SAN FRANCISCO (The Red Herring) - This is not a fairy tale. In fact, it may have happened before and probably will happen again.
It's a story that exemplifies the deal-making process and demonstrates where the power lies in the high-tech industry. It's about money and entrepreneurialism and, perhaps most of all, pragmatism. Like many Silicon Valley stories these days, it has a happy ending--deliriously happy for some. This is how the venture capital firm Draper Fisher Jurvetson (DFJ) parlayed two Web-based e-mail companies into a half-billion-dollar jackpot.
Three years ago Hotmail and Four11 were related but noncompeting startups pounding the pavement for venture capital: Hotmail was peddling a free e-mail service, among other ideas; Four11 was an Internet directory service provider. When Hotmail founders Sabeer Bhatia and Jack Smith first approached DFJ in early 1996, the VCs were unimpressed. "They were promoting a database product that other people already had," says DFJ partner Tim Draper. "We were about to show them the door when they mentioned the free e-mail idea. We ended up funding them with approximately $300,000."
Nearly six months earlier, while playing Ultimate Frisbee, DFJ had closed a deal with Four11 for slightly more than $800,000. It wasn't until a party DFJ held for its companies that the VCs introduced Hotmail's founders to Four11 CEO Mike Santullo. The two companies initiated a partnership, but while working with Hotmail, Four11's leaders quickly spotted opportunities for their company to increase its offerings. "We focused on Internet directories at the beginning, but we decided that we needed to expand our model to include different online communications services--one of which was Web-based e-mail," Santullo says.
DFJ was reluctant to endorse Four11's move into Hotmail's territory, but Four11's evolution was inevitable. "Four11 was our directory when we launched our first product," Bhatia of Hotmail says, "but it became apparent to them that we would be very successful. We were sending more subscribers to Four11's directory in three or four months than they had amassed in two years. Even though I was told that DFJ had discouraged them from getting into the e-mail business because we were there already, they started developing it internally when they saw how successful it was for us."
Much of Hotmail's growth may be attributable to a marketing suggestion from DFJ that Hotmail include a line at the bottom of each e-mail message that would direct the recipient to the free e-mail services offered at Hotmail's site. "When we first suggested it, they were taking the purist point of view, saying, 'We can't do that--it's spamming!'" Draper recalls. "But by the end of the conversation, it dawned on them that it wasn't much different from running a banner ad."
The result of this simple marketing device was an explosion of Hotmail's subscriber roster. "Hotmail grew its base faster than any company I can think of," DFJ partner Steve Jurvetson says. "They've spent just $500,000 on advertising in their whole history; they have several hundred thousand users in India alone, and they've never even done any marketing there." Draper says this expansion drove Four11 to diversify: "Hotmail executed so perfectly and their growth was so strong that the power in the relationship shifted toward Hotmail, and Four11 realized they had to develop their own e-mail service."
Playing favorites
After this split DFJ quickly realized that the firm needed to adjust its interaction with the two companies. (Other early-stage investors in the two companies included France Telecom and Olivetti in Four11 and Menlo Ventures in Hotmail, but, according to DFJ, Jurvetson and Draper were the companies' point people on the VC side.) This adjustment involved a considerable departure from DFJ's typical modus operandi. Because Hotmail and Four11 had become competitors, legal impediments made it impossible for the VCs to remain privy to the inner workings of both. Draper stayed on the Four11 board, while Jurvetson worked strictly with Hotmail.
Despite the arrangement's intricacies, Jurvetson says DFJ never considered using legal advisers. "We have an allergy to lawyers in general, so we didn't want to get them involved--and we knew the people involved weren't litigious," he says. "We put up a Chinese wall and simply did a really good job of keeping silent." He admits that it wasn't always easy, however. "It was frustrating because we're used to working as a team, and suddenly 100 percent of my focus had to be on Hotmail," he recalls. "I can remember standing outside a Four11 meeting, looking through the glass doors and wondering what they were talking about."
The wild card in this process was the third DFJ partner, John Fisher. Fisher acted as a sort of floater between the two companies, dispensing advice but, he insists, never betraying any competitive information to either Draper or Jurvetson. In the end, Bhatia and Santullo were wholly satisfied with the process. "The situation was a little out of the ordinary because Jurvetson had attended a lot of our board meetings at first," Santullo says. "But once the Chinese wall went up, they did a good job of honoring it."
Enter the princes
Although every entrepreneur would like to create the next Microsoft or Intel, the reality these days--certainly in the software industry--is that most nascent companies eventually must merge, get acquired, or die. But Draper, for one, says that Hotmail could have been a strong stand-alone company, and throughout most of the acquisition process he encouraged Bhatia not to sell.
Before either company could earnestly consider an initial public offering, a lineup of big companies came calling. At one point, apparently, Microsoft was thinking of buying Four11, and DFJ was weighing its own options. "One of our thoughts was to merge the two companies," Draper says. "It was a bit of a chess game. Santullo was entertaining offers, but I kept telling him no because I recognized the value of his company's service." Jurvetson says the role of the VC in instances like these is extremely delicate. "The last thing we wanted was for the two companies to compete with each other, to get acquired, and to weaken each other in the process," he explains, "The worst case would have been for Microsoft to play the two off against each other."
As the offers came rolling in, Draper says the figures that were dangled in front of Santullo became too difficult for him to resist: "I watched these companies mesmerize Santullo with how much money he personally could make. Finally Yahoo got the nod." Four11's selling price was approximately $93 million.
Santullo, now a vice president of corporate development for Yahoo, says he chose to be acquired because of Four11's second-place standing in the free e-mail market, figuring Four11 could use Yahoo's presence to build partnerships and a subscriber base. "We went the acquisition route because we were fast followers in the market but definitely not the leader," he says. "Hotmail had a lot of momentum and not much competition. And to establish a seat at that table, it became clear that we would need a lot of partners. Yahoo provided that."
Glass slippery slope
The Four11 deal both freed up Draper to work with Hotmail and gave him experience that undoubtedly helped the negotiations with Microsoft. "I'd just been through the whole process with Four11, and I'd seen the entrepreneur's eyes when he found out how much money he could make. When Sabeer got back from his first meeting in Washington, he had the same look Santullo had, and I thought, 'uh-oh, we've got trouble,'" he says.
Bhatia admits that the Four11 deal hastened his desire to sell Hotmail. "We knew Four11 would become more formidable because Yahoo is a strong company," he says. "With Microsoft we would get additional distribution and deep pockets. Plus, we didn't want to create another competitor, because Microsoft clearly indicated that if we didn't partner, they would enter the space on their own."
While Draper scrambled around looking for alternative funding to give Hotmail some leverage, Microsoft continued to woo Bhatia. "When the other options didn't come through right away, I put up $1 million myself, and a few others put in about $4 million more, to let people know that Hotmail was in a strong position," Draper says.
Microsoft's second offer was about twice its first. "We were starting to get a lot of pressure from everyone to sell," Draper says. "The last thing we wanted to do was block a deal, but we also wanted to hold out for the best deal." The strategy worked: Microsoft ultimately paid about four times its original offer for Hotmail, an amount rumored to be about $400 million.
Bhatia, now the general manager of Microsoft's wholly owned Hotmail subsidiary, is understandably jubilant about his fortunes. "If we did it over again, we would do everything exactly the same way," he says. Although the industry consensus is that Microsoft overpaid for Hotmail, the discrepancy between its price and Four11's is attributed primarily to the size of Hotmail's subscriber base, which at the time it was sold was about 1 million, ten times larger than Four11's. Despite his smaller windfall, Santullo is satisfied with Four11's acquisition. "I have no regrets at all," he says. "We thank Hotmail for creating such a good space and enabling us to follow."
Despite the trickiness of managing two competing companies through this process, Jurvetson says DFJ would do it again. This enthusiasm undoubtedly is fueled by the fact that the money DFJ earned from the two deals doubled its $25 million fund.
And they all lived happily ever after.
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