Giving money to the founders: In 2009, is this still absurd?
paulgraham.com
paulgraham.com
I think the VC should instead concentrate on businesses where their investment can make a real difference: Business plans that require a factory, or expensive custom hardware, thousands of servers, gigantic customer education, etc.
I know it's heresy on YC, but real VC's shouldn't be involved in companies where only $20k is required to start the business. Founders are taking the VC for a ride when they convince them to fund extravagant startups that should be started without big investment.
VC investors, if they still have cash, need to think bigger. They're not needed for software startups.
The amount of funding required to start a business is one of the best barriers to entry, and the VC should exploit that.
VCs should choose their investments by the expected return, not the amount of money they require.
AdWords was not launched until 2000 so it wasn't possible they were turning a profit before then.
In fact, IIRC it was Google's success at doing the "Get users first and profit will come" that made it fashionable among Web 2.0 startups. The idea was pretty disreputable after hundreds of Web 1.0 startups tried it and flamed out spectacularly.
However all is not equal, the extraordinary returns in recent memory have come from the web, and so venture capital firms will likely still be putting their thumb in the pie, even if it means cashing out to founders, letting them be CEO, giving them smaller rounds, etc. for software start-ups.
That server farm costs a lot, and therefore the required investment is a huge barrier to entry.
That business model is perfect for VCs, and that is where they should focus.
When they became the default search on Netscape, they had 30 computers.
Edit: Never mind, they switched over to Google in July 1999 (http://searchenginewatch.com/2167331), when it was quite possible that they still had 30 computers.
It seems more popular to think of VC as working capital here: start the company on $20K, prove that it works, then take VC money to scale. Hell, that's the whole YCombinator model.
In this market, where 'flat is the new up', I'd regard having founders cash out at early institutional rounds as unusual. There is comparatively little money being invested at the moment, and its a "buyers' market" which is to say that entrepeneurs have less negotiating power at present than they did when things were frothy.
More generally, no, I do not see any trend in rounds getting significantly smaller. I do see a trend in pre-money valuations coming down, of course, but that's entirely different.
The economics of bulge-bracket VC work when you invest say ~5% of your fund in each portfolio company, in the hope that 1/10 or 1/20 of your companies will hit it out of the park. Total fund size equilibriates when drivers for scale (partners' remuneration, principally, less relatively invariable overheads) balances with diseconomies from political inference effects which kick in when too many partners try to reach consensus and cut the cake. That's why top tier firms with a 'plain vanilla' strategy have roughly comparable fund sizes.
FUD aside, nothing I'm seeing at the moment that gives me any reason to believe that underlying model is 'broken' or failing (though of course '07 and '08 vintages will be shot). Almost all successful start-ups need a lot of money to scale beyond a certain point. Free software doesn't really change the cost of airtime, or a VP bus dev. I'm writing anonymously so I have no real axe to grind in saying that.
What is certainly happening in the industry is a shake-out. Good firms with strong reputations are raising quickly and comfortably (if quietly because it's not a time to be above the parapet), and will continue to invest without interruption. That is because there are well-priced deals to do in this environment, and innovation doesn't stop in a recession.
A number of 2nd tier firms, on the other hand, are finding fundraising very difficult. Many will not survive.
Firms that are thriving seem to be investing more slowly just at the moment. This is because there is a lot of noise in the market, and visibility is currently low. Analogy: when it's foggy you drive slower. (Economically: transaction costs rise as expectations less aligned, so liquidity declines.)
What is tough is the squeeze at the bottom end for start-ups. I get the impression (though have less direct evidence of this) that there is a bit less easy money on offer from HNWs sub $500k as many are licking wounds, etc.
1) In addition to building relationships, funding a significant portion of smaller businesses would increase the number of available quality deals at later stages. 2) Lowering the transaction cost of attracting, analyzing and screening deals to the point where smaller deals could be profitably funded, would likely have efficiency impacts throughout the funding process of any VC firm. In fact, you could make the argument that if a VC firm really masters this process, it could obsolete the need for the 'bulge bracket' model entirely.
YC did something innovative - they figured out how to invest <$20k in early stage companies in order to help those companies get to the level where they can bring a product to market. If the VC community really brought their perspective and resources to targeting this opportunity, it seems they would only stand to benefit in the long-term.
I'm sure there has been a discussion of this article before. But I get the feeling that you disagree with it's predictions. I'm interested to know which points you think are off & why.
The conclusion was that VCs are in a worse position. Investment needs to get smaller & to maintain their investment sizes VCs will need to buy shares from founders.
1 - Software Startups need/want less capital because of (a) lower technology costs (b) lower promotional costs (c) smaller teams.
2 - IPOs are less likely. This results in (a)the lower risk/reward goal of acquisition being set as a target. (b) less capital needed for the IPO process. I've added in point b
3 - Sellers' Market. (a)VCs' structure dictates investment size & fund size (as mentioned above) creating a surplus. (b)VCs are competing with acquirors offering a lower risk option. I imagine the current climate dampens these
I suppose the last point is most debatable. It may be temporary. The VC industry may contract or move away from Software. But if 1 & 2 are correct, this should result in smaller investments, founders cashing out or some combination of these. Do you see these points as being incorrect? Am I missing something else?
I agree that companies pursuing small opportunities (web 2.0 features, iPhone/Facebook apps, etc.) will face little competition from funded competitors. That's because there's little money to be made out of those innovations. In the short term, that may even apply to situations where the prize is large (Skype, Google, Facebook, etc.).
But in the longer term, economic systems operate in equilibrium, so you have to think about marginal not absolute factors. In equilibrium, competition will increase, and in turn cost of supply (of developers, airtime, etc.) will scale, in proportion to the size of the prize. Only proprietary cost advantages offer sustainable competitive advantage, whereas free software tools, cloud hosting, and cheap airtime benefit all contestants equally. When credible signalling costs are high and transparency is low, relative early advantage tends to be self-reinforcing. So when the pie is big enough, unfunded start-ups will find their marginal rate of growth just as constrained by a lack of capital as it's ever been, and will lose the initiative to better-funded rivals accordingly. Which means VCs will be just as essential in supporting high-value product development as ever.
Of course, you might say that the rate at which the marginal utility of wealth declines is high enough that few rational entrepreneurs will be motivated to pursue big new product innovations given the higher likelihood of failure compared to developing iPhone apps. In practice I tend to think that success for most entrepeneurially-minded individuals is as much about recognition (a positional good), as it is about absolute wealth. And again, in equilibrium, position goods are definitively scarce, meaning the arms race for status will continue ad infinitum.
There's an old adage about how to make money: sell bullets in the war without end. That's what VCs do. And the invention of the taser doesn't put gun makers out of business. On the contrary, it increases their utility.
In practice, I've found that adding more developers to a team actually makes it less likely to succeed. Imho, the ideal team size for a software start-up is three - three excellent, top-notch hackers, but just three. More than that and the communication overheads start to hurt your early progress and flexibility.
That's not to say that the three hackers won't want additional help later, which is where you could come in. But that's only the case until the tools get good enough that the three can continue as three pretty much forever.
The increased productivity of tools like Rails means that larger teams are actually at a disadvantage. This to me is the greater threat on your industry. In my start-up, I don't want us to grow to a mega-team of hundreds of people. In fact, we've already had numerous discussions about having it as part of our business model to keep the company as small as possible and outsource any work that's not core to the business - so that we can ensure that the only people we employ are top notch.
Otherwise, your analysis is good - but imho this factor could be the chink in your armour.
Money has diminishing marginal utility, and most people would be just as happy (or unhappy) with $10m as they would with $50m. That's not true at all for VC firms or their limited partners. Twice the profit is roughly twice as good for them, in fact in the competitive industry, it might be more than twice as good. If everyone is getting 15% returns, the difference between 10% and 20% for a VC fund can be tremendous the next time they're out raising funds.
By allowing the founders to cash out, it gives them the cushion they need to swing for the fences, rather than trying to sell their company as soon as it will make them independently wealthy.
I don't have enough data yet to say how the recession will affect this practice. But my guess is that if it did decrease, the decrease would be temporary. The long term trend is that founders are increasingly powerful. Which means they'll tend to get not just the option to sell stock (if they want to) but other things they want, like remaining CEO.
Just curious. Thanks.
For the app-writers, it won't just be seed funding anymore - it'll be no funding at all. The most they have to do is pay for some hosting, legal and financial services, but their burn rate will be so tiny as to do it on part-time wages.
As for the remainder, they'll still be operating a traditional startup with real funding needs.
PS: Twitter's cost's have far more to do with SMS traffic and staff than hosting their website.