eBoys: The First Inside Account of Venture Capitalists at Work [NOOK Book]

Chapter 6: Room at the Top

Voltaire's words had been used by the Benchmark partners to solicit capital for their first fund. Would institutional investors welcome another first-time fund such as theirs? Their prospectus optimistically quoted Daniel Webster: "There is always room at the top."

They had sought $85 million at a time others were raising $250 million, reasoning that small is beautiful. Whatever the size, Benchmark's backers expected the capital to be invested in a reasonably short period. With a smaller fund, the Benchmark partners would not feel pressure to invest in deals of only borderline quality, merely to put money to work. A smaller fund should be attractive to entrepreneurs, too, they reasoned. Each investment the partners would make would mean one more board seat that a partner would have to take, so with a smaller fund, they would avoid the danger of shortchanging an individual entrepreneur by having to serve on too many boards.

They successfully raised the fund, but one should look back and note the fragile position of the shooters without a large arsenal, of Benchmark itself, and of its tiny portfolio companies. Successes in a portfolio naturally draw attention, but the stories of companies that do not take off in a dramatic fashion, the ones that falter, are invaluable for reminding all bystanders that the start-up business is actually hard, even in golden times. The brave talk at Benchmark's inception-that young sharpshooting David will win over Goliath-was not borne out immediately.

Of Benchmark's first ten investments, two-Compact Devices and C. W. Gourmet-went out of business without glory. Xantel, which makes PC-based office-telephony hardware, almost did. A small stake in PointCast, the online news-delivery network that was the toast of the Valley in 1995, had brought with it endless headaches as the company groped for a business model while bleeding red ink. Jamba Juice and Broadbase, a software company that developed tools for analyzing large databases like customer lists, did moderately well. PictureVision, which developed a system for digitizing snapshots, could have sunk out of sight were it not rescued by Kodak. Benchmark's very first investment, Silicon Gaming, was done with Weiner Perkins and initially did the best of the first ten. It was the first to go public-but then the stock sank. It appeared that the brightest star of the early batch would be the eleventh investment, in Genesys Telecommunications Labs, one of Bruce Dunlevie's companies, which made software for routing telephone calls from customers in large corporate call centers.

The collective value of atypical venture capital portfolio will go down before it goes up-the pattern is called the J curve-because the companies that are not going to survive die before the best performers begin to shine and pull the value of the portfolio up with them. That, at least, had been the pattern in the past. In Benchmark's case, even though the partners would later talk about their first year of investments as a time of gaining their sea legs and learning how to refine their group approach to investment decisions, and even though the poorest investments were clustered in the very first group, Benchmark never passed through the dip of the J. By the end of its second year, boosted by sixfold gains from Genesys and Silicon Gaming, Benchmark reported to its investors that to date the fund was returning at a rate exceeding 100 percent annually. That's the beauty of a portfolio effect.

Entrepreneurs do not have the luxury of holding a basket of eggs, however; their egg, usually their only egg, must not break. Often the biggest threat to the embryo is not adult birds of prey, the entrenched competition from the Fortune 500, but rather carnivorous fledglings, fellow start-ups, some of which will have first-mover advantages and perhaps better capitalization. In eBay's case, at the time it was still sitting in the nest and Benchmark had invested in it, The Economist estimated that there were more than 150 online auction sites on the Web. One of those was far ahead of the rest, backed by Kleiner Perkins, and was already a public company with a market capitalization of about $175 million.

Onsale's founder, Jerry Kaplan, was at forty-three a well-seasoned entrepreneur with a Ph.D. in computer science. But he could as well have been a showman. He launched Onsale's website in 1995 just as his memoir, Startup, hit bookstores. The book spun an engrossing story of how Kaplan had, in essence, flushed $75 million of Kleiner Perkins's money down the toilet in a vain attempt to make a go of Go Corporation, which produced an operating system for pen Computers. He had dusted himself off and launched Onsale, creating a bidding experience that he described as "part Las Vegas, part P. T. Barnum, and part Price Club."

He had to start out with just his and his partner's money because Kleiner Perkins and every other venture firm he shopped the business plan to had turned him down. When he launched the company, John Doerr publicly derided Kaplan as being far out of his element, noting that he "doesn't have any merchandising or mass-marketing success." Amazingly, Kleiner Perkins later decided to let bygones be bygones and signed up to back Kaplan once again. Kaplan likened his ongoing ability to raise capital to the workings of Hollywood: "Just because you make Waterworld"-referring to the soggy 1995 flop whose reported budget of $175 million was the most expensive to date"doesn't mean you're not ever going to make Titanic."

Kaplan's original business vision was to provide merchants with an online auction site for baseball memorabilia, and initially its offerings were eclectic, including Mickey Mantle autographed baseballs, manufacturer's discontinued computer equipment, fine wines, and the last caboose in use by the Duluth, Winnipeg & Pacific Railroad. He relied on professional merchants or closeout houses, but by structuring Onsale as a commission-based business, he anticipated Auction Web/eBay's, model.

Kaplan quickly shed all lines other than closeout computer equipment; he also shifted away from commissions and instead purchased the closeout merchandise, gambling that Onsale could make a higher margin by taking ownership of the goods than if it remained content with small commissions. The inventory and price risks were tricky, especially so in the computer hardware business, where prices declined daily.

The problem seemed to Kaplan and his backers to be merely theoretical. The company could boast that it was already modestly profitable before it went public, and it appeared to hold special appeal to male buyers in search of computer gear. Ron Rappaport, a Zone Research analyst, described the appeal of Onsale to those buyers: "They go out, they find a good bargain, they hunt it, they kill it, they take it home. And then they're proud of it. They hold that carcass up in front of other Web users and say, `I got this same computer for twenty bucks less!'"

Even if it wasn't twenty bucks less, the hunters returned happy. Kaplan, the showman, could not resist telling the world that Onsale bidders enjoyed the hunt so much that they ended up paying online at his site more than they would have for the same goods in a physical store. A new television set that would normally cost $245 was sold at auction for $340; an $800 notebook computer was won with a bid for $909. "We're shocked at what prices these things go for," he said; he offered by way of explanation the site's tapping into "competition, winning, beating other people."

Onsale's trumpeting of the opportunity for "beating other people" is about as antithetical to Pierre Omidyar's eBaysian culture as it is possible to imagine. At eBay, every completed auction with more than one bidder did of course involve someone beating out someone else. But where Onsale fed blood lust, eBay averted its eyes and pretended the bidding process was entirely bloodless, and instead devoted its efforts to promoting amity. Omidyar would have been content to remain the disengaged pacifist, letting auction buyers choose between it and the warrior philosophy of Onsale, but in September 1997 the barbarians came right to eBay's door. First, Onsale attacked with what eBay feared was a multimillion- dollar spending blitz on exclusive portal deals. Second, rumors were launched that Onsale was going to add a new auction site that would depart from the closeout computer-equipment business and instead be modeled after eBay's, involving individual sellers offering a wide variety of items to individual buyers.

Until this point, eBay had not spent anything on marketing. It only had eighty-five thousand listings on the site, but its computer systems were too fragile to sustain any more traffic, so questions about a marketing budget had been moot. In fact, before the installation of a new system, eBay had to limit to ten the number of items any given seller could list. But when Onsale began to lock up portal positions, public investors seemed to feel that Onsale was securing an impregnable position; as September progressed, the trading price of Onsale's shares jumped and now, in just five months, were trading five times above their offering price of $6. Onsale's market cap had reached half a billion dollars.

Let's remain calm, Bob Kagle urged Omidyar and Jeff Skoll (Meg Whitman had yet to be hired). He said that the portals would not deliver the "competitive preemption" they were selling to Onsale. They would segment their sites, simultaneously meeting the strictly legal terms of the contract with Onsale yet selling advertising space to Onsale's competitors. Let Onsale spend its money there; Kagle favored low-cost guerrilla marketing. Throwing big bucks at portals, whose touted benefits had not been independently confirmed by research, would burn up cash without establishing the eBay brand. Experimental, inexpensive trials with Yahoo and AOL were inaugurated instead.

In mid-1997 Jeff Skoll received a call from Onsale: Would eBay like to sell its customer list? No, it would not, he replied. After this conversation, eBay's engineering staff noticed that bots-software agents-were crawling all over the eBay site, vacuuming up the e-mail addresses of buyers and sellers. Their source was traced back to Onsale. EBay had an attorney send a letter demanding that the crawling stop. Sorry, Onsale replied. Didn't realize it was going on.

The night before Onsale launched its new site, Onsale Exchange, several hundred thousand eBay users received e-mail from Onsale, offering free listings to sellers as an introductory enticement. EBay denounced the e-mail as spam and issued a furious press release, "Internet Community Outraged by E-Mail Assault," in a vain attempt to stir up media attention. Onsale shrugged, saying that it wasn't spam, it was "value-added e-mail." Michelle Kaplan, Jerry's wife, dropped in on the eBay chat room and invited everyone to "come on over to Onsale."

On the same day that Onsale Exchange launched, another competitor, Auction Universe, was relaunched, under the aegis of its new owner, Times Mirror. At the eBay offices, a conference room was dubbed the War Room and decorated with sheets of camouflage and dog tags. The executive staff met daily to plan responses and revive one another's spirits; eBay was feeling encircled by much better capitalized competitors. And when, in December, eBay's listings remained flat for the first time ever, it looked as if eBay's remarkable ride was over.

That was the low point. In January listings picked up; Meg Whitman agreed to come on board as soon as she could extricate herself from responsibilities at Hasbro; and Onsale apparently was not doing so well, because it extended its free-listings offer. Bob Kagle had some news for his Benchmark partners: Jerry Kaplan had approached Pierre Omidyar about merging Onsale and eBay, suggesting that John Doerr and Bob Kagle join the two of them and figure out a deal. Kagle reported to his partners, "Pierre talked with Meg, and they decided they were going to use the excuse, 'Geez, we're just hiring a CEO, and want to get that all integrated and everything.' I told them I thought that was not a good idea." Kagle predicted that agreeing to even talk about the merger would lead to Kaplan and Doerr urging Omidyar to abort Whitman's being hired. Kagle coached Omidyar to say instead: "This deal makes all the sense in the world, and it's bound to happen, there's no doubt about that at some point, but we just have to get public first and have a relatively fair valuation for comparison to make the decision on it."

"In other words," said Kevin Harvey, who relished cutting through politesse, "We like this deal-when we're buying you!"

"The `fuck you, die' thing," said Dave Beirne.

"No," Kagle corrected, "a friendlier version than that. So Pierre is going to call Jerry and let him know that."

EBay had an enormous advantage over the competition that it only then, under challenge, was coming to appreciate: a nicely balanced critical mass of sellers and buyers in each of hundreds of categories. This delicate balance had been achieved through the natural evolution of the eBay ecosystem, without the intervention of any guiding hand. If in any given category there were too many sellers compared with buyers, the sellers would have been discouraged and quick to jump to eBay's rivals to try their luck there. If there were too many buyers, and in order to win an auction one had to offer up a ludicrously high price, this too would have led to mass defections. Fortunately for eBay, the number of sellers and buyers, while growing exponentially, had remained well apportioned.

EBay's users remained loyal for another reason: feedback ratings. Buyers, after a transaction, could send in a report about their experience with the seller, which future prospective buyers could consult; sellers had an identical opportunity to evaluate their experience with the buyer. Over time, both sellers and buyers accumulated a number of positive-feedback ratings at eBay, a neatly quantifiable reputation, that they were loath to abandon. The eBay "community" stayed put.

In May 1998 Jerry Kaplan probed again, this time approaching Bob Kagle instead of Pierre Omidyar. There's only one winner in each category, so the two companies should join forces, he told Kagle, who recounted the conversation to his partners. If eBay and Onsale remained competitors, at best they would always have to explain why the one was different from the other.

Bruce Dunlevie laughed, mimicking Kaplan speaking to Kagle: "You're profitable!"

"That's right," Kagle said, continuing in the same spirit. "Our margins are ninety, yours are ten; let's start with that, then we'll go from there."

"Ours is a good business, yours is a shitty business," added Harvey. Kagle granted that Onsale was doing some things well. Kaplan had been at his gracious best when he said that he just wanted to be part of the winning team and did not himself need to be TheGuy. We'll get a banker to figure out which company would get what percentage of the merged entity, he told Kagle. Whitman could run it. He suggested that the new company be called E-Sale-the place to come to buy and sell anything.

Bruce Dunlevie asked Kagle if Kaplan had shut down his personto-person auction. No, Kagle said, it was still in operation. It presently had 7,000 listings, placing it fourth in size among personto-person auction sites. Collectors Universe, which was second only to eBay, had 22,000. And eBay had 450,000.

"I was thinking," Kagle said, "why would you want to dilute what eBay has with all that crap? I still feel that way, ninety-nine percent to one percent. But there was one thing that did impress me, and the systems side is very, very well run. The guy who is running operations for them is out of Schwab. I think their downtime is measured in some tiny infinitesimal fraction of what ours is. You know how you get that `server's busy' all the time at eBay? Part of it is they've got a fraction of our traffic. But still.

"So Meg's going to meet with them, just to chew the fat a little bit. I still think it's stupid to diffuse the pure play. But it might make sense after going public. Stay tuned."

That Kagle would not categorically rule out a merger did not sit well with the others. Bruce Dunlevie would not let the conversation end there. It was time to administer the same medicine that Kagle administered to other partners whom he thought needed to take a firm stand-what Kagle called the "spine stiffenola."

Dunlevie lifted his chin high and looked across to Kagle with a face of incredulity: "What I heard you just say is the real reason to buy Onsale is they have a good MIS guy"

No, Kagle demurred, he was not proposing an acquisition. EBay's systems could be improved, that's all.

How much customer overlap between eBay and Onsale, Kevin Harvey asked.

"That's the key question," Kagle said. "I said, `Jerry, I just don't see it.' He was giving me this thing about the mall. I said, `Look, the people who hang out at the mall are not the people who go to the flea market.' He said he has data. So I said we're open to data, and we'll take a third-party look at the data and see what we can learn. If there's a huge amount of customer overlap, then there's something to think about, right? But if there's relatively little, which is what I suspect-if there were more, his Exchange would be doing better." "Right. By definition."

"So I just don't believe it," Kagle said. "I think he's blowing smoke."

"He's good at that," Andy Rachleff said.

"Here's my view of the cultures," Kagle said. "EBay is the fair, open, honest marketplace that treats people the way people want to be treated and all that. And Onsale, I can tell you from being there an hour, is make-a-buck. It makes sense. Discount merchants. Toward that end, they've done some things pretty well there. For example, I spent ten minutes or so with one of the merchants who's monitoring all these auctions in real time, figuring out how many do we offer tomorrow, and where do we start the bidding, and how many weeks of inventory do we have of each one. They're turning their inventory on average in three weeks' time, which is amazing, at that level of business. That's not a terrible business. It's just no eBay. Whether you would ever want to take the execution risk of merging them together is a real question."

What are the numbers, Dunlevie wanted to know. How much do they lose on how much revenue? What's the break-even point in their business?

"Well, they have broken even in the past, at one point."

"Before they went public," Rachleff pointed out.

"Right, before they had to start buying traffic," said Dunlevie.

"Exactly," Kagle said. "All he told me is, `We're six to twelve months away from breaking even again.' I was reading tough quarter on his face. We'll see. He seemed a little too anxious."

Harvey, like Dunlevie, remained extremely skeptical of Onsale's business model. "Only on the Internet do you see this kind of revenue multiple on ten percent gross-margin businesses. That's going to go away. Unless you have a brand that's bigger than life."

"Unless your business is huge," Dunlevie said.

Kagle now seemed less ambivalent. "There's a lot of reasons to keep eBay pure-play. The story. The community. The culture. Everything."

Rachleff laughed. "Bob, I don't think you're getting any pushback!"