What could they possibly need /so/ much money for? Is it for hardware, developers, running costs, marketing?
Can someone please enlighten me?
If you think VCs are interested in companies that won't need 10 people to run their business, ever... you're thinking to small :) And not only there are your employees, but imagine hiring accountants, lawyers, cleaning staff... the list, only with actual human beings, is already huge!
Now add costs like transportation, hotels, food, all the furniture, the stuff you need just to have the office open, like electricity and water and... fumigation? Ad on Techcrunch? 20k for 2 months. NY Times front page on Sundays? 100k. And let's not even mention prime-time TV... It just costs a lot of money to have a big business running.
Open a spreadsheet anyday and do some calculations. I've only skimmed some of the costs with my examples here (even though I am sure someone will comment how NY Times ads don't apply to your question).
The yc vision seems more sustainable: $5k+$5kpf = you build something. If it's good you get to raise a couple hundred k to turn it into a company. If at that point it looks like you might be google, then raise the millions that you need.
The OP asked why VC funded companies need millions, and you've said yourself, they do need.
You don't need to be on the top 1% to have 10 employees. If you do have ~10 people working, then your operating expenses are in the million range.
But let's use your Google example. We know that the search market is dominated by Google, followed by Yahoo and MSN. Who are the others? I've searched and all I could come up in 10 seconds in this:
http://marketshare.hitslink.com/report.aspx?qprid=4
Let's go with Lycos. 0.01% market share. They have 500-1000 employees. Huge costs there. I am ignoring Terra, and Daum.
I guess what I am trying to say is that even a 0.01% market share can make you profitable, or attractive enough to get bought. And depending on the market (I did "cheat" a little by picking the largest internet market possible, search), even a 0.01% share might cost you millions to get there.
These huge sums are raised pre-launch/build because they're essentially, bets. Educated bets at best, but still, bets. The thing is that the payoff (for the VCs) can be huge, so they gamble on dozens hoping that 3 or 4 will provide return.
It's not my cup of tea, btw. I am currently building my Micro-ISV and I am quite happy, aspiring at most a nice boat, perhaps a bigger house. But the VC world is a reality :)
It's like complaining about software patents. They SUCK. But the system is set up in a way that you need them. It's part of the rules. You can complain about it, but they're there. So what makes most sense in the business sense of things is to get them. Just like VCs when you're trying to dominate a market.
2) Capital expenditures. It's nice to run on EC2 for awhile, but it might not be the best hardware fit for your product. Similarly, it's nice to use Cisco switches and not crappy switches when you want your network to work at high volumes.
3) Marginal costs. When you have millions of people using your site all the time, bandwidth, power, free tshirts you give new signups, etc all cost more and more money.
For many companies that are pre-product/market fit, raising millions of VC might not make sense. But for many rapidly growing companies where there is a lag time between user acquisition and user monetization, something needs to fill in the gap. Guess what that is.
Your first two points I can agree with, but it's the 3rd that troubles me.
Shouldn't a company that means to stay in business want to have slow but steady growth, a gradual climb, giving the them time to adapt.
Doesn't a company want to put its money making plan in action before it goes big time?
I know justin.tv has major bandwidth requirements, and from what I can see there is no revenue model apart from adverts in place, which probably can't cover the cost of the bandwidth alone let alone everything else.
Please take no offence but if a company has a cash gap it's usually a bad sign, and throwing money at the problem will only work for so long.
But most of the time VCs want what 37signals calls a "Hollywood Launch". One day your site isn't live, just a beta to a few select friends/classmates, the next, everyone and their mother is checking out your live site. And you have a product to sell/revenue model.
When marginal cost is greater than marginal revenue a startup can either a) find more vc funding to raise marginal revenue, or b) cut expenses to lower marginal cost.
Startups will press a) until the button breaks leaving b) the only option.
Now when investing it's a different matter, but the point stands, and so the after b) the only real option is actually c) liquidation
Economies of scale works on average cost, more specifically long run average cost, while it contributes to the MC going down, MC is more affected by fixed vs variable costs in the short term and more importantly it increases at a certain point when you reach the maximum capacity of your current infrastructure.
As for marginal revenue of the startup:
- Fixed rate = MR falls with increasing users.
- CPM = MR falls as the more the pageviews you get, the better a price advertisers will demand from you.
- Per click = MR remains relatively stationary but as with CPM, at some point demand and supply kicks in and when you supply more clicks than advertisers want (for a certain price), they will pay less /per click/.
To get increasing MR in advertising would require changing the rate of 'more likely to buy' users relative to users in general. On the internet it's the other way around, more users == less likely to buy, and with things like Adblock becoming more and more mainstream, it hinders it even more.
Advertising: $30k/mo
PR firm: $10k/mo
Rent: $12k/mo
Salaries: $100k/mo
Servers/bandwidth: $20k/mo
That's a $2 million/year run rate and I don't think this is even particularly on the high side and doesn't include upfront investments in servers, desktops, furniture, software, etc. I'm leaving out lots of stuff, really.
Taking VC means you're aiming high. Spending $2 million/year to take a shot at becoming a huge business is not that extravagant.
$100k/mo salary for 20 people is a fully loaded $60k/yr; that's less than half of what your mean FTE headcount cost will be in the Bay area.
15 people for 100k/month would mean you are paying an average of 74k/year. Who would willingly work for a startup for that, without lots and lots of equity (answer: the exact people that you would never actually want to hire)? And you can't give lots of equity to 15 people, and even if you give them 8% each you would be left with nothing yourself.
$12k per month on rent? You would have to be retarded to pay that as a startup. Rent an old house and get lots of card tables.
Servers/bandwidth at 20k/month? What kind of site is this? That's $240k per year of bandwidth. If you are serving up that much content and aren't making a profit already, you are either going to get bought out in a few months or go under in a few months after that.
My hypothetical startup budget:
Salary: Pay myself enough to pay bills and live on, as well as 2 or 3 talented confederates (if I happen to have 2 or 3 talented people, with skills I need, on tap. Otherwise, wait until some are located before hiring anyone. Nobody is getting my equity unless they totally rock.) Estimate: 6k-25k per month.
Rent: $0, I happen to have an office large enough for 4 people to comfortably work in at my home. If I didn't, I would charge a one time expense of $2000 to put some carpet in the garage, install an AC out there, and run some wiring and so on.
Furniture, equipment, etc: $500. Find your nearest very large public university. They probably have a depot that just sells old furniture and equipment. You can drive up with a truck and get enough furniture to outfit a small army for under $500 (one time fee). http://www.purchase.umd.edu/ttrader/items/showroom/index.htm....
Servers/bandwidth: This obviously depends on what site you are making. A Youtube needs way way more bandwidth/servers/rackspace than a yelp for the same size audience. Using EC2 as a guide, a small instance is $70 per month if used constantly. If you used say 100 instances constantly, and transfered 1TB a day, you would be paying around $12000 per month. That is a metric assload of servers and bandwidth, so the $20k number is probably retarded also.
PR/Advertising: I'm not sure. 10k per month buys a fuckload of adwords. At a CPC of .40, you are talking 40k * 2.5 = 100k impressions a month with that advertising budget. In reality you can get clicks for .20, and lately even less, unless you are selling asbestos litigation.
So my point is you can get a hell of a site out there for like $300k per year or way way way less, unless you are an idiot.
They're only interested in 10x home runs so valuations are almost irrelevant. Since a finite number of partners can only sit on a finite number of boards, they can't have 50 or 100 investments at lower valuation / smaller sums.
High valuations also pump up expectations on the startup -- which is bad for the entrepreneur because if you fail to hit your goals, it means a down round and a ton more dilution.
A comic strip illustrates the point: http://www.thevc.com/strips/strip38.html
"C'mon folks, we need major cash outlays. [...] Work with me here, we're talking BILLION with a B..."
I think this could also be called an instance of perverse incentive. VC's have perverse incentive to invest more money than given startups need. http://en.wikipedia.org/wiki/Perverse_incentive
But I understand your confusion. VCs are always knocking at our door and we still haven't answered the question, "What the hell would we do with 2 million dollars?" This is precisely why we haven't taken it.
Well, we've answered it, but it involves the words "hookers" and "blow".
* Carrying inventory, if you sell hardware.
* A 6-10 region direct sales force.
* A full time customer service operation.
* The reconstituted powdered startup marketing packets they sell you when you buy your CEO.
* The pro-forma engineering staff-up you do almost subconsciously to end up with a 50/50 b-team/engineering split.
If however you just want to make money, profit, things like that, you don't need to spend much money for a web based startup at all.
There is also the issue of leverage. If you need $500k, you don't raise $500k, because when you run out and start looking for more money, your negotiating position is very poor. Instead you raise $2M, then start to talk to investors again when you have spent half of it.
In my experience marketing is not a significant portion of expenses for a startup.
can yc/angel/vc backed startup be plentyoffish killer? i doubt money will help shrug