Early risers: Ease of launching Web startups alters terms between entrepreneurs, VCs

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Published June 16, 2008 at 6:23 PM

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When Increo Solutions Inc. closed a seed round of financing from Draper Fisher Jurvetson in May, the startup resembled scores of other enterprise software companies the veteran Silicon Valley firm has funded in its 23-year history.

Increo had identified a potential market among large corporate customers and developed a prototype product tested with early users. The company's software, an online collaborative workflow tool to help users share ideas on documents and images, was easily adaptable for use by big enterprises and came with high levels of customer support. To build its technology, Increo had hired professional engineers, luring them with the promise of equity, and was on the verge of hiring its first salaried employees and introducing its first commercial products.

That's where the similarities to earlier tech companies end. Unlike software startups of even five years ago, Increo had made no significant investment in capital equipment, conducted no professional business development to acquire testing capabilities and early users and had no pool of friends and family investors to begin the process of early dilution of its equity.

"We probably had put $1,000 into the company," says founder and CEO Kimber Lockhart, who formed Increo in January 2007 with a handful of other Stanford University computer science undergraduates after working on product ideas for about a year as part of their college coursework. And despite having the vast resources of one of the world's best academic computing programs at their disposal, Lockhart says Increo required only the same kind of high-speed Internet connection available to anyone for the cost of a cup of Joe at the neighborhood WiFi hotspot.

Increo exemplifies the radically altered environment that is making it possible for companies to launch on a shoestring. Factors combining to drive the trend are the availability of free open-source software tools, ubiquitous Internet access, outsourced tech development, scalable subscription services for both hardware and software and a burgeoning audience of Web surfers eager to preview the latest innovations.

Net Change

A host of factors--technological, financial, institutional--are today shaping early-stage investment in Internet companies, and range from falling startup costs, to the emergence of open-source software programming, to the spread of angel investors enriched during the 1990s' tech boom. The advent of other technologies, such as clean energy, is also playing a part by giving major venture capitalists opportunities to extract fat returns from large investments in capital-intensive businesses. Among the main factors driving the changes in early-stage investing in Web startups are:

Falling start-up costs
Open-source programming
Growth of outsourcing/offshoring
Ease of scaling up services for large markets
Speed of online distribution
Wide availability of broadband
Spread of on-demand computing and Web services
Development of "angel" investing
Emergence of capital-intensive sectors like cleantech

Source: Tech Confidential

Whether developing products using free open-source Web services tools, such as Ruby on Rails, or contracting for cheap offshore programmers, product developers today can take an idea and translate it into code fairly cheaply and easily, with little technology infrastructure or need for in-house talent. Combined with free or low-cost data storage and distribution resources and widespread broadband availability by potential users, some startups can gain traction before needing to fully define revenue models or capital needs.

Financing trends both reflect and amplify the currents shaping the Internet startup scene. The biggest venture firms have raised billions of dollars of capital in recent years and are under pressure to invest it. That increasingly precludes making small investments in early-stage Internet firms and spurs VCs to target more mature companies that require more substantial sums or even to focus on more capital-intensive sectors, such as alternative energy.

"For a firm with a $500 million fund, it doesn't make sense to put in $1 million to get $20 million out," says Tom Blaisdell, a general partner with the Menlo Park, Calif., venture firm DCM.

Meanwhile, in a twist that some in the tech industry describe with a measure of irony, VCs are effectively writing themselves out of the script by spawning a generation of startups, and technologies, that obviate the need for substantial outside funding.

The result: a capital gap for Internet entrepreneurs. Filling that gap are angel investors and early-stage VCs eager to help entrepreneurs create effective businesses. In return, such investors get a chance to put in as little, or as much, money as can be leveraged into a potential exit.

The swift rise of Web 2.0 and the Internet's evolution from a catalog of pages to a platform providing an array of services has already created a surprisingly well-defined market for advertising that targets viewers much more precisely than any previous medium. Countless other forms of monetization are sure to emerge. That has potentially changed the game for VCs, who on the one hand expect more from startups in terms of progress before seeking funding, and on the other are adopting strategies to gain a seat at the table before substantial capital is required.

"If the cost of experimentation is zero, the first thing I ask is 'How much experimentation have you done, and if not, why not?' " says Curtis Feeny, a managing director with Voyager Capital, an early-stage venture firm in Seattle. "The definition of a Valley entrepreneur used to be someone who spins an idea until it sticks with investors, but now they are able to put ideas out there until the market starts telling them they are worthwhile."

Less than a decade removed from the dot-com land grab that led Internet investors into deals that ran into the hundreds of millions of dollars, VCs also must contend with an environment where it is a challenge to put significant amounts of money to work in the hottest Internet sectors. Whether this is because too much money is chasing too few commercially viable startups or whether dwindling startup costs have yielded a surfeit of potential companies to invest in remains an ongoing debate in the tech community.

On the flip side, entrepreneurs eager to gain the contacts and expertise afforded by working with VCs are grappling with how best to put early money to work to justify diluting their equity when it may be conceivable, at least early in a company's history, to bypass outside funding.

Many of the worst blowups of the first wave of Internet investment in the late 1990s involved heavily capitalized hardware startups that sought to build faster, more powerful computer servers and technology to connect them. By contrast, the core underlying theme of virtually all Internet development today inverts that strategy. Rather than new proprietary technology and better silicon, it is open-source programming and the ability to link large numbers of servers built from cheap chips that led the Web market to where it is today.

"This pattern toward startups being cheaper all the time really started with the advent of cheap white-box servers, which was really the premise for Google," Blaisdell says. "But making them scalable by outsourcing the storage and computer platform has really made it much more possible over the last few years for small teams with very limited skills and little money to develop products."

For instance, while in the late 1990s the first wave of Internet companies invested heavily in their own computer servers, Increo developed and launched its first products on the Web using Amazon.com Inc.'s Elastic Compute Cloud, or EC2, commercial Web service, which allowed it to rent computer storage and processing resources beginning at about $50 a month. Lockhart says the system even offered pricing flexibility for its group of sophisticated computer geeks to supply their own server technology capabilities as a tradeoff for greater server space, but EC2 and a variety of other Web services provided by Amazon and others allow even the least sophisticated users to purchase the level of support they require.

Blaisdell points out that investment sectors such as cleantech and biotechnology are largely unaffected by the trend but notes that even semiconductor development costs have fallen because of lower computing costs and the availability of off-the-shelf intellectual property. Indeed, he says that decreased Internet and software startup costs are leading to larger sector-specific investments in capital-intensive industries, where a large war chest alone can create significant entry barriers to competitors.

In software and Web services, by contrast, it is more important to move first and use later-stage capital to retain that position.

"In the dot-com era, first-mover advantage meant being first to raise money and build a brand," Blaisdell says. "But with the viral aspect of distribution today, even though the barrier for entry is low, it is more easy-come, easy-go, and the two biggest success factors are gaining first-mover advantage by tackling complex problems to build a barrier of entry and continuous innovation."

Of course, in Web services and digital media, where distributing products and services to consumers is virtually free and viral marketing is the rule, these advantages can be fleeting. Although DCM looks for ways to invest in such deals, it can be hard to put enough money to work in early-stage deals to make it worth the trouble, Blaisdell says.

For his part, Feeny says the market for early investments of less than $1 million in Web companies is an opportunity for angel investors, while venture firms are more likely to bet on companies around the edges that can provide services to those startups. Voyager looks at a lot of Internet infrastructure companies, where the cost of experimentation is still low but which require significant amounts of capital to go to market, he says.

Other currently attractive areas for early-stage investment are software-as-a-service, or SaaS, where startups deliver a software tool over the Web on-demand, and server farm operators. SaaS has emerged as the dominant distribution platform for most new enterprise software startups. Such companies are also particularly suited to early-stage venture capital investment because startups reach a point where they can demonstrate significant market growth while generating only a trickle of monthly subscription revenues.

"SaaS is a great model, but enterprise customers used to write six- and seven-figure checks just to get up and running," Blaisdell says. "SaaS companies get a lot more visibility early on, but customer acquisition is still very expensive, and even if you are growing fast, it makes sense to pay $1,500 up front to acquire a customer with lifetime revenue of $10,000."

Indeed, the cost of expanding a new tech company is a critical -- and often ignore -- issue. The idea of intrepid Web entrepreneurs, finally freed from the usual dreary capital requirements, engaging in unfettered innovation is seen by some as a romantic, but ultimately simplistic, conceit. Despite the plunging costs of developing a Web or SaaS startup, building these enterprises to a significant scale still often requires considerable investment.

To that end, Blaisdell says that much of DCM's strategy, once it commits to an early-stage firm, centers on finding ways to expand commercial opportunities with accelerated investment. That may mean persuading entrepreneurs to put money to work sooner than they might otherwise have anticipated.

A key turning point in the lifespan of many Internet companies today is the stage when a startup, launched on a dime, must confront the need for more money, says Scott Kurnit, the founder of About.com and other companies and an active angel investor. That challenge puts a finer point on the long-standing dilution conflict that has always existed between entrepreneurs and angel investors and professional venture capital firms.

The April sale of publishing search tool maker Sphere Source Inc., in which Kurnit had invested, to AOL LLC illustrates how efficient use of capital early on in a startup's history can create confusion over how much money to invest during expansion. Sphere had raised roughly $4 million from Blacksmith Capital, Hearst Publishing, Radar Partners, Trident Capital and True Ventures, and the investors were eager to inject more money into the company. But management opted to sell Sphere for a price rumored to be about $35 million. The deal represented a strong return for founders, but hardly a home run for VCs, and for angels including Kurnit it was a bit of a mixed bag.

"As an angel, it is a complicated place to play, because you can get in with less money and possibly without any money from venture capitalists," Kurnit says. "But if you do take venture capital, the VCs want to put in a significant amount."

Tech investors and entrepreneurs face another related challenge wrought by the explosion in the number of Internet companies stemming from lower startup costs: sorting the wheat from the chaff.

"Given the low barriers to entry for creating and marketing new Web properties, there's now a substantial oversupply of seed-stage Web ventures in the financing market," says Adam Lehman, managing member of Rock Ridge Ventures, a Bethesda, Md., early-stage venture firm. "That makes it more difficult for any given venture in a category to separate itself and produces a lot of frustrated, underfinanced entrepreneurs and confused, and increasingly skeptical, investors," says Lehman, who sees these dynamics from both sides of the equation given Rock Ridge's seed investments in digital media and his role as president of GeniusRocket, a "crowdsourcing" platform for developing advertising and marketing content.

As a case in point, Lehman points to changing investor perspectives on social networks, such as Facebook Inc. and MySpace.com. Several years ago, networks with rapid user growth and a defined niche could easily attract early-stage funding. Today investors are much more discriminating. "Now many investors won't even look at a social network unless it's already achieved critical mass of 5 million users or more," he says.

Kurnit notes that professional investors are more likely to seek ways of guaranteeing their position early on, adding that he is currently looking at an angel-backed company that has strictures in place dictating that founders don't get anything in a sale for less than 3 times invested capital.

Feeny says lowered startup costs have also made it possible for different types of entrepreneurs to take companies to significant milestones, and investors need to discern their goals and work to educate them about the benefits of taking on venture investment. There are growing numbers of entrepreneurs like Craig Newmark, the founder of Craigslist Inc., who have little interest in monetizing their products. It is vital to identify that ahead of time to avoid the acrimonious relationship Newmark now has with minority shareholder eBay Inc., which acquired 28.4% of the company from a founder who cashed out.

More often, Feeny says, he encounters entrepreneurs who know they require additional capital to be successful but who are unwilling to accept dilution. In some cases Voyager will introduce entrepreneurs to industry executives to talk about dilution issues.

"The normal entrepreneur subscribes to the idea that capital is a strategic weapon and is very willing to make a tradeoff of dilution for a larger opportunity," he says. "But there will always be entrepreneurs that aren't venture-ready, and we don't spend a lot of time with them."

Such entrepreneurs are multiplying. For if one thing is clear, it is that the trend toward lower startup costs will continue. Each phase of incremental innovation creates opportunities to cobble together large opportunities from good ideas.

With a much wider playing field to experiment with early ideas, it may be that venture capitalists will largely sit out early development and invest only at the stage when companies are prepared to spend aggressively on expansion.

Until the innovation cycle turns again. Kurnit says that developers increasingly look at Web services like electricity. They don't have to make it -- they just know it flows from somewhere and that it makes things work. That means entire products and distribution models can be developed with no more resources than a startup used to invest in the monthly light bill.

"There are going to be a lot of little inventions, and there are going to be a lot of crappy inventions," Kurnit says. "But for the ones that pop through, there are eventually going to be big marketing costs, and VCs are going to get a seat at the table."

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