Just a few years ago, large venture firms were incubating companies for months. During the incubation period,
the founders wrote 70+ page business plans, which described the market opportunity, the execution plan, along with
the five year financial projections. The plan was a proof, a risk management tool, used to justify that the idea
has legs and will work.
But this isn't true anymore. You can't afford to be in stealth mode for months. Your can no longer build realistic projections for five years. The only way to create a technology company in this market is to evolve it.
If the way in which a company is built has to change, the way in which it is funded needs to change as well. What are the new rules for tech venture capital? Where and how should the money be allocated? In this post we take a deeper look.
In the good old days, startup funding was a well a understood process. The founders would write the business plan. Typically it would be a lengthy document including opportunity, market analysis, competitors, description of the business, execution strategy staffing and five year financials. With this plan, they would then knock on the doors of different venture firms - usually through connections, as sending the plan by mail or email was not likely to turn people on.
If all went well, they would score a pitch and get to present to a few partners. Large firms would take their time to make sure the plan was solid. They would bring in consultants, typically founders of already funded startups, to look at the idea - to poke at it from different angles. Then, if all added up, they would invest - typically 5M+ in Series A - and get the ball rolling.
After the technology was built and looked promising, they'd line up for series B with 10M+ and bring in more VCs. The typical series B was aimed at shifting focus from engineering to business, so a new CEO would often come on board at that point - as well as an army of sales staff. All of this would take years and cost massive amounts of money.
Among the factors that caused a major paradigm shift in technology investment, two stand out: 1) a drastic drop in initial startup costs, and 2) the increasing willingness of the public to pull technology into the market (i.e. try it, adopt it, champion it).
In the old days, $1M was needed to even get a technology off the ground - but these days, it can be done with $100K. Because the hardware is cheap, the web infrastructure (like Amazon Web Services) is in place and software libraries are abundant, creating new software is dramatically simpler. It is all about the idea, whereas before it was all about the infrastructure.
Image via Cogdog blog
The social web made people more receptive to new technologies; it taught us how to love new tools and services, and made a major step towards curing the public's technophobia. People realized that software does not need to suck, that it can be fun and more importantly useful. 'Build it and they will come' turned from a joke into a reality.
If the bottom-line costs of getting a tech startup off the ground are a fraction of what they used to be, then the old approach to funding no longer makes sense. In the old days, top-tier VC firms would do 5M+ series A in exchange for 40%+ of the equity. Today, a typical series A is just 1-2M for 15-25% of equity. As it is cheaper to build the company, large VC firms find it harder to get into series A. The market has created an opportunity for smaller size funds.
Large VC funds have hundreds of millions and even billions of dollars under management. Because they engage individually with each
investment (like any VC firm), their most valuable asset is time.
For these funds, having a lot of small investments is just not possible, they are not setup that way. Instead, they are designed to methodically research and identify the best opportunities and then deploy large amounts of money in each of them.
Because of the way this equation plays out, they also need to make sure that they own a substantial stake in each company, typically at least 20%.
Smaller funds do not have this problem. They are agile and flexible and look to invest much smaller amounts. And they do not necessarily need to own 20% of the company. Fred Wilson, the managing partner of Union Square Ventures, explains in his blog that the "need" to own 20% of a company is no longer true.
Lots of people have already acknowledged and recognized the coming change. Here are some examples:
Maybe not all that we are seeing is real and going to stick, but certainly reactions are rolling in. To be able to get into the game early, large firms need to re-think their play. Doing smaller rounds for less equity is certainly an option, but the question is - can this scale? Since a VC partner's time is finite, the answer seems to be 'no'.
There is an interesting dynamic brewing in the technology VC space. Since the last bust, IPOs have been scarce.
Only recently have some companies gone public, but at large this is still far from a good opportunity. The big exits have
been far and a few between. YouTube and MySpace are the exceptions, not the rule.
Now, putting it all together, leads us to conclude that large venture money is going to migrate away from technology. Specifically, this is what is likely to happen:
The markets are endlessly fascinating. If a few years back someone would've claimed that big VC firms would face a tough tech market, people would've simply laughed. Yet, here we are and it is true. This change has led to a new category of smaller tech funds, as well as some shifts of big money from tech into other sectors.
But just because big money cannot be deployed, does not mean that big money can't be made. A company can become big and successful with much smaller investments. del.icio.us, Flickr and StumbleUpon are a few such examples. But even though the return multiple is the same, the scale is going to be different. 10x return on 1M cannot be compared with 10x return on 10M; and this does fundamentally change the business.
At the end of the day, the winner of all this turmoil is going to be the consumer. Because there will be more smaller funds making many small bets, the result is going to be fierce competition and superb products. So here is to change, endless innovation and technology improvements!
Disclosure: Union Square Ventures is an investor in Alex Iskold's company AdaptiveBlue.
Listed below are links to blogs that reference this entry: The New Rules Of Technology VC.
TrackBack URL for this entry: http://www.readwriteweb.com/cgi-bin/mt/mt-tb.cgi/1675
Semantic Web. Implicit Web. Web 3.0. Lot’s of happy new buzz phrases being tossed about. Of course, the academic one is “semantic web” - all the rest are made up trendy things. While there are plenty of a... Read More
Comments
Subscribe to comments for this post OR Subscribe to comments for all Read/WriteWeb posts
Alex,
i think i need to steal you away from RRW and get you to post this stuff on the Union Square Ventures blog instead!
Fred
Posted by: fred wilson | October 4, 2007 1:24 PMHi Fred,
I do not think you need me, you and Brad put out a goldmine of great content for startups and vc-alike.
Thanks!
Alex
Posted by: Alex Iskold | October 4, 2007 1:27 PMGreat post that captures the changing landscape nicely.
The larger firms are going to have to turn to later rounds of tech + bio and alternative energy. It's a function of their structure and returns necessary to flourish.
What's most interesting to me lately is the change that's occurring at the earliest stages of start-up investment as the changing dynamic of the industry has opened a gap that has created an opportunity.
Firms that invest along early-stage processes are starting to emerge and succeed. Invention Capitalists, Commercialization Capitalists, and the like are bridging the gap along with innovative VCs.
It's an exciting time to say the least!
Posted by: Fraser | October 4, 2007 1:30 PMAlex,
Yours are of the few posts that I read completely - not scan: read.
Thanks for the insights. Much appreciated.
Tara
Posted by: Tara Kelly | October 4, 2007 2:33 PMTara,
My pleasure :) This is the best compliment I
could possibly wish for!
Alex
Posted by: Alex Iskold | October 4, 2007 3:45 PMVery, very insightful, and I like the optimism ... more 'boutique' investors investing in a greater number of projects. You're right, good for everyone.
Posted by: Jeff Crites | October 4, 2007 3:46 PMmaybe the big guys need to create satellite funds that can compete with the smaller funds.
Posted by: Darren | October 4, 2007 3:49 PMoh and great read by the way.
Posted by: Darren | October 4, 2007 3:50 PMhi Alex, this is a great post. As a peripheral player with a start-up currently in the Series A funding cycle, I find it amusing from all those who talk as though there is money everywhere. "Just come up with an idea and someone will come along and fund it." That's just not reality.
But I am definitely seeing a difference with the attitude of VC's in general. There is a lot of skepticism about Facebook (which surprised me!! I thought the entire valley was drunk on its koolaid, not to take anything away from FB's success but can all these start-ups be funded on advertising alone? Are there enough advertisers out there to support them all anyway?) and skepticism about making money and monetizing many of these businesses. So they're not all out there looking for the next Facebook. This is different than just a few years ago when EVERYone was looking for the next Google. It's a subtle difference but an important one. Spending $20-30M and getting bought for $50M isn't an ideal, but it's what many companies end up doing lately.
Getting VC investment is still a long, tedious and tenuous at best process. Whatever the stat - 1 out of 50 who seek it find funding, and a lot of those deals are built upon the pre-existent networks of who knows who, most companies outside that will be forced to make a business model that works, or fade away. And that's not a bad thing at all, but I'm still reading the forums on many of the tech sites there are still so many who think they're going to easily get funding and rapidly become bazillionaires.
Posted by: Antje Wilsch | October 4, 2007 7:05 PMGreat post, Alex. You did a very nice job of articulating a feeling I had about a year ago. My related blog entry can be found at http://abovethenoise.blogspot.com/2006/11/funding-software-companies-aint-what.html.
Posted by: Perry Mizota | October 4, 2007 8:50 PMAlex,
Posted by: Hardik | October 4, 2007 11:05 PMawesome post. cheaper than cheaper. but we are considering Startups. i think we need to redefine the startups now a days. Are we talking about Technology platform startups like zimbra. or are we talking about cool SOCIAL startups.no doubt cost for the social startups have tremendously gone down.
Great post, Alex.
This might be a little off-topic, but what would you expect a startup to achieve (or consist-of) with a $100k investment, e.g. user adoption, employees, market share, revenue, or (dare I say it?!) - profit?
Other than social bookmarking sites, I haven't seen much in the way of startups that have 'made-it' on that much cash. Didn't YouTube take $11 million to get where most startup founders would like to be?
Posted by: Neil | October 5, 2007 1:43 AM@ Neil,
It depends... In the early stage you do not need to scale so its very cheap. Amazon Web Services (S3 in particular) can be a real help. I can tell you that seed funding for AdaptiveBlue was less than 100K and that lasted 1 year.
Alex
Posted by: Alex Iskold | October 5, 2007 5:42 AMNice post Alex. We posted a rebuttal on alarm:clock. In summary, you are spot on that so much has changed for Web content companies and that the likes of Clavier and Wilson have advantages with these changes. But Web content is a small sliver of the technology sector. The basics have not changed that much for hardware, semiconductors, Net infrastructure, enterprise software, wireless, networking, batteries, security, games, homeland security, nanotech, eCommerce, telecom, consumer products and so on. VCs keep investing here and continue to be rewarded so I don't expect that "large venture money is going to migrate away from technology" as you conclude.
Posted by: Jon Burke | October 5, 2007 9:51 AMhttp://www.thealarmclock.com/mt/archives/2007/10/rebuttal_vc_biz.html#Permalink
Neil I have to agree re. $100K - maybe for 2 kids who can live on a sofa and eat ramen noodles for a year.... they certanly aren't getting a salary & any kind of health care insurance, that wouldn't be enough to cover good legal representation, a solid patent application, pay themselves, build custom software, buy hardware, a suit to meet the VCs in, AND market, on $100k.
Like Guy Kawasaki stating that his last venture only cost $12,600, and no offense Guy but the get-what-you-pay-for shows, (I love his books, just not a fan of that particular site) but moreover a disservice that it does to the development industry- $12.5k to build a site, maybe if off-shored and assuming that Guy's time to manage the project (advising, building specs, giving input, testing etc) is worth $0/hour in "costs".
Posted by: Antje Wilsch | October 5, 2007 11:37 AMAlex:
Dinosaurs and slow-to-respond industry giants just can't see things quickly enough to make the necessary change in course to avoid the icebergs. When they crash and sink, suddenly lots of "oxygen and sunlight" become available to help the little trees grown up. Thanks for cheerleading the need for VCs to remain flexible and sharp. I cross-posted on your piece to http://blog.innovators-network.org The Innovators Network is a non-profit dedicated to bringing technology to startups, small businesses, non-profits, venture capitalists and intellectual property experts. Please visit us and help grown our community!
Best wishes for continued success,
Anthony Kuhn
Posted by: Anthony Kuhn | October 5, 2007 3:23 PMInnovators Network
As an early stage angel investor with the most prominent angel group in the US, there is very strong demand for our investment. We have multiple screening committees just to get through the monthly deluge of submissions, many of which are high quality opportunities.
What is interesting is that it has been known for some time that there is a "funding gap", yet there really has not been a large growth in smaller firms. There are new players certainly, but no major rushing in to fill the gap.
What is equally interesting, is that in our 20 year history at the pinnacle of angel investing, our group has generated a roughly 54% average annual return. However, breaking down the returns into M&A vs. IPO, M&A exits have returned...wait for it... a negative 4% return.
While some will do well with M&A exits for lightly capitalized companies, the IPO is still the exit of preference for VC.
Posted by: Don Jones | October 5, 2007 4:54 PMNice theory, but really, you need to make people aware that the product exists, so unless you are a per project for some blogger, you are just as dead as in the good old days, without a marketing budget.
Posted by: Mikael Bergkvist | October 6, 2007 12:57 AMAlex,
Great insights on the changing landscape in VC.
As a service provider (recruiter) to early stage, venture backed companies, I think the service provider community (lawyers, accountants, recruiters, PR firms, etc) have an opportunity to rethink how they charge their entrepreneurial clients who are taking less money to get a product to market quicker, generate revenues and prove the business model.
A lot of the established service firms that are based on partner-led pyramid infrastructure models need to be able to adapt their cost structure to accomodate an early stage company's need to keep costs down. Service providers have been able to take advantage of some tech advancements as their clients.
The alternative for the entrepreneur is to find providers who can deliver their service at a lower cost, without compromising quality. There is a large ecosystem of top flight but less well known service providers who can deliver great results at lower cost.
I would encourage some of the VCs who are investing in companies with smaller A rounds to build an ecosystem of service providers that can deliver superlative results at lower cost with the same passion as their client entrepeneurs.
Posted by: Ed Zschau | October 6, 2007 6:02 AMEd,
I completely agree with you about services around startups. The crazy legal fees just can't be there if we are talking about substantially lower funding levels. Leveraging a hive of services is a great idea, and I think VC have been doing this already.
Alex
Posted by: Alex Iskold | October 6, 2007 7:05 AMOne of the thing we believe is "going to happen next" and certainly are trying to actively promote is "seed acceleration" programs modeled on YCombinator but in an open format. With FundCamp we want to put in place a freely replicable process and open tools so that anyone can organize their FundCamp and accelerate seed investment and growth on particular segments or geographies while using limited amounts of investments.
This is for sure no change for the VC world in the short term, but this really looks to me as having all the standard attributes of a potentially disruptive approach for their model.
Posted by: FredericBaud | October 6, 2007 8:19 AMI doubt the large VC firms ever put much money in early funding phases of startups with just a "70 page business plan" without a proven prototype & cashflow to show.
I do agree that there is more sense of urgency now. That is because technology cycles are now faster.
Business plans are certainly fundamental, but more for the founder to work out the details of his strategy and vision than for impressing investors.
Certainly it also better just to get on with it. Doing development by bootstrapping, instead of endlessly fine-tuning a 70 page business plan and waiting on investors.
And with lower and lower funding needs for funding isn't the point soon reached that it is better just to get a loan from the bank and keep 100% of the company for yourself?
Posted by: Chris Rijnders | October 10, 2007 9:16 AMGreat Post! As a tech startup founder I am seeing first hand the need for less funding, because I can do everything out of pocket. I have not gotten a series A funding my focus is on understanding the needs of my potential customers, and system development. What is missing from this post is with so many choices for series A funding available how does a small fund differentiate itself from other funds? I would say by focusing in vertical areas.
It's not about the funding anymore it's about connections so that when we do the series B those investors will understand the business and provide exposure to potential customers.
Are these smaller firm focused around vertical industries?
Posted by: Terry Leach | October 12, 2007 7:10 AMThis post and the comments have been a great resource for a fledgling web 2.0 startup! My partner and I have been in the process of putting together the business model and concept of a need we see that is unfulfilled in the current market. The quandry we have now is given we come from the strategy side of things (MBA grads) and not the technical side (building the sucker)...what is the best path to take to get to beta?
Do we bootstrap with $50-100k to get a beta up and running (albeit not out of the blocks as fast or as fit as we would like) or do we take the concept (unproven but with solid market analysis) door to door to get seed funding?
The model has no great technical IP but is a service not currently offered that we think needs to be done well from the start to ensure first mover advantage.
Any advice would be greatly appreciated...and thanks again for the posts.
Posted by: Dan Bisa | October 23, 2007 7:05 PM