In part II of this series, I argued that it has become so cheap to launch a Beta Web service, that VC level funding is no longer required. This changes the game somewhat in regards to product development and exit strategies.
Today, students can throw together a basic service over the course of a few weekends and run it from the family basement over a DSL line. Why bother then with market research when you can field test ideas this quickly and cheaply. Have an idea? Build it, throw it out there and repeat until one of them gains traction.
Paul Graham was one of the first to grasp this new reality and put it to the test with his Y-Combinator. The recipe is simple: give small amounts of seed money to bright kids, provide top tier mentors and see what they produce. I think it’s still a bit early to call, but the fact that there are now TechStars in Denver, YEurope in Vienna and SeedCamp in London would seem to indicate that the idea has legs.
So, founders can test their ideas cheaply, but once they start to gain traction, they still need to scale the business and that requires money. This is where VCs come in. They have the resources and expertise to accelerate a startup’s growth. In the nineties, in order to get an exit, the company would go through several rounds of financing, cranking up the valuation (and hype!) each time, before going public. Today, however, IPOs are out of favour (at least until Facebook goes public and makes a bundle for its investors), so VCs try to sell the company instead, once they’ve pumped its value up to a respectable level.
Now if you are a big Internet or media player and you have the opportunity to buy a promising startup, when would you rather do it: when they first demo their Beta service or after their Series C round when they have a valuation in the ten’s of millions? Obviously, if you believe in the company, acquiring it early on before its valuation rises too much is ideal. But that will be difficult if the company has taken money from a VC fund, because VC money always comes with special privileges, such as the right to block the sale of the company. While selling the startup after a successful Beta might provide a quick 3x return on their money, the VCs are aiming for the homerun, so they will often block the sale and take their chances growing the business. If the founders bootstrapped their launch or used Angel money, then they get to decide whether they want to (a) cash out quickly, (b) build a business that grows organically or (c) take VC money and go for the gold.
Call it a lack of ambition in today’s youth if you will, but it seems that many young founders are quite willing to exchange 12-18 months’ worth of effort for a couple of million dollars… and so is Google.
Google started by inviting founders to come pitch to them. This gave Google the opportunity to acquire promising startups before the VCs got involved and pumped up the valuation. Their acquisition of Zenter is a prime example of this: Zenter went from seed to exit without even bothering to build a business in between! Google has now taken it further and is providing seed funding for developers that want to build upon their Gadget platform (Google Gadget Ventures). Other big players have also adopted this strategy; Conde Nast’s acquisition of Reddit is a perfect example. In a world where Web startups can sell themselves after taking only a few $100k in financing, what role remains for traditional VCs?
Some VC funds have started to adapt to the new reality of Web startup financing. The best-known example is probably Charles River Ventures’ Quick Start program. Looking at the amounts involved and deal structure (up to $250K as a convertible loan) the program clearly aims to compete with Angel money. It also includes the right to fund 50% of an eventual A round. Another VC Fund, Union Square Ventures, have adjusted to smaller deal sizes, but admit they aren’t staffed to go as low as the CRV Quick Start program.
Other firms are trying to do smaller deals than in the past, but haven’t changed the structure of the deal; this is often awkward for everyone involved. The VCs have to deal with high overhead for small deals and the larger number of deals causes the resource squeeze discussed in part I of this series. As for the entrepreneurs, those that we’ve spoken to recently, say they feel pressured into taking more money than they need and find the terms overly restrictive for a seed round.
So what do you think? In a city with limited angel activity, how should entrepreneurs proceed? What should local VCs be doing?
by heri
if we focus on the web, the new reality is that there are now new technologies and framework like Ruby on Rails, Django , cakePHP etc. that allows pretty much any programmer to launch a web application. I consider that there is now no barrier and the real deal relies on the design of the product.
one implication of having these open source frameworks is that you will so more people trying to launch a website, more ideas will be tested, markets will be fragmented. and that’s why i think the VC model (funding of more than $1million) is now irrelevant. unless you launch a service that needs a lot of logistics like moo.com or woot.com
i think the y-combinator model is the best you can get. provide early funding to as much teams as possible, diversify, provide backup, connections, advice, invite some key speakers. we have 4 universities in montréal, polytechnique and ETS and i believe once you get the word out, you will see a lot of creative ideas. and we know that creativity is one of montreal’s strenghth.
also, VCs will then have to turn to other areas like telecommunications, hardware, mobile networks where you still need a lot of capital to get a company started.
by Daniel Haran
Looks like my trackback didn’t work, so here’s my blog answer:
http://danielharan.wordpress.com/2007/07/31/vc-capital-in-montreal/
Heri – the YC model is great for students, but that’s not enough money for most potential entrepreneurs to pay their bills. Something a bit closer to CRV’s program would be easier for a lot of people with kids and/or mortgages. Also, as you say, the design of the product is now a bigger part of the success – it would be nice to have enough cash to hire outside expertise for design and usability.
by daniel
I think that in the past, an online venture had to deal with tech risk and business risk. With a dozen years of web development experience and rapidly improving tools and frameworks, most of the tech risk has been eliminated from web startups. The business risk however, remains. Good design is necessary, but so to is a good marketing strategy, ability to execute, adequate financing and luck.
Seed level funding allows you to test ideas cheaply, but when one starts to take off, you are going to need more servers, bandwidth, sys admins, staff to handle inquiries, etc. If growth is rapid, then you are going to need VC money to cope. If several startups are in the same space as you, you need to grow faster than the competition to establish a dominant market position. This requires VC levels of investment.
Also believe that the Y-Combinator companies have three choices after their three months are up: (1) try to sell themselves for a relatively low valuation, (2) raise VC money to grow the business, or (3) raise some angel money, to buy time to accomplish (1) or (2). Y-Combinator kick-starts companies, but it doesn’t output self-sustaining businesses.
by David Dufresne
Very interesting series of post… I’ll try to find time to comment in more details. I’m curious about your MSU project. I do see the huge funding gap and I’ve long been convinced that someone could go far with a bit of money and a pool of expertise.
I agree with your last comment. VC money isn’t needed to build web apps and services anymore but it is still needed to build companies, in most cases. But yeah we need to adapt and get used to doing smaller rounds of 2 M $ and sometimes much less, at least in Web. I personnally try to size a new investment by the potential exit-size, which is often only marginally correlated to the investment-size…
by jai
I admire your initiative and investing pedigree. Curious about following …
Why would a kick-ass startup look for funding in Montreal? Hasn’t the precedent been established that more savvy investors ‘who get it’ are to be found south of the border? I would view that as one of the web 1.0 lessons and not necessarily picking on Montreal (there are other places that have ‘worked hard’ to develop that reputation) … I’m sure you’ve been over this as you work on developing your ‘product’ and would be keen to hear your take.
Cheers.