The move comes hot on the heels of Rackspace’s acquisition of OpenStack specialist Anso Labs, which NewEnterprise reported exclusively last month. Rackspace is calling the new unit Rackspace Cloud Builders, and will offer training and certification, deployment and support to companies that want to build and maintain their own cloud running OpenStack. Jesse Andrews, co-founder of Anso Labs, has the title of director of development in the new business unit.

Rackspace is just one of a batch of companies backing the OpenStack movement; Dell and Citrix are also big supporters. Dell has created an OpenStack installer that can be used to get the software up on a set of servers, and once field tests are completed, it’s expected to be offered to the open-source community.

The news here is for companies that have been looking on jealously at all those taking advantage of the public cloud, but that for whatever reason aren’t willing or able to do so themselves. OpenStack offers a way to easily build a private cloud that, depending on its structure, offers at least some of the advantages, like ease of of setup, without some of the perceived drawbacks, like a loss of control over data.

Meanwhile, the speculation around Rackspace and whether or not it’s going to be acquired continues unabated. Its shares have improved by nearly 20 percent since the first of year. It’s certainly not behaving like a company that expects to be acquired. Earlier this week it disclosed in an SEC filing a new 15-year lease on more than 21,000 square feet of data center space capable of maintaining a maximum critical load of nearly four megawatts of power, ready for occupancy by February. Combining that with the cancellation of a lease on a smaller facility, the deal is worth $88 million. Maybe when CEO Lanham Napier said the company is not for sale, he really meant it.

So many people have asked Napier about the possibility that Rackspace might be taken out, it’s not hard to detect that his answer is well rehearsed. Rackspace is not for sale, he says, and he won’t comment on any approaches by larger companies it may be fielding. But he clearly doesn’t mind the speculation.

The market certainly is working on the assumption that an acquisition is coming. I talked with Napier on Friday, the day after Rackspace reported quarterly earnings that grew 50 percent over the same period in 2009, which was enough to send Rackspace shares up by more than $3, or more than 8 percent, closing at $40.07–more than twice what it traded for a year ago.

Rackspace will be a giant all its own, Napier insists, before it gets taken out by one of the lumbering tech giants that might like to drop a few billion dollars to absorb it. Ask him Rackspace’s chances of being acquired in the next several months, and he insists the company is not for sale. It sure sounds like he means it, as the growth opportunity that lies before him is just so good. But it’s also clear that he enjoys being in the position of being asked.

It’s a nice sentiment, but organic growth is only going to get you so far. Rackspace will cross the billion-dollar mark in revenue for the first time this year, and it has only $105 million in cash, so the only acquisitions Rackspace can make without going into a debt are small ones like the one last week of Anso Labs that NewEnterprise reported exclusively. The smart money says we’ll get a chance to see how serious Napier is about remaining independent before the end of the year.

NewEnterprise: Let’s talk about your business against the backdrop of the industry you’re in. In the last few weeks we’ve seen both NaviSite and Terremark acquired by larger companies. Clearly there’s some consolidation going on in the Web hosting and cloud services hosting business.

Napier: There is a shift in technology market around cloud. The market is shifting from one where companies do things themselves to buying technology as a service. We think of it as a world that’s going from buying inputs to buying outputs. We think this is a nascent trend and we’re in the first game of a seven-game series. On a macro basis we see this as the biggest growth opportunity in technology. Our strategy is to win the most valuable segment, which we believe is going to be the service segment. So if you look at how the market is developing, you have players like Amazon that’s offering a do-it-yourself cloud. For people who want the lowest price, and can do the work themselves, Amazon is an incredible pick. What we’re focused on is trying to be a service leader. We want to serve companies that want to run a critical app and who want us to run it for them and take accountability for it so they can sleep well at night. Over the past six quarters or so we’ve found ourselves in a crazy good spot. The growth opportunity ahead of us is expanding.

Let’s talk about growth. You don’t have all much cash on the balance sheet, about $105 million or so. You can grow organically, or you can acquire. You’ve made some small acquisitions recently. Is that going to continue?

We are an organic growth company. We have been since inception. The acquisitions we’ve done have been about technology and talent to improve our portfolio and the way we serve customers. We will remain an organic growth company. There are, I think, really two kinds of companies. Those that can grow organically and those that can’t, and so they grow by acquisition. Some companies are good at growing through acquisition. We’re just not. We’re organic growth folks here, so we’re going to stick to that. But we’ll still buy technology, capabilities and talent that we think is critical. As to the consolidation that’s taking place in the industry, it’s a great validation of the growth opportunity. There are some legacy tech and telecom companies that are behind and are trying to buy their way into the game. There was a similar wave of consolidation eight years ago and a lot of our competitors got taken out.

So let me ask the question you’re getting a lot lately. I’ve had three conversations with different people who have each picked three different large technology companies they think should acquire Rackspace. Have you been approached by anyone?

We have a policy not to comment on anything like that all. What I will tell you is that we’re not for sale. We feel like we have a tiger by the tail. I’ve been lucky to be at the company for 11 years and I think the next 11 years look better than the last. We’re not building the company to flip it. We think the market opportunity is such that new giants are going to emerge, and we want to be one of those giants.

Absent a scenario that someone shows up with eight or 10 billion in cash to buy your company, what are your strategic priorities for the year?

There’s a couple. We are making big investments in our product and service portfolio. That’s one. And then number two, we think we have a chance to improve the fundamental economics of our business model. As we make these investments, we’ll add more services and capabilities on top of our basic compute service. This drives up the average revenue for our basic compute which creates better outcomes for our customers and increases our economics. It’s a virtuous cycle. Our average revenue per server has increased for six consecutive quarters.

What are your biggest costs, and what kind of gross margin do you tend to run?

I think of them as investments, but I know that’s just semantics. Our no. 1 investment is technology and the Rackers [employees] that serve our customers. So if you look at the cost of revenue line, a year ago it was 31.5 percent. As of the end of 2010 it was 31.1 percent. We made some improvement. But we’re more focused right now on developing customer loyalty than we are in driving efficiency. It’s early in the game, and anytime a market is going through a period of rapid growth like this, it’s all about winning as many loyal and profitable customers as we can. When the growth slows down someday we’ll focus more on improving efficiencies throughout the business. Even so, in 2010 we grew faster, increased our margin and and improved our return on capital. Those are all difficult things, and we pulled it off.

I’m not exactly sure why Viacom dug up YouTube’s profit-and-loss statement and balance sheet from its pre-Google days, but I’m glad it did. You can see the entire thing, which covers YouTube’s birth in the spring of 2005 through August 2006, at the bottom of this post.

But these excerpts give you a very good snapshot of what was going on in the company’s early days–hypergrowth, followed, eventually, by revenue (click to enlarge):

Some context: Chad Hurley registered the YouTube domain in February 2005, but the site wasn’t up and running for a few more months. Co-founder Jared Karim uploaded YouTube’s first video, “Me at the zoo,” in late April 2005.

By December 2005, users were uploading 6,000 clips a day, and the site was streaming 2.5 million videos a day. By February 2006, those numbers had jumped to 20,000 and 18 million, respectively. In July 2006, YouTube users uploaded 2.1 million clips and watched three billion of them.

Which explains the skyrocketing Web-hosting bills. But do note the burst of revenue from direct sales in August 2006, which allowed the company to generate a gross profit. A lot of people assumed that YouTube had to find a buyer like Google (GOOG) a few months later because it couldn’t pay its own bandwidth bills. But these numbers suggest that this may not be the case.

Also of note for Web video and Web ad nerds/historians: Check out the detailed breakdown of YouTube’s ad revenue and hosting costs, both real and projected, circa December 2005.

youtube pl

balance sheet

The presentation catalyzed a movement. Start-ups everywhere adopted a lean, low-burn, low-investment model. To this day, companies seeking funding at our venture firm, Andreessen Horowitz, proudly proclaim in their pitch decks that they are raising tiny amounts of capital so they can run lean.

On the one hand, it is a fact that capital invested is negatively correlated with returns in the venture capital industry. Pumping too much money into a small start-up is unhealthy for both the company and the investor. On the other hand, Facebook has raised several hundred million dollars and is on track to produce fantastic returns for all of its investors.

So what’s a start-up to do? Much of what has been written and said about lean start-ups makes good sense. However, that advice is often incomplete, and some of the things left unsaid are the least intuitive. In this article, I will articulate some of those things left unsaid in arguing the case for the Fat Start-up.

Here is my central argument. There are only two priorities for a start-up:
Winning the market and not running out of cash. Running lean is not an end. For that matter, neither is running fat. Both are tactics that you use to win the market and not run out of cash before you do so. By making “running lean” an end, you may lose your opportunity to win the market, either because you fail to fund the R&D necessary to find product/market fit or you let a competitor out-execute you in taking the market. Sometimes running fat is the right thing to do.

What the hell do I know?

“Al Pacino couldn’t be no gangsta, DeNiro in ‘Casino’ he no gangsta
Wanna be, wanna see, wan’ get a shovel
dig Tookie up n*&%^!, cause he know gangstas”

–The Game

At this point, some of you are asking yourselves, “What the hell does Ben know? If he were really smart, then he’d know that thin is in.” It turns out that I have some experience in managing a fat start-up through the dot-com implosion of the early 2000s. This chart offers a brief summary of equity market history when I was CEO of Loudcloud and Opsware (click to enlarge):

Note that the Nasdaq index is very highly correlated to the start-up funding environment. During the two years I was CEO of Opsware, the Nasdaq fell 80 percent, far more than it has fallen during the current 2008-10 downturn. So the 2000-02 environment was at least as traumatic as this one for Silicon Valley companies–and arguably much worse.

Here is a brief summary of Loudcloud/Opsware’s fund-raising history during that time:

• September 1999: Loudcloud founded
• November 1999: Loudcloud raises $21 million at a $45 million pre-money valuation (Benchmark Capital is the lead investor)
• January 2000: Loudcloud borrows $45 million from Morgan Stanley (MS)
• June 2000: Loudcloud raises $120M at a $700M pre-money valuation
• March 2001: Loudcloud goes public on Nasdaq, raises $160 million and is valued in the public markets at approximately $480 million. Total funds raised to this point: $346 million.
• August 2002: Loudcloud sells the managed services business to EDS (this was the only actual business we had at the time) for $63.5 million and becomes a software company (and changes its name to Opsware).
• September 2002: Opsware trades for 35 cents per share or approximately a $28 million market cap.
• September 2007: Hewlett-Packard (HPQ) acquires Opsware for $1.6 billion

During this period, Loudcloud/Opsware had over 20 direct competitors. Almost all the competitors from the Loudcloud era went bankrupt, including MFN/SiteSmith, Exodus, LogicTier, Williams Communication, Global Crossing, WorldCom/Digex and Storage Networks. Those that survived got bought with valuations of less than $100 million (e.g., Totality) or still have very low valuations (e.g., Navisite).

How did we do it?

“I had a dream I could buy my way to heaven
When I awoke, I spent that on a necklace”

–Kanye West

So how did we navigate through the great dot-com crash, crush the competition, emerge as the No. 1 company in our space and sell the company to HP for $1.6 billion? Did we “cut spending, cut now, and preserve capital?” Did we make cash preservation our No. 1 priority?

No, we didn’t. To underscore the point, here are Loudcloud’s average monthly cash burn figures for the quarters ending in:

• Apr 2001:  $39 million
• Jul 2001:  $35 million
• Oct 2001:  $29 million
• Jan 2002:  $25 million
• Apr 2002:  $22 million
• Jul 2002:  $19.4 million

As you can see, we were aggressively investing in the business throughout 2001 and 2002. While we did reduce our cash burn, we did not make cash preservation our No. 1 priority. As it was, over the course of the transition from Loudcloud to EDS, we sadly laid off 400 employees and transferred another 150 to EDS. However, we didn’t scrimp and save our way to a $1.6 billion acquisition: Instead, it’s what we chose not to cut that ultimately got us there.

Loudcloud was a Web-hosting business. Today, we’d call it a “cloud services” business, but people weren’t quite ready for the “cloud” in 2001. We supercharged our hosting business with software (called Opsware) that automated our Web-hosting operations. The other cloud services businesses of our day also had software investments. However, as the macroeconomic climate changed, they all “cut deep and cut now.” In the end, they ended up putting their software in maintenance mode and stopped building new features.

As we weighed a decision to make the same deep cuts in our own software R&D efforts (a move advocated by the intelligentsia of the day, as well as nearly every MBA we had working in the company), I faced a hard decision: Cut deep and get to cash flow break-even quickly or continue to invest heavily in software?

In the end, I decided to run fat so that we could continue to invest in the Opsware software. At the end of the day, I realized that much larger companies like IBM (IBM) could hire smart people and train them. But without a lasting technology-based advantage, it would be increasingly hard for us to defeat them and build our customer base despite early wins with Ford (F), Fox Sports, and the U.K. government (to name just three of our early customers).

Running fat meant that I laid off zero software engineers so that we could keep on investing in our technology, find our product/market fit, and build a lasting technological advantage.

Still, we had to reduce costs or we would clearly go bankrupt. With this new view of the world, I decided that rather than divesting our intellectual property, I would divest our business. Now, that may sound logical the way I’ve described it, but consider these facts:

• We were generating $65 million/year from the Web-hosting business.
• We were a publicly traded company with a market capitalization of close to $200 million.
• All of our investors (pubic and private) believed in and invested in the Web-hosting business.
• We had close to 500 employees at the time. Nearly all of them were supporting the Web-hosting business.
• We had no other business. We had software, but we did not have a software product and certainly did not have a software business.

Despite all of this, we sold the Loudcloud hosting business to EDS and became Opsware the software company. It was not clear that this was a good idea at the time. In fact, the market thought it was a terrible idea: Our stock promptly lost 80 percent of its value, putting our market cap at about $28 million. It’s worth pointing out that this was about $40 million less than the cash that we had in the bank.

During the transition, we shrank our payroll from 450 employees to fewer than 100. Even with this massive reduction in expenses, it would take another three quarters to reach cash-flow break-even, a milestone we finally reached in Q2 of 2003.

One could argue–and many did–that we should have cut a lot deeper than we did given that we only had one customer. Although EDS was a very large customer (it generated $20 million/year in revenue), a brand new software company doesn’t need 100 people. We could have taken steps to reach cash-flow break-even immediately (clearly, that might have helped us get above 35 cents per share). In other words, we could have “gone lean” by cutting deep, cutting now, and preserving capital.

But rather than do what seemed obvious, I decided to keep on investing. Here’s why: In an economic boom, cash is great, but not necessarily a meaningful competitive advantage. If every company is well funded, being super-well funded doesn’t help you win. In fact, being super-well funded can actually screw you.

But in a bust (like the one we were in), having a lot of cash can be a huge competitive advantage because you can use that cash to put enormous pressure on your underfunded competitors. And that’s what we did.

We spent aggressively to match our best competitor’s product, feature for feature. And we used our public currency to acquire important adjacent functionality (network, process and storage management) that our competitors did not have and couldn’t acquire because they didn’t have the cash (or the equity).

In doing so, we were able to beat a really high-quality start-up (Bladelogic) that did not have the massive technical and cultural baggage that came from exiting the managed services business. Bladelogic was eventually sold to BMC (BMC) for $800 million. But I’m firmly convinced that had we not spent the money, Bladelogic would have emerged as the No. 1 company in the space and gotten the $1.6 billion exit instead of Opsware.

In the end, by continuing to invest aggressively in our technological advantage despite a hellacious funding environment, we were able to turn a doomed business into a winning one.

That is the very short version of how we won the market during the great tech recession of the early 2000s.

So did we learn?

“Hegel was right when he said that we learn from history that man can never learn anything from history.”

–George Bernard Shaw (1856-1950)

Every start-up is in a furious race against time. The start-up must find the product-market fit that leads to a great business and substantially take the market before running out of cash. As a result, the top two priorities are always to:

1. Find the product that 1,000 enterprise or 50 million consumers want to buy and grab those customers before your competitors do.
2. Raise enough cash and spend it intelligently so that you don’t go broke along the way.

Clearly, you can’t succeed if you don’t achieve both priority No. 1 and priority No. 2. So why is taking the market more important than not running out of cash? Because the only thing worse for an entrepreneur than start-up hell (bankruptcy) is start-up purgatory.

What is start-up purgatory, you ask? Start-up purgatory occurs when you don’t go bankrupt, but you fail to build the No. 1 product in the space. You have enough money with your conservative burn rate to last for many years. You may even be cash-flow positive. However, you have zero chance of becoming a high-growth company. You have zero chance of being anything but a very small technology business (see Navisite). From the entrepreneur’s point of view, this can be worse than start-up hell since you are stuck with the small company.

You recruited all the employees, you raised all the money and you made all the promises. You either see it through or leave–without your good reputation. No one wants to work for an entrepreneur who quits his or her own company. This is start-up purgatory, where you work just as hard, reap none of the rewards, and watch all your best people leave you. It sucks to be you.

The Bottom Line

Spending a little or spending a lot is a means, not an end. Choose the right strategy to win the market or you may end up going straight to purgatory.

As you listen to the virtues of the lean start-up–lightweight sales, light engineering, and so on–keep the following in mind:

• If you are a high-tech start-up, your value is in your intellectual property. Don’t stare at your spreadsheets so long that you get confused about that.
• You cannot save your way to winning the market.
• The best companies can raise money even in this market. If you are one of those, you should consider raising enough to wipe out your competition.

Thin is in, but sometimes you gotta eat.

Ben Horowitz is co-founder and general partner of Andreessen Horowitz. He co-founded Loudcloud, later renamed Opsware Inc., in 1999 and served as CEO of the company before it was acquired in 2007 by Hewlett-Packard. He was most recently vice president and general manager of Hewlett-Packard’s Business Technology Organization Unit.

Denied Internet access by Global Crossing and Hurricane Electric, bot-hosting network McColo is clearly having trouble spewing out spam and malware. There has been a 41 percent drop in spam volume since the Washington Post story broke.

Sadly, it’s certain to rise again, once McColo finds some new upstream providers.
(Thanks to reader Dave Barnes for the tip.)

Denied Internet access by Global Crossing and Hurricane Electric, bot-hosting network McColo is clearly having trouble spewing out spam and malware. There has been a 41 percent drop in spam volume since the Washington Post story broke.

Sadly, it’s certain to rise again, once McColo finds some new upstream providers.
(Thanks to reader Dave Barnes for the tip.)

There is damning evidence that this activity has been going on there for way too long, and plenty of people in the security community have gone out of their way to raise awareness about this network, but nobody seems to care.”

– Paul Ferguson, a threat researcher with computer security firm Trend Micro

According to security experts, Web-hosting outfit McColo is responsible for enabling the broadcast of more than 75 percent of all spam globally. Its client list is a rogues gallery of bad-guy syndicates involved in everything from botnets to counterfeit pharmaceuticals and kiddie porn. So how is it that MoColo’s ISPs, Hurricane Electric and Global Crossing, were unaware of that until notified by a Washington Post reporter?

I’m not sure there’s a good answer to that question, though it would certainly be interesting to hear one. Almost as interesting as hearing the two ISPs explain away their network traffic from known criminal botnets Mega-D, Srizbi, Pushdo, Rustock and Warezov, all of which have their master servers hosted at McColo.

“We shut them down,” Benny Ng, director of marketing for Hurricane Electric, told the Post. “We looked into it a bit, saw the size and scope of the problem you were reporting and said ‘Holy cow!’ Within the hour we had terminated all of our connections to them.”

“Holy cow?” More like, “Holy cow, someone finally noticed we’re the preferred ISP of a massive criminal syndicate! What do we do?!?”

“ISPs can’t take the ‘I see nothing, I hear nothing’ approach to this content,” said Mark Rasch, a former cyber crime prosecutor for the Justice Department. “It’s a little bit like a landlord who owns a building and sees people coming in and out of the apartment complex constantly at all hours and not suspecting their may be drug activity going on. There are certain things that raise red flags, such as the nature, volume, source and destination of the Internet traffic, that can and should raise red flags. And to have so many third parties looking at the volume and content from this Internet provider saying ‘This is outrageous,’ clearly the people doing the hosting should know that as well.”