I work at a brand name venture capital firm which is actively investing.
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.
Are you seeing any trend of investments getting smaller? E.g. would your firm invest $200k into a promising company, or is that still out of the question even in these "tough times"?
My firm would do and always has done pre-Series A stage, with a view to building a relationship and following-on in due course. However that is and has always been a less common strategy: most 'bulge bracket' firms (active fund of $300-600m) don't invest such small amounts.
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.
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?
PG's argument as I read it is that there's a shift in comparative market power towards entrepreneurs qua producers because the barriers to innovation have fallen so their funding needs are less.
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.
I think the only fallacy I'd point to in that argument is the idea that "more money helps" when building software.
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.
Even were that uncontroversial, the cost of developers' time generally accounts for only a small proportion of the costs of bringing product to market.
At some point, isn't it in the best interest of the VC firms to pioneer innovative methods for screening, analyzing and funding large amounts of quality smaller deals?
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 know virtually nothing about YC so it seems off for me to be jumping in on this. But is YC really pioneering methods of investing.
Aren't the other components: motivation, introductions, community, promotion, etc. more substantial the the "investment" element. I guess you could call those things investment too, but not capital investment. Basically, is YC in the same industry as VCs at all?
In an age when anyone can do a startup, the word "startup" here on YC has somehow been distorted to mean "small software business that was started in the last two years on a shoe string budget."
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.
I thought that was Excite? I don't recall Google becoming the default search on Netscape until FireFox. I remember that when all my friends first started telling me to use Google (1999/2000, well after they had 30 computers), we still had to type in www.google.com to get there. And I was a die-hard Netscape fan then.
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.
They got to profitability on angel money. They were already profitable when they raised money from VCs. I don't know exactly how much angel money it took. Probably a couple hundred thousand. Costs have decreased so much since then that it's reasonable to think one could do the equivalent for $20k today, if one had to. But whether it would take $20k or $100k, the point is that the amount needed would be way below the typical series A deal size of $1-3 million. An order of magnitude less. Which means this is a company where VC-scale investment isn't required to win.
According to their SEC filings, Google turned a profit for the first time in 2001. Their first funding ($100k) came in 1998. They then secured $25m in 1999.
AdWords was not launched until 2000 so it wasn't possible they were turning a profit before then.
They were profitable from their deals to supply search technology to Yahoo, etc. If they didn't call themselves profitable in their SEC filings, it was presumably because of some accounting rule about the cost of options or something like that.
Yeah, I'd like to see a source for this too. I recall there being a big flap about how much money they were burning back in 2000/2001 with no possibility of revenue (hah).
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.
I get the impression that Google cares so little about haters that they don't even bother to correct them. If someone claims they're doing something immoral, then they'll respond, because they don't want people to have a bad opinion of their character. But if someone says they're stupid or won't make money, their attitude seems to be that the appropriate punishment is to remain benighted.
Maybe there's ground in the middle that looks something like this: VCs have a stronger bargaining position in capital intensive startups than in software. Stronger bargaining leads to more power to direct the returns to their pockets rather than the founders'. So the model is VCs maximize their after-costs (founders and otherwise) rate of return which is likely to be higher in non-software ceteris paribus.
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.
The idea that VC's shouldn't be involved in companies that only require $20K to start is fairly popular here on HackerNews. Just ask the TicketStumblers, or the VirtualMins.
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.
The reason that founders cashing out on big rounds was never absurd, and will never be absurd (though market conditions may make it less common for a time) is that in many respects it aligns the interests of the founders with the investors.
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.
Yes, it seems to be increasingly common for founders to sell a little stock personally in the course of a funding round. At least, it was till the market crashed.
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.
The middle to higher end of that range, maybe more. It only tends to happen in high valuation deals (usually later funding rounds) so a little stock is usually worth a lot.
I'm especially interested in seeing if companies where the founders are allowed to cash out a bit up front actually do better and do better because they were allowed to cash out a bit. May take a while to get that data though.
I think that increasingly, software-based businesses will be starkly divided by the "application" and the "infrastructure" realm. While the former is made by a single person or a small group and runs on preexisting systems, the latter builds and maintains said systems, and has to pull in serious resources to do so.
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.
I don't see your model as being intrinsically separate pieces. IMHO we're already at the stage where pushing out software is cheap, and can be done with zero investor funding. Scaling on the other hand, is still as expensive as ever. Your next Twitter can only go so far on a single box, and there will be a time where it's make or break - you'd have to sink some serious money into building out infrastructure to keep growing the business.
A single box can handle a lot of traffic. A well tuned web server should be able to handle enough web pages that your making about 1$ / second in peek times from advertising. That much revenue should let you double your number of servers each month should you need to. EX: In 2007 Slashdot used 16 web servers with 2 Xeon 2.66Ghz processors, 2GB of RAM, and 2x80GB IDE hard drives. (http://meta.slashdot.org/article.pl?sid=07/10/18/1641203) today that's cheep.
PS: Twitter's cost's have far more to do with SMS traffic and staff than hosting their website.
The reality is that the Web is so big now that you can start smaller firms for next to nothing in lots of niche markets. That doesn't mean VC is broken, it just means that smaller firms can exist without it. You're not going to start Amazon or NetFlix without follow-on capital. You can start a Web gadget company that makes $50k just fine though.
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.