Invest in Music Startups?

In my first few months at Venrock, I have seen many music deals. I’m happy that entrepreneurs and existing digital music companies have sought me out to look at their companies. The unfortunate truth, however, is that we are unlikely to invest in many music companies in 2009. Here’s why.

The digital music business is not an attractive sector for VCs and investors in general. This is largely due to the economics of the underlying licensing deals. The great mistake the major labels made was to set licensing terms in punitive ways, treating start-ups as predators instead of partners. They still have not realized that they must innovate their way back to consumer relevance. The best way to do that is to partner with leading entrepreneurs. If they treated these relationships as partnerships, they would have set terms which allowed joint business success. But voluntary licenses never allowed for that, and as a result, I can think of only two or three digital music business (out of hundreds) which have built actual businesses on top of licensed music (iTunes, eMusic & Rhapsody — note Pandora is successful but does not depend on voluntary licensing.). Even sadder, the best entrepreneurs have moved on. I have seen dozens of great pitches in the past few months and none are around music.

I don’t expect this reality to change in any meaningful way in 2009. The record labels and publishers need a generational shift in their management teams and a drastic alteration to their compensation structures to encourage risk-taking, investment in new businesses, and allow for cannibalization of their existing, declining business. They need to embrace come-one, come-all licensing, offer simple, transparent and equitable licensing without demanding arbitrary advances and guarantees. Otherwise, the only businesses which reach scale and are interesting to consumers will be the infringers (like Project Playlist) which we’d never fund as infringers.

I honestly hope this all changes. I still believe there are far more interesting digital music services that consumers would support, but there is little incentive for great entrepreneurs to build them.

Digital – It Shrinks The Pie

In 1996, when many of us were lauding and forecasting the impending digital transformation of media, one observation we made was the great margin enhancement likely to result from analog media turning digital. We saw the disappearance of physical goods as a reason to expect margins to expand. No more trucks to distribute newspapers, no more physical COGS for plastic shiny discs, no more giant warehouse and inventory costs tying up valuable capital.

But two things are happening to undermine that: First, markets are efficient. As the lower digital cost structures appeared, margins naturally compressed to take advantage of that. Second, as advertising for the first time because highly measured, CPMs plummeted based on the (newly discovered) efficacy of online marketing. Where TV CPMs can be $80, video ads online fetch $25 CPMs. Many people argue that this is because TV is “more valuable” a medium. I contend it is simply because we can actually track who is watching online, and it’s far fewer people than we expected to find. If we knew the truth about TV ads, advertisers would not pay $80 CPMs.

Jeff Zucker, in one of the few comments of his with which I agree, said…

“Our challenge with all these [new-media] ventures is to effectively monetize them so that we do not end up trading analog dollars for digital pennies.”

Well, that is exactly what is happening, and it cannot be stopped. The “new” super-blog newspapers and magazines like Huffington Post, and Silicon Alley Insider will continue to be fantastically successful delivering a product highly appropriate for this medium. But they will do so with vastly reduced cost structures more appropriate for the modesty of their business size. They will fetch $10 – $20 CPMs (maybe a bit more when highly targeted) and deliver revenues of $10M – $40M at maturity. Those are interesting numbers when their cost basis includes 10 employees and some space on Amazon S3 and EC2. But these new web businesses do not support housing your employees in a landmark building at 43rd & 8th or the CondeNast building at 4 Times Square. And Hulu and Veoh won’t support the compensation structures and elaborate media exec pay packages at NBC.

Indeed, we now know that digital shrinks the pie. Something like for every $1 of ad revenue that goes to Politico.com or YouTube probably takes $5 away from a traditional media company. The new businesses are taking audience away, selling advertising for less, and doing it all for a fraction of the cost. The good news is that this is disruptive and new value is created elsewhere. The flip side is that the new businesses will have tighter margins as a result of the great efficiency available online. Hey, at least there are no trucks and warehouses.

The only way the Big Three can have my money

The only way it makes sense to bail-out the poorly-run and dying US automotive industry is with severe requirements attached to the money. Here’s what I would do:

1. All three must immediately enter Chapter 11 and the US Gov’t becomes the debtor-in-possession.
2. During Chapter 11, the US Gov’t will guarantee the warranties of any cars purchased.
3. Each automaker must close 40% of their factories, 40% of the dealer network and discard at least half of their brands. It doesn’t make sense to keep Buick and sell Volvo. No sacred cows. Under-performing brands are gone.
4. By the end of 2010, no single non-truck vehicle can be sold that gets less than 40 mpg
5. The existing UAW contracts are immediately terminated. The US will assume normal pension benefits to existing retired and terminated workers. All wages, heathcare, and so-called “job bank” programs will be re-neogtiated in accordance with the bankruptcy process. The new UAW deal will reduce wages and all-in labor costs to be 10% less than that of Toyota.
6. Every worker terminated as part of the restructuring can choose to enter the largest job/skill retraining program since the WPA. For one year, a US-sponsored program will retrain every worker to learn how to build solar panels, nuclear reactors, and other clean-tech products. During that one year program, each participant will be paid a fair wage equal to the equivalent salary of a similarly-skilled Toyota employee. At the end of the one year retraining program, the worker is on their own and may have to move to join the green tech companies that will quickly emerge from this program.
7. Each company will sign an agreement forbidding any lobbying on CAFE mileage standards, pollution standards, or OSHA worker safety rules for a period of 25 years.
8. Every C-level and EVP executive in the company is immediately terminated without severance and may choose to enter the job retraining program. Key executives may be selectively re-hired at adjusted salaries but will likely be replaced.

The companies will emerge leaner, stronger, and focused on building competitive, high mpg automobiles at reasonable cost structures. Unless a litany of conditions such as this is placed on all the capital offered to the companies, I am adamantly opposed to a bail-out.

Half-baked idea: an open source VC

What do you guys think about this?

An open source VC. Suppose I exposed an API that gave you access to every pitch Venrock sees? You could get access to every deck we get and all the work product we produce as we evaluate an investment. There is a lot of data inside Venrock on the performance of past investments, the best structures which produce the best returns, etc. We could group collaborate on valuing the likely outcomes of the company. We could collectively monitor the twitterstream, the blogosphere and crowdsource the view of our network as to the likely prospects of the company. Once we decide to invest, we could use our collective networks to promote the company, create distribution deals for our companies, and otherwise work to build it into a successful enterprise. For every deal we decide to do, we would create some sort of carry-sharing where the economic upside is distributed among those in the network. Not sure how we divide up the spoils in a way that is fair. More to come on this, but surely there is power in the network we have assembled. Thoughts?