Could VC be a Casualty of the Recession? | Hacker News Reader

Could VC be a Casualty of the Recession?

paulgraham.com

160 pointsmqt139 comments

The startup I work for just hit profitability and we're basically giving up on funding. The offers that we were getting weren't good enough. We'll grow slower, but we won't get dilution unless it's really worth it.

What I'm curious about is that I thought the purpose of VC was not just to stay in business, but to grow fast. I'm pretty sure PG said in a previous essay or comment that if you skip out on VC and someone else takes it you can get overtaken or not be able to catch up to the market leader.

That's an excellent question. Begs these questions:

How much speed does the investment buy you? How much is speed really necessary?

Take the viaweb example: Supposedly, their advantage was in being first. A 6 month head start was a great thing to have when the concept of an online shop was 3 yrs old, the concept of an online shop builder 2 years old & the concept of an online online shop builder 1 year old.

But was it such an advantage? Sure it was from viaweb's perspective. That may have been what allowed them to sell. But what did Yahoo (the buyer) gain from this extra 6 months?

There are still companies making & selling online shop builders of various sorts. They are still largely built by startups. A 6 month head start is virtually meaningless in that market. Yahoo stores is older then any of the players, & it doesn't stand out really. It's a player with a piece of the pie in a pie industry.

Yahoo search on the other hand could have used a 6 month head start. If Google had left them a couple of years to realise they were losing search share, realise how important that was & do something about it, they mightn't have to sit in fear of a hostile takeover.

What am I saying? I think I'm saying that from the early perspective, it's difficult to know if moving first is important. Since when it is important, it is very important, acquires will buy early leaders so the problem is theirs not founders'.

On the other hand, I think it seems likely that the winner take most market is not going to remain the default target. That changes the game. If it's 1997 & you are building an online shop builder to be a serious player with a serious slither of the market in 2017, you can afford a six month break. If you expect a winner to be declared in 18 months, you need any speed available.

The catch 22 is: If speed isn't that critical, you need a different advantage against big companies. But then I think there is one somewhere. Most online shops are not made by huge companies.

It's true that it can be dangerous not to take VC if your competition takes it. But it's not so dangerous if the reason you don't take it is that VCs are saying no to everyone, because that implies your competitors are also less likely to get it.

Yes, but the question the essay is setting out to answer is: what happens when the VCs recover?

I think one of the last points I need to buy into the essay is that it isn't just the starting up costs which have gone down. The commoditization of computing in the cloud means that as long as you're profitable on a per-user basis the cost of scaling is also way down (although the amortized cost might be up).

The other danger is not being able to hire enough of the right people, but the number of people necessary does seem to be going down as the tools get better. The startup I'm working for has just decided to stop looking for funding and do our hiring more slowly over the next year, so I suppose we're a part of that trend.

Yes, but the question the essay is setting out to answer is: what happens when the VCs recover?

I've been thinking about this a lot recently. I think that the answer is, that VC's aren't going to be able to fund web based software startups as much. We just don't need the money.

Who does need the money? Green Tech, Biotech, hardware/embeded, enterprise software. Those companies can use the capital and might actually be willing to jump through the hoops necessary to IPO. VC's only really get paid off when companies IPO or get acquired for huge sums of money.

I think that this is going to be a water shed in Silicon Valley culture. One of the reasons that there are so many software engineers in the Valley, is because there have been a lot of VC funded startups and jobs since the first bubble in the 90's.

VC money is going to start chasing different kinds of companies, which means more green tech, biotech and hardware/embeded, enterprise software jobs. That means more electrical, genetic and chemical engineers and less software engineers in the area.

This in my mind is the interesting question ... does cloud computing provide the means for scaling. No doubt a web business can achieve profitability on much less than before, but the question of whether VC is needed is in scaling that business to something other than a small profit maker and/or an exit to a larger company.

I guess we'll see how that plays out. One of our competitors has taken $1 million in funding, the other has taken $10.5 million in VC funding.

http://www.crunchbase.com/company/fansnap

http://www.crunchbase.com/company/tickex

"we got a record number, up 40% from the same cycle a year before."

I agreed with much of this article, but not that line. A lot more people have heard of YCombinator since a year ago, so all else equal, you'd expect applications to rise over that period. So comparing the number of apps with the corresponding value from a year ago isn't a fair comparison.

Indeed, looking at http://siteanalytics.compete.com/ycombinator.com/?metric=uv we see that the number of unique visitors to ycombinator.com is up 3x from a year ago. But applications are only up 40%. To be fair, we probably can't expect applications to grow 3x since many of those visitors are international, or otherwise unlikely to apply to YC. But to make the statement pg wants to make, I think we need a better metric than raw growth in applications.

Perhaps I should have added that 40% was more than applications usually go up year to year.

I'm pretty sure, based on conversations with founders, that this spike in applications wasn't due to people learning of our existence for the first time. Most people we interviewed seemed to have known about us for a while.

I don't think application numbers are much correlated with News.YC traffic either. I think most people who come here are just looking for what people found at Reddit 3 years ago.

Ah, okay. That does make it interesting.

The interviewees might be a biased sample of applicants, though. I guess you could get some insight into that by looking at data on the age distribution of the the accounts that applied, and comparing that to previous cycles. But I suppose you have better things to do :)

"I'm pretty sure ... that this spike in applications wasn't due to people learning of our existence for the first time."

Maybe the spike wasn't, but my application was. I never heard of YC until three days before the deadline. It's a coincidence that I was already working on a new app so I had a reason to apply.

Wasn't it also the first cycle where "Startup Ideas We'd Like to Fund" came into play? That seems like a giant roadmap for anyone who may have heard about YC and never seriously considered it before.

I guess the test is: Were the pitches clustering more around those ideas?

I realized that might be a difficult question to answer.

One more test I can think of: If, as expected, the recession is still bottoming at the Spring deadline then the numbers (gross or percent change) should be comparable if that craziness is driving folks, in swarms it seems, to the founder path. However, if it was "Startup Ideas...", then, as a singular event, the growth should be closer to a normal rate if not an overall decline in gross from the Winter.

Care to make a guess which way it will go?

While mid-October was well after the "crash" there would have been no impact on founder's and their dreams. The types of founders that YC encourages are recent college grads who have not learned anything about economic cycles. They do not look at what is happening to housing, the stock market, the bond market, and decide to hunker down and get a job or go on to grad school.

Drawing conclusions from a single data point, proposals received in October, is as faulty as deciding the world is careening into climatic disaster based on drops in temperature measured in fractions of a degree C over the last few years.

"Maybe things will be different a year from now, if the economy continues to get worse, but so far there is zero slackening of interest among potential founders."

(http://paulgraham.com/divergence.html)

I would like to believe Paul's thesis, but in the back of my mind, why do I get the feeling "He is trying to scare investors into putting money"?!

Seriously, I think over-supply of start-ups will crash prices. Yes, there is no limit to wealth creation, but even so, it is easy to upper-bound wealth creation over, say, the next 5 years. We can say with confidence there won't be more than, say, $10 billion worth of web start-up acquisitions over the next 5 years (in total, not per year) - that was about the total in the last 5 I would estimate and I think I am being fairly optimistic here. Even that $10 billion would be parceled out in the 80-20 rule - a couple of YouTube home runs, a few singles and doubles, and the remaining mass of start-ups have to fight over a fairly small pot of gold.

My objection is consistent with economic theory: over-supply leads to serious price crashes, even when you make the favorable assumption (which is not exactly true in the start-up case) that in the long run, the over-supply can be absorbed.

If I were motivated only by self-interest, I should want later stage investors to drop out. That would leave seed stage investors like YC as the only game in town.

And incidentally, I don't see why it's easy to upper bound wealth creation over any time period. If everyone woke up tomorrow and started working twice as hard, what would limit their output?

Why would you want later stage investors to drop out? You have early, cheap equity; don't later stage investors reset the valuation and give you a shot at cashing out if you want? (I really don't know, I'm actually asking).

The valuation goes up between us and a series A round, but in a successful startup it should go up much more afterward.

How many companies that get a series A round end up being successful? It seems like having that opportunity to decide if you agree that the company will keep growing or that you've made enough and would rather reinvest in the next round of startups would be nice to have.

It wouldn't be nice to the startups to do that, because it would send an alarming signal to the series A investors that would drive down the valuation and maybe even prevent the round from closing.

If everyone woke up tomorrow and started working twice as hard, what would limit their output?

demand and supply, as always

it is trivial for some hypothetical foobar corp to spit out twice as many widgets as they do now. but why would they? without viable demand, they indeed show a loss for their effort-spurt. as you heard the CEO of ford say today, oversupply was a major problem for the automakers. working twice as hard will kill you if you don't have twice the demand

the better question is how currency growth can be employed to stimulate demand over a period of time. growth comes from healthy inflation (3-5%). inflation is always a monetary phenomenon. this is why you will often hear opponents of "secured" currencies (gold etc) tell you that you can't get growth in an economy in the mid term unless you have a fiat currency.

What limits demand for cars is that people can't afford them, not that they don't want them. But since by my assumption everyone is working twice as hard, including the buyers, there should be demand to match the supply.

no, the demand does not manifest itself spontaneously. people just don't decide to wake up and work twice as hard, there has to be legit economic growth. there is a monetary role. its no coincidence that "healthy" economic growth conforms to healthy monetary growth. this directly addresses your point of people wanting cars but not being able to afford them. this demand could be trivially induced artificially by monetary means, but it would lead to unhealthy inflation

monetary cycles typically manifest over an eighteen month period. i.e. the increase or decrease in Fed policy would impact demand directly likely no less than a year. the only way to dramatically alter this...i.e. to actually get people to wake up and work twice as hard takes drastic currency action.

this is all undergrad economics

"What limits demand for cars is that people can't afford them, not that they don't want them."

Or that they already have them? In the U.S., isn't the ratio of eligible driving population to drivable autos approaching 1? So, twice as many cars would likely not find buyers and drive down prices a lot.

Sorry if I'm missing the bigger picture stuck on this specific detail.

Maybe try the idea that everyone works twice as hard, but instead of building twice as much stuff, everyone just builds the same products better.

(Of course, if you think about this carefully enough, the distinction between "more" stuff and "better" stuff falls apart.)

Is it not the case that like a VC, a seed-stage investor maximizes his income when the startup he funds tries to hit a home-run? And are not home-runs much more likely if a VC invests in the startup?

Home-runs are more likely if VCs invest, but it is hard to say whether this is because VCs select the companies most likely to be big successes, or because their participation makes companies big successes. So it is very hard to predict what would happen if startups stopped taking VC.

"If I were motivated only by self-interest, I should want later stage investors to drop out. That would leave seed stage investors like YC as the only game in town."

But isn't the entire YC experience designed to get angels and VCs at demo day to make an investment in each company?

No, the main focus is on whatever the startup is building. Toward the end of each YC cycle we switch to talking about how to pitch to investors. But even there the way to be convincing is to be working on something genuinely great, and just tell the truth about it.

Why are you focusing on acquisitions? There are profitable companies that remain private, like 37signals (plus ones you never hear about because there's no point in talking about how much money you make) and also IPO, which is rare but potentially huge. Google alone is worth $86B, at that IPO was only 4 years ago, so your "$10B in the past 5 years" number is clearly incomplete.

If your thesis is correct, then these are really the ones that need focusing on. If the world is about to be be bombarded with startups, they can't all be bought or go to IPO.

The remaining startups will need to find a middle ground of some sort.

I don't think there's any limit to the number that could get bought. The upside that founders are willing to trade in exchange for safety is an opportunity that would call acquirers into being if they didn't already exist.

And why couldn't there be 100 or 1000 times as many public companies? Stranger things have happened in history.

"And why couldn't there be 100 or 1000 times as many public companies? Stranger things have happened in history."

They would need to be smaller or the economy would need to be bigger. Ties in with your other essay.

There could be 100 times as many U.S. public companies while Sarbanes-Oxley remains in effect?

Obviously not, but that wasn't the point.

Sarbanes-Oxley is probably not going to be repealed or significantly reformed, so was the point purely theoretical?

It's a mistake to view political barriers as insurmountable. It's practically impossible to repeal the legislation, but maybe someone will open another liquid market for equities through some weird loophole. And remember that we are talking about social change in a timeframe of decades here. There is no telling what could happen.

Efficiency and reason tend to win in the end. There is much to be gained by having less bureaucracy and red tape for public companies, assuming that they are public companies of a different type than what they are today.

Private companies can issue dividends too - it's what we plan on doing if we're fortunate enough to get that far (1). M&A is for suckers (2) and IPOs aren't worth the trouble anymore unless you desperately need liquidity (e.g. Google) or you're not profitable.

1 - Assuming the capital gains tax remains similar to what it is currently.

2 - http://is.gd/2Fla

http://news.ycombinator.com/item?id=304790

If there's any truth to pg's claim that the paradigm is shifting and that talented people are increasingly likely to start their own thing than go work for a boss (and personally, I believe there is), then one would expect just the opposite of what you assume: more wealth should be created this way in the next 5 years than in the previous 5, because more value will be. And the productivity delta between startups and large companies will grow even faster, since the latter will be increasingly starved for new talent.

Edit: one might also expect current economic conditions to accelerate this process, since downturns are harder on inefficient players than efficient ones. It occurred to me the other day that for this reason, downturns are a healthy part of the economic system, kind of like forest fires in ecosystems.

If there's any truth to pg's claim that the paradigm is shifting and that talented people are increasingly likely to start their own thing than go work for a boss (and personally, I believe there is)

no there isn't. come back in five years, the top ten internet companies will control 95% of all traffic and 99% of all revenues. this market has almost zero friction...how is it that google has already sewn up over 80% of ad revenues on the web? where are all the mom-and-pop ad networks? they're on deaths door

by the same token anyone can build a PC...so what happened to the 10,000 little PC makers that used to be in every strip mall? today we have basically three pc makers....hp, dell, apple. so much for "low barrier to entry = high res"

I don't get this argument. Assign the top ten companies as high a percentage of whatever as you like: it won't prevent people from seizing opportunity to create value at a higher rate than large organizations are able to do. The point is that the two barriers that largely prevented talented people from doing so in the past - cost of entry and cultural beliefs - don't hold sway anymore.

The fact that some markets have matured and been commoditized hardly implies that there is no new value to be created.

The problem is, "low cost of entry" is just another way of saying "commoditization". Your argument depends on the assumption that because it's cheaper to produce a website than (say) a motherboard, it's therefore going to be easier to create a valuable website. That's wrong.

Ultimately, there's no strategic advantage to be gained by entering an industry where the barrier to entry is so low that everyone can do it. When you're competitor N+1 in a market like that, your only hope is to compete on efficiency (i.e. the Dell model), or novelty (i.e. the Apple model). Otherwise, you're just a guy in a strip mall, selling beige boxes; you might make a living from it, but you're not going to get rich.

In short, don't think of the PC industry -- think of the teriyaki restaurant industry. It's cheap to open a teriyaki joint, and anyone can do it, but unless you're going to serve gourmet teriyaki, or find a way to produce it for less (/shudder/), it's not the place that you want to be as an aspiring entrepreneur.

Gee, after reading some of your comments, I almost feel like giving up on and going off to live in the woods.

The woods are peaceful, and have a way of changing your perspective. I recommend them.

(Seriously: I am not a pessimist, but compared to some of the wild-eyed optimism that gets thrown around here, I may sometimes seem like one. My world view is that, given a choice, you should live life in a way that maximizes health, happiness and satisfaction, not money. Start a company because you want to work for yourself, not because you want to get rich -- because you probably won't.

If your whole goal when starting a project is to achieve fame and fortune, you will go through life in an almost perpetual state of disappointment. If, instead, you make choices that allow you to live a good life now, you'll be happier by definition.)

You guys are comparing a single saturated market to the economy as a whole. That's a category error. New markets are always emerging.

No I'm not -- my comments are limited to saturated markets.

Obviously, one of the ways to get rich is to create a new market and exploit it. But that's probably not as easy as building the better Teriyaki restaurant, judging by how rarely lucrative new markets emerge.

Low cost of entry means anyone can try any number of ideas with minimal investment. Commoditization means all of those ideas will be the same, thereby lowering the value of the idea.

They are not the same thing.

There might be a limit, but it's much bigger than $10B in 5 years. Just in 2007, I counted up $29B of publicly announced web startup acquisitions. That easily justifies thousands of startups trying for a piece of that pie.

A good list (including more than web) is at http://startup.partnerup.com/2008/01/02/2007-acquisitions-we...

This is an interesting perspective, but it seems to be (potentially) true of one class of startup, but there are many others, requiring much large amounts of money to start, that will still rely on VC funding.

Software startups, specifically web startups, have been a favorite of VCs (for good reasons). If those startups no longer seek VC funding, will it trigger a renaissance in funding for other startup classes (e.g. semiconductors or hardware)?

Biotech, greentech and embedded systems are a few areas that look poised to keep growing and need a more significant amount of capitalization to get off of the ground.

but greentech will require more funding per instance than any VC firm will be able or willing to put up. show me the VC firm that is going to put over $1 billion into any single investment...when it comes to nuclear or hydrogen, a billion might only bootstrap the company. these industries are going to need massive amounts of funding. only one entity can do it - uncle sam, DARPA and the DOE

when it comes to nuclear or hydrogen, a billion might only bootstrap the company.

One of the only giant LBOs that isn't a disaster area is the buyout of TXU. I would expect VCs to hand it off to PE guys if they had an asset that generated a steady, regulated cash flow.

There's a lot more to Greentech than energy or hydrogen fueling. Also note that most people don't consider nuclear power green. (Arguments of cleanliness aside, it's just usually one of the thing that green campaigners disapprove of.) My co-founder tonight met with the founder of greenvironment.com and I know that they're certainly not working in the billion-dollar range.

Perhaps we could see co-investments or investment pools by several VCs.

There are probably in thousands of potential greentech companies that could achieve profitability on 10 - 100 million. Probably the best example here is solar, as many companies already have achieved profitability, but there are tons of opportunities in fuels, materials, building technology, vehicle technology, water supply, agriculture, construction, data centers, refrigeration, industrial processes, road construction, and so on. There might exist companies you'd need to pump a billion into, but why attempt it?

If you believe Al Gore, for $90MM you can build a giant New Mexico wind/solar farm that would supply enough electricity to power the entire US. (It's been a while since I saw the presentation so some details might be wrong but I am at least in the ballpark, especially regarding the price tag). Seems like 10 VC firms could easily get that sort of money together.

90 Million? The entire US? That's way off. I haven't seen the numbers, but that's like saying a car engine can get 1500% efficiency, or that a ten-year-old neighbor can bench-press 2000 pounds. It's just not in the cards.

"If you believe Al Gore" being the key phrase :-P

> If you believe Al Gore, for $90MM you can build a giant New Mexico wind/solar farm that would supply enough electricity to power the entire US.

Al Gore has over $100M. If he isn't doing that....

Yeah, the essay needed s/startup/internet startup/ in at least one place, perhaps with a bit of explanation.

It all comes down to capital requirements. If you require a lot of money to get going, you need VC.

"Yeah, the essay needed s/startup/internet startup/"

I think if you read pg's essays for a while, you mentally do that substitution automatically.

I agree with Paul's point, but it seems like the flip side of the equation is that most startups these days don't have the kind of big exits that internet giants like Amazon, Ebay, Yahoo and Google had (or even the mass market penetration that MySpace and Facebook have gotten for that matter). If a these new startups truly had the potential to capture huge markets, they would need the funding, because 3 guys in an apartment simply can't go after a $5bil opportunity. I think the phenomenon Paul describes is the result of 2 trends, not just one: 1) it's cheaper to start companies and 2) most startups are going after small markets (or whatever is left from big markets that bigger companies have already captured).

Wealth is created when people take existing resources and transform them into something of higher value. Money is simply one very liquid type of input that a creative entrepreneur can use to create wealth.

If the marginal value of more investor capital to web entrepreneurs falls below the cost of acquiring and managing investors, then predictably web entrepreneurs will stop seeking capital. A more interesting insight, though, is that long before things get to that point, smart investors should be seeking to deploy their capital to ventures that can actually use the money to produce a better return. If capital is no longer the limiting reagent in web startups, then the money should go to places where money is the limiting reagent, and consequently has a higher value.

It's worth noting that Kleiner Perkins, as one data point, got out of the web startup business some time ago and has been investing in energy and biotech.

It's worth noting that Kleiner Perkins, as one data point, got out of the web startup business some time ago

That may be their PR, but they're very much still investing in web startups. Here's a list of their investments: http://www.crunchbase.com/financial-organization/kleiner-per...

Completely, totally agree. I was just discussing this today with my business partner; I think that many people won't even know what to do with extra money if it is given to them. That's never happened before - there's always been the "well, we could use more servers" or "well, we could always hire more engineers" argument. Today, I think a lot of people are beginning to realize that 1) if you engineer your applications properly, and on the right platforms, you can scale your server demands along with your userbase/revenues; 2) more engineering/other assorted human capital won't necessary translate into better, more usable product.

I personally believe this is the beginning of a massive shift, and one that isn't even tied to the economy - but, of course, will be dramatically accelerated as a result of it. On the point of what happens to the startup community, however - I think it will be a lot harder to start a me-too company and get any traction; as a result, even with the lower cost of business, there will be fewer people able to enjoy the benefits. It's sort of like the rest of the economy - if you are the absolute best at what you do, it's a great time to be in business; for everyone else, the situation is precarious. Running on $3000 a month is great, but not if that means you're losing $3000 a month with no foreseeable way of recouping your investment.

Perhaps that's where the VCs will step in - sweep those flailing enterprises under their wings, pump greater capital/human resources into them, and try to brute-force them into successful enterprises. In effect, they would become the startup version of their private-equity peers; not a bad place to be, but again - the best will survive, the rest will die.

Interesting. I wonder if, 10 years from now, VC will simply be high tech private equity?

I don't think this is likely, because turning a kind-of-flawed tech business into a good tech business usually (though not always) requires a lot of technical work. I could imagine a collaboration between VCs and hackers, though, or just a group of savvy hackers, taking on this kind of role. Basically a larger-scale version of going around to my friends and saying "I think doing X would make your company better and I'll do it for 10%."

Paul - Assume that

1) your thesis is correct, and,

2) that a good startup hub is created primarily though the availability of investors (as observed in the essay "The Hacker's Guide to Investors"),

Don't these two things imply that Silicon Valley's prominence as a startup hub will wane?

No. First of all, SV doesn't depend only on investors. All the support for startups is here, from lawyers to graphic design to (probably most important) other founders.

Second, not taking VC doesn't mean not taking investment. If startups downshift, the next lower gear is angels.

What if angels are few and far between, and those that are there lack any experience about angel investing?

"The reason startups no longer depend so much on VCs is one that everyone in the startup business knows by now: it has gotten much cheaper to start a startup. "

Maybe I'm biased because I was in YC and it was mostly first-timers, but most of us don't even remember a time when it was a lot pricier.

You've been unusually prolific lately.

Maybe we're just seeing a buffer being flushed. He may have worked on all this stuff earlier.

Partly. "High-Res" and "Artists Ship" were both things I started during the summer and didn't have time to work on again till after interviews. This last one I wrote a month ago and then had to sit on because it was supposed to appear in a print report.

I actually forgot about "Artists Ship." Then a few days ago I was talking to Paul Buchheit and he mentioned how great it was to be able to release code instantly at Friendfeed, compared to the delays he had at GMail. As we talked about the question I had this weird sense of deja vu, so I went home and looked around my hard drive, and sure enough there was this nearly finished essay. The write date was Aug 11, so I must have started it just before Demo Day and then forgotten it during the ensuing bustle.

Can you tell what kind of company commissioned or requested this essay? I'd speculate it was one of the top VC firms...

As a FriendFeed user I'll echo, it is great that Paul and others can release code quickly.

'Thankfully', I'd like to add, at the risk of looking like a ...

The current generation of founders want to raise money from VCs, and Sequoia specifically, because Larry and Sergey took money from VCs, and Sequoia specifically.

Excluding YC and the likes, I would have thought, by now, a lot of startups would want to raise money from angels that have formerly started startups -- there are tons of them around. That would be the #1 choice.

#2 choice would be the Founders Fund, Union Square Ventures, First Round Capital, Atomico, Ambient Sound Investments and the like.

Failing these, the #3 would be the Sequoia's, KPCB, Khosla Ventures, Benchmark, Accel's, Menlo's of the world.

What do folks on HN think?

Agree 100%. Although we were talking to some of the VCs in your 2nd bucket, we ended up going with #1. Our seed round is entirely angel funded, with one institutional player (#3 type) making an exceptional angel investment.

I think pg's right in regards to web startups. The only role I see for VC is in scaling sales and marketing. If you get your business to a point where you can spend $10 million on sales and marketing and turn it into $30 million, then taking VC makes a lot of sense. It gives you a lot of extra leverage.

I do hope VC thrives in other sectors - clean energy, hardware, automobiles, biotech - etc. If Kleiners-Perkins can make money off its CleanTech investments, the world will be a vastly better place.

That's a fundamentally different kind of investor.

This post reminds me of a post I made a while ago called Don't Raise Venture Capital. http://www.startable.com/2008/09/26/dont-raise-venture-capit... This may seem a bit odd, as I am a VC. My point was not 100% aligned with Paul's, as he's suggesting something a bit more extreme, but there is a similar point - these days you can build a good business without significant funding. And you are potentially better off not raising any venture capital. Although I hope the venture business hasn’t become totally obsolete, as I really enjoy spending time with entrepreneurs!!

PG is spoiling us with great articles this month. Sort of like early Christmas presents.

If he really wants to play Santa, he can follow up with a bunch of improvements in a new Arc release. :)

The real Silicon Santa is Ron Conway.

Russian Translation:

http://www.web30.ru/2008/12/07/mogut-li-venchurnye-kapitalis...

Very interesting ... I think this is true for a class of startups, but not all. The question for this approach will be how to achieve scale (of if they even want/need to) to achieve their goals.

While profitability can be achieved on $15k, is it sustainable and can it achieve scale on that money? Cloud computing may help, but may not solve it all. Facebook, Google, etc. all needed VC $ to fuel scale.

Implications exist for founders and early investors if future capital is needed for scale or an exit. If the goal is to either sustain the profitable model and owner control at lower revenue, then this model works. Also, if the goal is to sell to a larger company to achieve an exit and return, then it also works. All depends on the market opportunity and founder goals, but don't think it kills the need/importance of VC.

If the goal is to capture a significant market and be the leader, and software markets tend to be winner take most markets, then achieving scale fast is necessary and VC$ necessary even in a cloud model. Under the new landscape articulated by PG here, the underlying platform could be built & proven with angel money or no money, and thus preserve more upside and better terms for the founders that choose to seek scale in large markets.

There is a big difference in capital required for an online internet, service or software company and most other types of start-up businesses. VC will absolutely play a major role because money is needed for equipment, teams of people and global operations. The effort required to raise $1M is way more than 1/10 of raising $10M - so raising small amounts of capital is probably very inefficient in general.

Great post Paul. One thing to highlight is that traditional VCs, historically, don't make "venture level" returns in efficient markets.

Your examples highlight the cash efficiencies of early stage software/web based businesses from which VCs have been making a fairly vocal move away from for years. Similarly scaled efficiencies aren't yet being recognized in clean tech, new materials, networking hardware, semiconductors, pharmaceuticals and many many categories.

As for web and software, I think the lesson many firms are beginning to apply from this last wave is that there's an inflection point a company hits where its been sufficiently derisked and is poised to scale at which time the VC is more than happy to dip into their large funds and "pay up" in terms of valuations. Its what they did with Google and Facebook (among others). I think it will create a more bifurcated web/software venture environment than we have today but I don't see that as the death knell for the broader venture industry. Certainly a great opportunity for seed funds like yours and ours...bryce@oatv

This is a good question.

I think that VC in its current form will be a casualty of the recession. In its current form, the VC grabs a chunk of cash as a management fee, and another chunk of cash to put "adult supervision" of seasoned executives on the management team. Also, VCs are not able to manage the kinds of small investments that startups need because VC partners have limited time. Because their of their high overheads in the form of management fees, "adult supervision" the small investments simply will no longer pay them what they need to profit. Therefore, from that perspective, I think that VCs are going to be forced out of the web startup sector.

In addition, they will also get booted out of sectors that use successful web startups to bootstrap other kinds of businesses. Let's face it...just as you can use a consulting business to bootstrap a company, you can also use a successful web startup to do the same.

I think that a new trend that will emerge is that large enterprises will start buying up web startups to take over the product for use in their internal operations. Think of it...suppose you are a large enterprise who wants to build some fancy web based software to improve some business process. You have a choice between funding an internal group that may take 12 months using "Cadillac" components and cost $600k , or you could just troll the 'net and look for a startup that does something similar and buy them up for $300k, which gives them rights to working software and the talents of the developers (using appropriate golden handcuffs). It also gives YC a the proverbial 10x return on its proverbial $15k investment and each of the proverbial 3 founders a $50k equity bonus. This will diminish the influence of VCs because web startups that have taken in even a million in VC funding will not be able to sell out for less than $10 million...a price too high for enterprises to spend on business process improvement.

What wizard is going to run your cheap adword campaign (or maybe adword is dead too?) How are people going to find your site? What’s your sale process and have you understood your audience? How are you going to answer those service calls and emails? Are you going to run the next Google on the cloud? There are costs associated with all of that, and, even if they are compressed by technology too, the investments required to keep differentiating yourself are increasing.

What’s worse perhaps is that, with all its focus on IT, Paul seems to forget that not all start-ups are web start-ups. How about biotech, cleantech, robotics? Is marketing and distribution free for those ones as well?

There is, as always, some truth in what Paul is writing - the man is smart - but in my view, VCs are certainly here to stay and scale those start-ups that can make it into serious money machines. What do you think?

Full comment at http://www.torevenue.com/?p=3

Would be possible to build a google/facebook/linked-in all the way to profit without significant cash up front?

Any business relying on network effects is going to need upfront cash. Since these types of business tend to become the fund-making "homeruns", I think VCs will stick around, doing what they are best at - chasing the big hit.

TicketStumbler, like any other marketplace, definitely relies on network effects. And, Google arguably doesn't rely heavily on network effects. Google's value to me (in the short run) is unaffected by how many other people use it.

Sort of. We rely on how many providers we have, but even that has its limits once you have all the big ones (which we do). TicketStumbler is just as useful for one person as it is for 1,000.

You'd be right if you applied your statement to Stubhub or Ebay. We're more of an aggregator than a market place.

I'm pretty sure facebook was __started__ without significant upfront cash. Obviously they got to a certain point where they needed more, but the key thing is to have lots of momentum when you get there.

See, for example, digg.com. ~ $15 k upfront, $50k angel funding 6 months in, VC around month 10.

You paint a very bright picture for stratups and a dark one for VCs. While as an entrepreneur myself, I wish that was the case, in reality though, the two are tightly coupled.

Even though startup funding-needs are smaller these days, very few entrepreneurs can find a team who would work for free all the way to profitability. In fact, VCs today are able to get more equity for less money.

But the fundamental problem is that the average time for exit is getting longer, mainly due to the poor stock market condition, where IPO have almost disappeared and corporates are willing to put smaller amounts for M&A.

Once the market will bounce back and stratup will have a more promising outlook, I'm sure you'll see VCs happy to invest and startups happy to take the money.

Mor Sela Co-Founder and CEO http://www.ProCompare.com

I'm not very knowledgeable about this, but from the charts I remember seeing during the Sequoia "buckle-up" PowerPoint, isn't it an undisputed fact that there has been an unsustainable boom in VC? Investment in VC has been independent of it's marginal profitability declining due to traditional deals becoming fewer and the recession in general.

The shift in what is funded is no surprise by now. The only questions are 1)if the new bio/green tech startups will be successful, and what the role for VC will be in other sectors and 2)What will happen to the current crop of VC firms now? As flattering as it is that funding in VC has remained constant, is it still a wise investment?

I don't know what the answer to these questions are, but they're the ones that stick in my mind. On a positive note, at least one stressful part of the Internet startup process is in decline.

For a long time VCs have prided themselves on "adding value" beyond the capital invested. I wonder if part of the phenomenon you describe is a realization, at last, that there is no value-add. Which is not necessarily a comment on VCs, but also on the increased sophistication of entrepreneurs.

Couldn't agree more. As a serial co-founder myself, I can't wait to be able to fully start businesses with no VC involvment.

One thing is bogus in the article though: it's age-biased. $3000/m to cover living expenses for the founders? Yes, if you are talking about kids straight out of college living in a dorm. What about slightly less desirable older people, like say 30-year old (now, that's old :-). So a startup with 3 founders would need closer to $15,000/month of revenue. Well, it's not so easy to generate that kind of revenue.

The better advice is to find co-founders who can work part-time (evenings and weekends). That can sustain itself for a long time, even if it feels like it takes forever to get anything done.

fairsoftware.net - where software developers share revenue from the apps they create

"So a startup with 3 founders would need closer to $15,000/month of revenue."

This depends on where you live. I'm just starting a project with one partner -- we are both entering forties and have two kids each -- and even with another employee we plan to live comfortably while burning under $10k.

Although web software companies can easily grow with small investments, hardware companies are a different story. Saas can make it easily with no help but if we are looking for an apple, a super android phone, a new sidekick or another AMD VCs better keep writing big checks.

The problem with the VC model is that they look for a large liquidity event in the short term, and so push companies aggressively to reach this goal. With the number of IPOs so low these days, these liquidity events are much more infrequent than they used to be, yet the VC model remains the same. It angers me that nobody is doing anything to innovate in this space, as funding is hands down the most limiting factor for a new venture's growth. I found this slideshare presentation which includes some of the freshest thinking I've seen on the subject. Any thoughts? http://cli.gs/g3BA9v

I never understood this one:

"Someone running a startup is always calculating in the back of their mind how much "runway" they have—how long they have till the money in the bank runs out and they either have to be profitable, raise more money, or go out of business."

Why go out of business? Okay, you're out of money and you're not profitable yet. Let people go and return back to square one. Two founders in the garage, but now you have a codebase, a beta version probably, a website and some connections in the industry. Yeah, tough times, but when I see people going out of business in such situation I always think that they were there for a VC-backed salary and some fun.

What about angel funding? Cnet News is carrying a story that sounds very scary (the news media thrives on scariness) about "Agnels flee tech start-ups":

http://news.cnet.com/Angels-flee-from-tech-start-ups/2100-10...

In the mean time, Mr. Megalomania Ray Kurzweil (who has yet to comment on how well his "house casino" hedge fund has been doing lately) said he's starting The Singularity University:

http://news.cnet.com/8301-11386_3-10155303-76.html?tag=mncol

In my opinion, there are some problems with this premise. Even though a company is profitable, it may have negitve cash flow, and need to raise money. Then there is the oppertunity cost, say you make a better mousetrap, but I raise all the money. I can buy you, and still make more. There have always been ways to start a company without investment, I started a company with $10,000 and sold it two years later for $1MM, and that was in 1986 without any internet! I dont think the writter of this article has thought this through, too many holes. David Schulhof

Very interesting ... I am going thru this exactly. We had a couple vc's that are in due diligence, but in this economy, I don't think it's best for us to take the money. Our overhead (as you mention in your article) is essentially just the founder's living expenses which we have been able to cover for nearly 4 years now.

My choice is either raise vc, or sell something. Selling something is non-dilutive. VC's need to get a clue. If I take $1 or $5M, I'm going to give away 1/2 the company, so might as well as for $5M. But what the hell do I need that much money for!

Bootstrapping's back in style.

1) Time is money. All the time a start-up invest in pleasing and answering VC's, it is time that they could have spending on developing or marketing their product or solution.

2) Maybe VC's will now have to approach start-ups and ask if they can help to grow the company.

3) Currently there are many small companies running out of money. Larger companies will buy them up at prices below the investments VC's have made. In many cases VC's never going to get their $33mio back on companies that hardly have a revenue of $10mio in a limited market.

(We're self funded: Engago Technologies Ltd.)

I'm honestly surprised that it's taken you this long to go out and say this. I've loved reading your articles and essays about startups, and I've soaked up all of it, but one of your big topics is dealing with investors. I've talked with a lot of entrepreneurs, and bootstrapping seems to slow things down slightly, but with the technology available as cheaply as it is, living expenses are the biggest thing, and if people can figure out how to live on the margin, they could launch a startup on next to no money at all.

This is something that I've thought about for the last several years. I think that this article should mention that what is meant by VC is really "VC for web companies". What I suspect will happen is that there will be fewer and fewer web companies (with good ideas and the need for large capital) that need funding, and it will make more sense for VC's to invest in startups that are in more capital-intensive sectors like energy and biotechnology.

Paul,

Great post, extremely poignant!

In a few years time, VCs may be pitching to Entrepreneurs (Dragon's Den Syle! [1]) :-)

Links:

1. http://www.youtube.com/watch?v=HDczbpIO85g - note these guys like most missed the Linked Data URI pitch with their DNA miscue

Kingsley Idehen http://www.openlinksw.com/blog/~kidehen

There's another explanation for the 40% rise in applications received by YCombinator. Much of YCombinator's seed-stage competition is moving up-market. All the VCs we've talked to on the east coast now target post-revenue companies, not seed-stage start-ups. If there are fewer VCs looking at early investments, you'd expect YCombinator's applications to go up.

Largely true, not controversial, I'd say. The VCs I talked to are not in denial; but still value cash they're getting from their management fees. That phase will be over soon. Question for Paul: what alternative investment vehicles will arise in the years to come? How about some smaller-scale buyout businesses?

A lot of people want to start companies now, VC or no VC. But IT and development jobs remain relatively abundant; someone who can make a credible run at a startup can also land a new job in less than a month. That may not remain the case, and job security could constrict the flow of talent into crapshoot startups.

From the title, for a moment I thought the article was about some new result in machine learning that would make Vapnik-Chervonenkis theory obsolete...

http://en.wikipedia.org/wiki/Vapnik-Chervonenkis_theory

What a great post Paul, thanks for this. we are workin hard with a new funding business model & service for web start-ups, see www.growvc.com

"What do you get when you break the traditional vc funding model and then restructure it with some social media & web 2.0 glue?”

"Imagine what it would do to the VC business if the next hot company didn't take VC at all."

No need to imagine. Just look North -- this is reality.

Neither RIM (makers of the blackberry) nor Cognos (now IBM) took VC funding.

VC has imploded in Canada and startups are surviving as they have always.

RIM started in 1984 and Cognos in 1969 [!], so I'm not sure what conclusion you can draw from their early histories.

Also, RIM "was financed by Canadian institutional and venture capital investors in 1995" (http://en.wikipedia.org/wiki/Research_in_Motion).

See Valley Guru Michael Malone's "Washington is Killing Silicon Valley" in the Wall Street Journal for more on this. Be sure to consider all these new outside forces. Some factors are better than ever, but others are worse than ever.

The conclusions really applies to VC for IT, not so much Biotech or clean energy.

Its more than the recession. Its the next revolution. We have microtized/DIY everything. VC's are just one of those that is both a casualty and a cause.

Wrote about his over two years ago but re-posted recently at www.flairjax.com

We always wondered what brings a VC besides money and pressure? VC's require time too (5% of your time).

If a VC can bring leads, customers or users, then he brings additional value. If not the added value of a VC is just money.

In Arizona, if we depended on Vc, we'd be dead. We have a very vibrant startup community that works by collaboration,mentoring, and whatever it can scrape together. Do we start Google? no. Do we innovate? yes.

pg won't be getting a job at 37signals.

http://news.ycombinator.com/item?id=219085

It sounds overly optimistic.

Why a total amount of money spent online should increase? More and more players are competing for the same or diminishing pie slice.

Google can buy only so many startups after all.

Is money spent online really one category? Why should money spent at malls increase?

summary: bootstrapping is easy when you only weigh a few pounds.

In Russian http://spring.jumpidea.com/2008/12/paul-graham-divergence.ht...

Excellent assessment, and a definite possibility - though hardly foregone at this point.