(The views expressed here are those of the author. AssureConsulting.com takes no responsibility for them. The article was first published in http://www.waxy.org/random/arsdigita and was written by the CEO of the company before the settlement.)

ArsDigita: From Start-Up to Bust-Up

f you've been hanging out around courthouses in Delaware lately, you may have heard about some legal acrimony involving ArsDigita's venture capitalists versus the ArsDigita co-founders. This letter explains how it came about (from the perspective of one of the defendants).

Note that 99 percent of the information in this document is irrelevant to the lawsuit. The lawsuit has to do with the rights of the shareholders to control management based on some technical points of law and contract. In other words, the questions of who is best qualified to run the company and whether business decisions have been correct are largely irrelevant.

Background

Let's go back to 1993. That's when we started developing the domain knowledge that led to the ArsDigita Community System product. Most people who've made money in the software business are those who wrapped their minds around a problem earlier than others. You can't base a business on "we'll be better programmers than the folks at Microsoft and Oracle"; each company has enough computer science PhDs and expert software engineers to bury 100 competitors. You can, however, base a business on "we'll attack this problem a few years before Microsoft and Oracle notice it and recognize it as a problem."

Adobe is a good example of a small software company that has thrived despite possible competition from much larger companies. Check out www.adobe.com /aboutadobe/pressroom/executivebios /johnwarnock.html and www.adobe.com /aboutadobe/pressroom/executivebios/charlesgeschke.html You can see that these two guys, who have managed Adobe since its inception, spent a lot of time at Xerox PARC and Evans and Sutherland grappling with substantially the same kinds of problems for which Adobe provides solutions.

Adobe's engineers and founders aren't smarter than Microsoft's; they merely started thinking about graphics and publishing before the Microsoft folks did.

Fast forward to 1998. We have contracts with a few big companies: AOL, HP, Levi Strauss, Oracle. We are recognized as thought leaders (publication by Macmillan of Database Backed Web Sites) and market leaders (our open source software for online learning communities). As GE's Jack Welch will tell you, it is a lot easier and more fun working for a company that is #1 or #2 in its market. For one thing, customers will knock on your door.

By 1999, customers were knocking like crazy. A good example was Siemens. They had a critical business problem that could be solved by the ArsDigita Community System. Recognizing the goodness of fit between our product and Siemens's problem, Boston Consulting Group brought them to our old HQ (603 Franklin) and within two weeks we had a contract.

We expanded. We were still small, though, and we avoided direct confrontations with heavily financed competitors. They were closed-source; we were open source. We'd undermine them by creating a world-wide open-source standard rather than try to outshout them with full-page ads in Business 2.0. We laughed at most of the small closed-source companies, asking "What's their marketing slogan? We're just like Microsoft and Oracle but without the market leadership and profits? And how does that slogan work for recruiting?"

By March 2000 we had grown to 80 people. I was still CEO and beginning to feel nervous that, for every task in the company, I could not say exactly who was supposed to do what and by when. But we were profitable, with monthly service contract revenue coming in at a $20 million/year rate. We'd paid nearly $1 million in income tax on our profits for calendar year 1999. Not so bad considering that we built everything from a $10,000 investment.

We'd never sought venture capital but our revenue and profits were bringing some of the top East Coast firms to our door. Most of the time these guys were being forced by the frenzied times into investment in a company and figuring out how to get revenues later (and profits much much later). ArsDigita looked a lot better than than the typical "wing and a prayer" bunch of guys with a fancy spreadsheet. Despite 1000 percent annual growth, we had cash. Most of our revenue was recurring. Most of our customers were happy and loyal.

Companies don't like to rely on enterprise software from small companies. There is too much risk that the vendor will go bankrupt. Open source ameliorates this risk to some extent but the tendency to stick to IBM, Microsoft, and Oracle is strong. We tried to present a face of financial invincibility to the world. We bought a Ferrari to give away to any employee who recruited 10 friends. In reality the car only cost $2,000 per month, the person who won it only got to drive it for as long as he or she was employed, and the cost of a Ferrari is much lower than 10 headhunter commissions. But sitting in the parking lot it gave us the appearance of extravagance while inside the building we were living the frugal life--in a world starved for software development talent, it would have been hard to lose money paying MIT-educated programmers $50-85,000 base salaries plus an end-of-year bonus based on accomplishment and the firm's performance. We had a couple of other Ferrari-like schemes up our sleeves. One was a beach house on Cape Cod where teams of programmers would go to work and write. Another was ArsDigita University, a tuition-free post-baccalaureate one-year computer science program. These things sounded outrageous, gave people a way to remember who we were, gave journalists a reason to write about us (and they did), all while costing no more in total than our 1999 profit (i.e., practically nothing if our revenue had continued to grow).

At the end of March 2000 we closed a venture capital financing with Greylock and General Atlantic. By the time a couple of small checks arrived we had an extra $38 million to put in the bank. We figured that we could use the extra money to place some bets on product development and marketing. Under the product development rubric we thought we'd not make the client teams carry the full weight of ACS development on their shoulders. If they found a client whose needs were similar to what we wanted in the product, we'd do the job for a low-ish price to get experience with that problem (see the "domain knowledge" sentence above) and develop reusable code to enhance ACS. Under the marketing rubric we'd expand our "education marketing" program. Finally, we wanted working capital. A company with $20 million in revenue really needs to have about $10 million in the bank in case a customer doesn't pay, the economy turns soft, an important project is late, etc. Because we'd been growing 1000 percent per year we never had more than a couple of million dollars in the bank.

The terms of the venture capital investment were that the VCs purchased stock that gave them about 30% of the issued shares. Under standard corporate governance, a minority ownership interest such as this would give the VCs little or no control over the direction of the company. So we also had a stockholder's agreement that required the existing shareholders (myself and Jin Choi) to vote for a board of directors that consisted of

1 Greylock person
1 General Atlantic person
3 senior officers from ArsDigita, including the CEO
2 outsiders

So the VCs would have 2 out of 7 board seats. The shareholders would elect the rest. Plus the VCs got veto power over certain kinds of big transactions, such as the buying of expensive capital equipment, the selling of the company, the acquiring of another company. Finally in the event that the company was sold, they were entitled to the first $38 million off the top of the deal (note that this makes all of the common shares theoretically worthless in the event of a sale for less than $38 million). The terms we'd been offered from the three other serious venture capitalist bidders were similar. They wanted "a seat at the table" but nobody was asking for absolute power over the company going forward; the firms proposed to help ArsDigita's founders do what we'd been doing successful already.

In parallel to all of this VC stuff we'd been trying to recruit an "outside CEO". Based on my conversations with successful business people around the world, I now believe this is a fundamentally bad idea. Even the most able person will need a few years to learn about a company's market, challenge, mission, culture, and people. A fresh-from-the-outside CEO might be successful at a 50-year-old company with a huge bureaucracy that manages itself (cf. George W. Bush taking over the Federal Government). But young enterprises don't have that kind of inherent stability.

Anyway, as it happens we recruited Allen Shaheen on the recommendation of Chip Hazard, a Greylock employee who would ultimately represent the firm on our Board. Allen came from Cambridge Technology Partners (CTP) where he managed a large group of consultants in the overseas division of this IT services firm. I knew that Allen had no background in the software products business and that he had not been responsible for establishing overall strategy and thought leadership at CTP. In short, he had always worked for someone else and in a less competitive business than software products. Still, the other candidates we'd interviewed had been either very poorly prepared (one from Lotus) or were very aggressive and in-your-face and my top managers at the time didn't think that they could work with them. Allen seemed like the kind of guy who would work well with the difficult personalities populating the companies' far-flung offices. He had experience managing a multi-national services business. So the plan was that I'd keep responsibility for engineering, education, and evangelism; Allen would build the rest of the business.

Within a few weeks of Allen's arrival, I found people telling me that I had no power at all, pointing out that Allen and the two VCs could vote as a bloc on the Board. We had not yet filled the two outsider positions so this point was tough to argue. 3 out of 5 = absolute power. Period.

April 2000 through March 2001

For roughly one year Peter Bloom (General Atlantic), Chip Hazard (Greylock), and Allen Shaheen (CEO) exercised absolute power over ArsDigita Corporation. During this year they :

  1. Spent $20 million to get back to the same revenue that I had when I was CEO
  2. Declined Microsoft's offer (summer 2000) to be the first enterprise software company with a .NET product (a Microsoft employee came back from a follow-up meeting with Allen and said "He reminds me of a lot of CEOs of companies that we've worked with... that have gone bankrupt.")
  3. Deprecated the old feature-complete product (ACS 3.4) before finishing the new product (ACS 4.x); note that this is a well-known way to kill a company among people with software products experience; Informix self-destructed because people couldn't figure out whether to run the old proven version 7 or the new fancy version 9 so they converted to Oracle instead)
  4. Created a vastly higher cost structure; I had 80 people mostly on base salaries under $100,000 and was bringing in revenue at the rate of $20 million annually. The ArsDigita of Greylock, General Atlantic, and Allen had nearly 200 with lots of new executive positions at $200,000 or over, programmers at base salaries of $125,000, etc. Contributing to the high cost structure was the new culture of working 9-5 Monday through Friday. Allen, Greylock, and General Atlantic wouldn't be in the building on weekends and neither would the employees bother to come in.
  5. Surrendered market leadership and thought leadership

How could these three guys have achieved such dreadful results? For that it is worth looking at what kind of leadership is required for a software products company. First, you probably want someone who has previously founded and run a company or been CEO at a company founded by others (i.e., not someone who has been an employee his or her whole life). Second, you probably want someone who has previous experience as an executive in the software products business. Third, you probably want someone with domain knowledge. Fourth, you probably want someone with technical knowledge.

Whatever strengths Peter, Chip, and Allen may have, all three were 0 for 4 on the qualifications listed above.

Software products is a rough business because it moves fast and attracts smart people. Furthermore you have companies like Microsoft where people work nights and weekends backed up by a cash hoard of $20 billion and a global brand. As an investor, you never want to send your company up against the Microsofts of the world unless your managers are smart, hard-working, and have the right experience. If they don't, you need to look for a less competitive business. Maybe you can offer training or admin services for a Microsoft or Oracle product. Or maybe you should get out of the IT business altogether and apply your capital and employees to something like party equipment rental (you don't see too many table and chair rental companies with $20 billion in the bank and MIT PhDs working nights and weekends trying to put their competitors out of business).

At this point you might ask "Hey, weren't you still on the Board?" Sure. But for most of this year Chip, Peter, and Allen didn't want to listen to me. They even developed a theory for why they didn't have to listen to me: I'd hurt their feelings by criticizing their performance and capabilities; self-esteem was the most important thing in running a business; ergo, because I was injuring their self-esteem it was better if they just turned a deaf ear. I'm not sure how much time these three guys had ever spent with engineers. Chuck Vest, the president of MIT, in a private communication to some faculty, once described MIT as "a no-praise zone". My first week as an electrical engineering and computer science graduate student I asked a professor for help with a problem. He talked to me for a bit and then said "You're having trouble with this problem because you don't know anything and you're not working very hard."

A seat on a Board of Directors that never meets

After December 2000 they stopped having board meetings altogether. Instead they had "investor meetings" that were attended by Allen, Ern Blackwelder (the COO, who'd already been told that he was going to be replaced), Greylock, and General Atlantic. In other words, all five board members except me would meet.

Board-level decisions were made not only without the chairman having an opportunity to vote but without the chairman (me) even being given notice. For example, after that final December 2000 board meeting, Allen, Ern, and the VCs (a) decided how much bonus to pay the CEO and COO for 2000, (b) named Jim Jordan to be Chief Financial Officer (see http://www.arsdigita.com/news/), (c) decided to eliminate me as Chairman and announced to the press that I was already gone (implying that I'd resigned though it was untrue), (d) hired and appointed Richard Buck as Senior Vice President of Engineering, (e) hired and appointed Dave Menninger as Senior Vice President of Marketing (again, see http://www.arsdigita.com/news/ ), etc.

What about the two outsider seats?

At this point you might ask "Hey, what about those two outsider seats?" At various times during the rule of Greylock, General Atlantic, and Allen I would push for the nomination of someone with software products experience. Nobody was ever approved. On November 22, 2000 I emailed Bill Helman and Bill Kaiser, two other Greylock employees who'd pitched ArsDigita, trying to set up a meeting to discuss getting a couple of good outsider board members:

... As an investor in the company, though, I'm concerned that ArsDigita is
left without a single engineering expert on the board or on the
management team. I'm not sure what your experience is but mine is
that it is tough for tech companies to succeed without some
engineering expertise at or near the top. ...


They were reluctant to get involved, saying that normally everything should be piped through the Greylock employee actually sitting on a portfolio company's board, in this case Chip Hazard, the very person whose lack of engineering experience was contributing to ArsDigita's bleed. Kaiser agreed to meet me, however, after a couple of weeks. We walked around the MIT campus for 30 minutes. When I explained the problems with the product and the financials, Kaiser said "Isn't it possible that this is just your opinion, that Allen and Chip would see it differently?"

Relativism. It was impressive in a way to see Protagoras's sophism alive and well after 2500 years. But the "all points of view are equally valid and supported only by someone's opinion" ignores the fact that it is easy to measure the correctness of business beliefs: some people are losing money and some are making money; some companies are gaining market share while others are losing market share.

We gave up on the idea of finding any help from the Greylock corner.

With no voice in company operations and with a board seat in a company that did not have board meetings, it seemed that there was no longer anything that I could do to express the co-founders' wills as shareholders. Keep in mind that ArsDigita had been running in exactly the opposite direction from the way that we wanted it run. We started aD slowly and carefully. We ran it profitably. We placed small bets. We handled money conservatively (though we tried to give the appearance of wildness and fantastic prosperity to the outside world there is actually nothing extravagant about having a fancy beach retreat for a team of programmers that is excited and working 6 days/week, 12 hours/day). We made sure that we were working as hard as teams at Microsoft and startup companies.

By contrast, Allen, Greylock, and General Atlantic presented us (Common shareholders) with a strategy of "here's this spreadsheet that shows us going bankrupt in one year unless a big stream of license revenue starts coming in." And, oh yes, the revenue would be coming from a product that had never been built, purchased by customers to whom we'd never sold anything.

Do these kinds of risks bother venture capitalists? Having a first-time CEO with zero experience in the industry? Staking everything on a to-be-finished software product? Perhaps not. General Atlantic has $10 billion under management, according to their Web site (gapartners.com). If they point ArsDigita in a direction that leads to tankage, they can fall back on their $9.98 billion in other investments. What about the Common shareholders, though? We never signed up for this kind of risk and we don't have substantial other investments. I put 8 years of my life into ArsDigita Community System. Jin put in 4 years. We would be unhappy to see the company spend through its accumulated profits plus $38 million in capital merely so that three guys in suits could learn a little something about what it is like to run a software products company.

Philip Greenspun

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