a moment. Instead of thinking about public versus private, we should view companies on a spectrum, with companies changing their capital structure as the number of investors grow. As the company grows, it will need to attract more capital and that will mean more investors.  This in turn will dictate more mature corporate structures.

Today, there is so much focus on the IPO and getting ready to go public. I argue elsewhere (constantly) that there is too much of a disconnect between the way that private companies prepare for their IPO and what their life is like once they are public. If we were starting from scratch today, we would have a more gradual transition. Each step in the fund-raising process should be preparing companies for being more mature. Instead, of slowly aging, the system today treats companies like they are caterpillars that enter a cocoon and emerge at IPO as a butterfly (or ugly moth).  As if these were two wholly different stages of life.

I think the changes in the venture industry will be mirrored in the public markets as well. I think more mutual funds will enter late-stage private financing rounds. As Suster (and others) note, the returns in growth investing are increasingly going to private investors. So it makes sense that the money managers of the world will follow Sutton’s Law and go where the money is.

Obviously, we are not there yet, but you can see the pieces starting to fall into place. The crowdfunding ‘movement’ is likely to grow, and seems set to provide the regulatory bridge between public and private investors.

This will be a change not only for venture investors, but for the whole financing business.

Mobile Gaming’s Giant Treadmill

I find that I have been having the same conversation about mobile gaming repeatedly, with a number of different people. Usually, that’s a signal that I should publish something. Ben Thompson’s post the other day about Buzz Feed was close enough to my subject that I wanted to respond, and just as I went to publish this piece I noticed there is something related on Techcrunch (I have not read the TC post yet, but you should go ahead and click, they need the pageviews more than I do).

Mobile Gaming seems to be the great success story of the Appconomy. There have been something like a dozen game-related IPOs in the past few years, probably double that if you count the China companies. There have also been a large number of nine-digit exits.

Yet for some reason, the mobile gaming industry does not feel like a growth industry. As I posted a couple weeks back, Independent developers are re-considering their career choices. And if you look at the major, public game companies it is hard to find clear signs of mobile wealth. Having spent a few days last week in the Valley, I get the sense that VCs are making few new mobile gaming investments. They are supporting their existing portfolio companies, but there does not seem to be a lot of appetite for new gaming investments.

We could delve back into the subject of the problems with App Stores and new app discovery, but I think there is a broader issue. Mobile gaming has become intensely competitive, and is now very much a hit-driven industry. The most immediate example of this is the decline of King Digital’s fortunes. Their stock is off sharply since the IPO. Their hit title Candy Crush seemingly came from nowhere to become a huge hit. It still throws off incredible amounts of cash, but its growth is slowing and the company has no easy way to replace those declines.

This is the central issue with gaming. Every few months some new game comes along and goes viral, generating huge downloads and revenue ramps. But eventually they fade. Candy Crush seems to have been displaced by a Kardashian game. Remember Farmville? That great Zynga hit, which eventually fell victim to Clash of Clans and Candy Crush itself.

Mobile Gaming is a treadmill. Individual games can grow quickly and last for a long time, but eventually the decline sets in. I think it may prove impossible to build a game with a long shelf life in mobile. Or at least, there will be very few games that can last a long time. This is not so terrible in itself, but it makes it very hard to build an ‘investible’ business, meaning one that can become a sustainable public company.

I think gaming companies are going to start looking a lot more like movie studios. Investment dollars will flow to management teams that can prove they can build a pipeline of games. These gaming ‘studios’ will need to adopt a portfolio approach to game development, knowing that 7 out of 10 games will fail, two will carve out niches for a period, and one will be a multi-year hit or franchise.

The problem with this is that this is not the kind of business that VCs want to invest in. See Thompson’s Stratechery post for more on why that is. For movie studios today, the truth is that movies are just a small part of the business. Any individual film is financed through a hodgepodge of sources. The studios actually outsource a lot of financing of films, and most movies probably lose money. But the studios continue to make a lot of money by selling rights to the movie to every available channel – including DVDs, cable channels, online streaming and merchandising rights. (If you want to understand more of this, I highly recommend you read “The Hollywood Economist”. That work shapes a lot of my thinking about this subject and is very revealing for those of us in Northern California seeking to understand Southern California.)

When I originally started looking at this subject, I thought that today’s mobile gaming companies would end up looking a lot like mobile gaming companies from a decade ago. Remember Jamdat? Probably not, but they were the first mobile gaming company to go public and eventually sell themselves for a healthy sum. Ten years ago, there was an initial rush to build mobile games for phones that were just starting to have color screens. This business was hijacked by the carriers who insisted on something like 50% of the economics, or more. Apple broke that model completely, and if nothing else, we should all be grateful to them for doing so.

However, the more I worked on this, the more I realized that today’s mobile gaming market, for all its problems, is much healthier. In the last go-round, mobile gaming companies ended up being largely dependent on existing media brands. There was no way to build a successful game through word of mouth or feature-phone based ‘app stores’. For a while, there were several dozen mobile gaming companies all trying to buy licenses for whatever movie was due to come out that month. If the movie was a flop, then the mobile gaming company went out of business, having bet their entire cash balance on upfront payments.

Today, mobile gaming companies are no longer stuck between the movie companies and the carriers. They still have the potential to build a hit game. And there is still a lot of room for independents to get lucky. Clash of Clans, Candy Crush and many others are immensely profitable. It is so much cheaper to launch a game today than ever before. As a result there are a lot of profitable games out there.

So while conditions are much improved from ten years ago, mobile gaming is still a cottage enterprise. To become a real industry will require some corporate structure that allows for greater scale. My guess is that companies like Pocket Gems, Kabaam and probably even Zynga, are steadily moving in this direction. These all seem to be doing fairly well now (we’ll see about Zynga), but I think that with time their business model will gradually shift. Instead of designing all their games themselves, they will become platforms for smaller developers to emerge. This is less about technology and more about licensing and clever talent-spotting.

Will the media conglomerates dominate this field too? It would seem natural that the seven studio majors could eventually dominate mobile gaming, given the overlap in content and business model. On the other hand, I think the mobile market is different enough that a few mobile studios will emerge. They will find a way to better cross-promote across their brands. This has so far been hampered by some of the iOS policies, but that is a subject for a different day, and probably not a hard and fast rule in itself. Mobile studios will find ways to make the most of what mobile has to offer and use that to their advantage.

Another way to gauge the value of this market is through the tool makers. A few weeks ago, I admitted that building developer tools did not look like a promising area, but there are still some stand-out successes in gaming. Notably Unity, they build what is probably the leading mobile gaming graphics engine out there. Given the huge number of Unity-based games out there, this company could end up becoming one of the great success stories of mobile gaming. (That being said, I have no idea what their financials look like.)

In the end, I think we still have a lot of transition and exploration ahead of us.

The App Store needs a Refresh

There is an interesting post from Marco Arment today on “App Rot”. In it he takes a look at App Store economics. Like many people before, he points out that the structure of the iOS App Store needs some improvement. There are so many apps, and discovery on the App Store is not that advanced. Arment’s post stands out because he is looking at it from the point of view of an independent app developer, and weighs decisions in terms of what job a developer should take next. (Arment was one of the early developers of Tumblr, and has made some great apps since setting out on his own.)

The root of the problem is that the App Store is out of date. There are basically two ways for users to find apps there. Either Apple chooses to feature them or the app does so well that it is listed in one of the various Top 10 or Top 50 lists. There is a search function but it is pretty basic (albeit greatly improved over past versions).  The problem is that neither of the two leading discovery methods work that well. Apple’s choice of which apps to feature appears to be a random process, at least it appears that way to outsiders. And the ‘Top ‘ lists are self-reinforcing, leading apps can hold onto those positions for a long time.

Arment’s suggestion to developers is to get more efficient in writing apps. Use the best practices and the latest iOS features to stand out. To its credit, Apple is doing a great job of adding features to new versions of iOS every year, and smart developers are getting new tools, and new code (e.g Swift) which make writing apps easier.

Nonetheless, the root of the problem remains. My post on App Store Optimization is over a year old, and the problem pre-dated that post by a couple years. Analytics site Xyo showed data a few years ago showing that the length of time a Top 10 app stays in the Top 10 is growing, meaning that there are fewer new entrants to the Top lists.

I think the best solution is a revamp of the App Store. I have no idea if Apple is working on this, but I can think of a few features I would like to see.

First, better search. Apple knows which apps I already own,  and I would like to see better personalization in the apps I get served as search results. For instance, I have no interest in Korean language apps. I am sure they are wonderful, but my Hangul skills are pretty limited.

Second, the landing page of the App Store should be greatly reduced. There are too many apps on display. This seems counter intuitive. The problem, as I see it , is that once I am on the App Store, I spend the first 15 minutes just looking at what is new, and then I lose interest. Even clicking one level deeper, for instance to look at the Games page, requires another 15 minutes of looking. The landing page should be intended as a starting place for navigation, and geared to helping me think about what I want to look at next. Right now, every click on the app store is a choice between looking at 100 apps or just looking at one. I would prefer a more gradual process that lets me look at a smaller number of the best apps, with links to more exploration.

Third, better filters.  There are large categories of apps in which I have no interest. I would like to have a way to not have to look at those. For instance, a huge portion of games are now Free, with monetization through In-App purchases. I would like to be able to avoid seeing those most of the time.

An important subset of this feature would be the ability to find the latest apps, as well as those using the most up to date versions of iOS. When I search for certain apps, I find a lot of the results are for dated apps with basic functionality and old code. How about a section that show the most up to date apps using all the coolest iOS tricks?

Fourth, a human-curated section. I find that I discover a very large portion of the apps I buy (especially games) from the “Apps We’re Using” list compiled by Apple employees. How about a whole page of those?  I think a dose of human editorializing would go over well.

Fifth, I would like a page of random apps. Just show me 20 or 30 apps picked at random from the App Store (adjusted for language preference and excluding apps I already own).  I think this sort of randomness could greatly accelerate purchases. For a while, I used to look at the App Store on my iPad which allowed for sorting of apps by release date. This was only really useful in creating a list of random apps, and I found a lot of things that way that I would not have found elsewhere. A more organized randomization process could create a nice jolt of serendipity.

Finally, better recommendations. This is a tricky one, it is a hard problem to solve. It would probably work best with links to Facebook or other social networks. But Apple knows what apps I have, combine that with what apps my friends have and what apps the people I follow in Twitter have, and the end result is probably some good app ideas.  There was news this week of a start-up called Homer that is trying to do this. You log onto this app with your Facebook ID, then send them a screen shot of your phone. Homer then decodes the screen shot to capture the apps you own and compares it screen shots it gets of apps your friends own.  The trouble with all this is that individual Apps cannot see what other Apps you have on your phone. This is a sensible privacy policy, but it also means that only Apple can really make these social comparisons.

I could go on, but I think this list is a pretty good set. It would help improve searching for specific apps as well as  enhance discovery of apps I never new existed.

UPDATE: I wrote this post in the morning California time, but did not get around to publishing until late in the day. And over lunch a discovered a healthy Twitter conversation on some very similar subject.

Talking my book on Amazon

Amazon reported disappointing results on Thursday, knocking almost 10% off the stock on Friday. I think the company still has a lot going for it, and that this reaction is overdone. Before I get into my reasoning on this, let me state a big disclaimer. I freely admit that I am talking my own book here. I own 15 shares of Amazon. I bought them below $200, so I have a lot of cushion here, and it is not that large a piece of my net worth. But I have not sold the shares, and have no plans to do so. But I thought you should know that I have an economic interest in this argument. Caveat lector.

I have seen a few explanations for the stock sell-off. Revenues were in line with expectations, but profitability was a bit light. Guidance was lower than ‘whisper’ expectations. The usual. But a bigger concern seems to be the fact that Amazon Web Services (AWS) revenues fared poorly, with revenue actually down from the prior quarter. I think this is the first sequential decline in revenue that AWS has ever seen. The AWS aspect of the results featured in much of the tech blog coverage of the results, with a good piece from GigaOm on the subject. Probably the best-stated bear case came from the Register, with their usual blend of tabloid meets solid analytical thinking.

The bear case holds that Amazon is now facing real competition in the public cloud. The Register is the only piece I saw that really explicilty connected the price cuts among AWS, Microsoft’s Azure and Google a couple months ago. This actually makes a lot of sense to me. There is clearly a price war taking place among public cloud vendors now. So it is not surprising to see this hit AWS’ numbers.

Nonetheless, I think this is one of those stereotypical “Wall Street is too short-term focused” problems. The investment case for Amazon is that they are disrupting pretty much everything. They have huge scale, and they are using that to bring down prices on many products and services. This punishes their less efficient competitors, and eventually Amazon should emerge with a very powerful position. The company is in investment mode today, but has its sites  on much greater pricing power further down the road. This is clearly true of the book business where they started. And it seems likely to be true of public cloud computing as well.

Back in December, I wrote about AWS’ cost structure. The conclusion of that post is that AWS is actually immensely profitable. The company has huge leeway to engage in a price war, even with someone as large as Microsoft or Google. In fact, I was starting to think that AWS was getting too expensive and risking turning customers away. Amazon is now cutting prices on AWS at just the moment when more companies than ever are looking to start using public cloud resources. I think this round of price cuts could go a long way to lowering the barrier to adoption, opening doors to a huge new customer base.

I find it very odd that a week or two ago, the blogosphere seemed convinced that Amazon was about to take over the world. Then one quarter of slowing numbers turns that perception on its ear. I do not think much has changed, and AWS will likely continue to grow at a tremendous pace.

Say what you will about the ruthlessness that rests behind this strategy, but if you are willing to accept that Amazon is in investment mode, then this week’s news is not that meaningful. For several years now, investors have accepted the fact that Amazon is not focused on profitability, because it has so much opportunity in front of it, the smarter strategy is to forego profits and grab all the land it can. That remains the case, and I think the company still has a long way to go.

Coming of age in mobile. Yahoo buys Flurry

I wanted to comment briefly on the news that Yahoo! has acquired Flurry. This a turning point, or a milestone. A marker of some sort. The End of the Beginning of Mobile, something along those lines. I originally wrote this the day of the announcement, but delayed posting, in part because I wanted to take some time to read Fred Wilson’s post on Flurry’s history.

First the facts

Flurry was one of the first mobile analytics companies to gain scale. They offered a free suite of tools that developers could embed in their iPhone apps to give the developers a better sense of what users were doing with those apps. For commentators on mobile apps, Flurry was a huge help in the early days (circa 2010). They had data on hundreds of thousands of apps at a time when no one else really had any hard facts (at least no one after AdMob got acquired). Later Flurry added a whole host of other tools, largely around ads and user tracking.

Yahoo! confirmed the deal late in the day, but no terms were disclosed. The big blogs cited valuations from $200 million to $1 billion. RWW literally has the range at $300 million to $1  billion. This is the same as saying no one knows how much Yahoo! paid because that range spans the gamut from a great exit to a weak one. According to Crunchbase, Flurry had raised $73 million, although I suspect that data may be understating the total. Reading between the lines (aka guessing) if Flurry had really sold for $1 billion or anywhere north of $500 million, someone would be saying so, loudly. Bottom line, seems like a modest exit for a well known company.

Truth be told, I have been hearing warnings about Flurry’s results for a couple years. The first red flag was their pivot in 2012(?) hard into the ad space. I regard the Flurry team very highly, so I think this exit has something to say about the broader app market.

 

Now the Analysis

Flurry’s early success led many (myself included) to wonder if the mobile app market was going to develop very differently from the shrink wrapped PC software market that came before it. With mobile app stores providing a largely open distribution channel, the way was now open for hundreds of thousands of new developers to enter the market. We are still feeling our way through that change.

The first takeaway I have from the news is that selling tools to developers is still a hard business to be in. This was one of those old truisms from the PC software market. Surely having all these new customers offered a new market for tools. Turns out that some things never change. The Developer tools, or Developer to Developer (no relation to this D2D) market is not big enough to support large companies.

The second conclusion I have is that there is a bubble in app development, and that bubble is stretched pretty thin. I am not calling the whole appconomy a Bubble (capital B), nor I am claiming that the whole mobile space has gotten overly-frothy (San Francisco real estate not withstanding). Nonetheless, Flurry’s sale seems to me an example of what happens when there are too many venture dollars chasing a too small market. Flurry had a lot going for it,but was never able to find a breakthrough business model.

Again, I am referring to that pivot into the ad market. Flurry has more data on mobile app usage than probably any company out there other than Google and Apple. But the value of that data, apparently is not worth so much. There are too many other companies out there charging little or nothing for smaller subsets of that data. Those companies will probably not exist much longer either, but they were around long enough to make the future of Flurry cloudy enough to merit a sale. This is bad money pushing out the good. I am not saying every mobile ad company is bad, just that there are a lot of bad business models getting funded out there, and that makes it hard for the good business models.

So what does this sale mark? I suspect this just proves what we have long suspected – Google, Apple, Facebook and a handful of others are the big winners in the app market. Google is able to take app usage data and throw it into its core search business, Facebook can do something similar with app usage against its social graph data. And Apple likes having a robust, highly competitive app market because it highlights their integrated hardware’s advantages. I think the mobile ad market is solidifying around the majors. This is not necessarily bad for app developers, but probably should be of concern for the hundreds of ad networks out there.

Finally the Lament

I want to close on a personal note. I was a big fan of Flurry. Not as a customer, but as someone deeply involved in the mobile app space. I will be sad to see them swallowed inside the “mobile first” Yahoo!. Covering the mobile app space has not been easy. Finding hard data has been challenging. For a long time, there was only AdMob and their excellent monthly reports. Much of that team ended up at Flurry after the Google acquisition of AdMob. They continued to put out some of the most interesting blog pieces about mobile usage. You know that meme that compares consumer media usage (TV, Newspaper, Mobile and radio) to ad spending? The one that showed mobile ad spending is poised to grow hugely… That came from Flurry. China is now a huge app market. You know who called it first? Flurry. I could go on, but you get the idea.

As you go into the dark Purple ether, know that you will be missed.

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