Web 2.0 Is A Gift, Not A Threat, To VCs

NOTE: I mislabeled the x-axis in the orginal charts in this post as "months since formation". They should have been labeled "quaters since formation". Thanks to Brandon Watson for pointing out the error. I've changed the charts and they are correct now.

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It's Christmas time and I've been thinking about gifts. In this case, I've been thinking about what a gift the evolution of the web from its first generation to its second generation has been to the venture capital business.

Yes, I've read all those posts (and have even written a few of them myself) talking about the capital efficiency of building and deploying a web service these days. And it's true that it's getting easier than ever to start a company without needing venture capital. So many have posited that web 2.0 is a threat to the venture capital model. I think that's totally wrong. Web 2.0 is a gift to the venture capital business and I'll explain why.

I've been investing in web startups for over 10 years. I was a very active investor during the first incarnation which we now call web 1.0. And I've been an active investor during this incarnation, which we now call web 2.0. I've been involved in more than fifty web startups through Flatiron Partners, Union Square Ventures, and a number of angel investments.

And I have paid close attention to the capital requirements of all of these businesses. When you write the checks to keep the project going, you generally have a good sense of how much it all costs.

Back in the late 90s, you had to build everything from scratch. The LAMP stack wasn't the obvious platform it is now. There were no off the shelf commerce solutions. A content management system cost a million bucks or more. Streaming video meant huge license fees to Real. Web servers from Sun could force you to do the next round of financing. And it always seemed to take 20 engineers or more to build whatever it was you wanted to build. At a minimum, you were looking at $5mm in first round venture financing just to build the service.

Then you needed another $5mm in second round financing to launch and market the service. Back then there were no blogs which could tell the world about your new service. You had to do expensive PR, marketing, and the expensive anchor deal with one of the portals that ended up bringing you no traffic but still cost you millions.

If you did all of that well and built a large audience for your service, you then needed to build a business model (ie revenue). So you went out and hired a salesforce to sell whatever it was you were going to use to monetize (ads, subscriptions, licenses, etc). That meant a third round and at least another $5mm.

And if you got the revenue flowing, you'd generally need one more round of financing to carry you to profitability because the expenses were going out the door faster than revenue was coming in (they call that "working capital needs"). So you went out and raised another $5mm to get you there.

Best case in web 1.0 world, you could get profitable in four years for a total of $20mm. It almost always took more, but regardless, my main point is that the capital requirements were linear over time. Five million per year for four years. The chart looks like this.

Much of that story has changed in the past six years. The bubble burst and it was the best thing that could ever have happened. Web entrepreneurs were forced to figure out how to build stuff for less (a lot less). The LAMP stack emerged as the platform of choice. The MBAs and big company types who invaded startup space in the late 90s went back to "real jobs" and the only people left were hackers and geeks who knew how to write code themselves. And so they did. They formed small teams of two or three people and built some really important web services initially by themselves and a few friends/colleagues. What they figured out was how to build a web service for less than couple hundred thousand dollars (more than an order of magnitude less than people were spending at the top of the first bubble).

At the same time blogs emerged. They were initially a new form of self expression, a merging if you will of the role that forums and personal homepages had played in web 1.0. But they were quickly adopted by the same community of geeks and hackers who were building the first web 2.0 services and they became a way for people to tell each other about new web services that were being built. Because blogs are link heavy they generate traffic. And they also are search engine optimized. So Google + Blogs = Traffic. And that formula has been perfected to the point that it no longer requires an expensive PR firm and a portal deal to launch a new web service. You start with the blogs and go from there. I've seen some of our web 2.0 companies get more traffic from blogs in one day than some of our web 1.0 companies got from expensive portal deals in their entire existence.

The net result of these two fundamental changes is that you can build AND launch a web service in less than a year for less than $600k. And so many have done it that its not even worth pointing to examples. They are everywhere you look.

That's the story that's been written. That's the story that leads to the "web 2.0 is a threat to the venture capital model" theme.

But as I sit here at the end of 2006, with a portfolio full of web 2.0 companies that are growing and thriving and expanding, I am going to tell you a story that hasn't been written (at least I haven't seen it).

And that story is that some things don't change about starting a company.

It may take only two or three great developers to build and launch a web service. But it still takes a bunch more to maintain it, develop it from there, deal with scalability, deal with feature enhancements, take the service in new directions, respond to competitive threats, etc, etc.

Two years into the creation of a web services company, you'll certainly have more than ten engineers on your team and you could be looking at closer to twenty. That costs money.

Another unavoidable fact is that customers are expensive. They require service. And you can't provide customer service forever with a blog that most of your customers don't even know exists. You have to provide email support for sure. And more and more web services company (certainly the ones who want to service mainstream customers) are moving to some form of phone support.

And then there is that thing called revenue. You can launch with Adsense. That can get you to first base in the revenue ballgame. But you eventually need to go past that. There are other ad networks like advertising.com, TACODA, Tribal Fusion, FeedBurner, Federated Media, and others. They can bring you a lot more revenue but you are going to need to hire someone to manage all of this activity.

And eventually you are going to hire your own sales force. Salespeople take time to get up to speed. Particularly the first couple salespeople who are doing missionary work. Salesforce = big time cash burn. It always does.

Another challenge that a growing audience creates is scalability. What once ran on a single server and a T1 now requires twenty racks and more bandwidth than can be found in a single facility. And what about redundancy? So you open a second facility. And what about storage? Most web 2.0 services use data to deliver a compelling experience for their users. But you have to store all that data somewhere. I see more money going out for storage hardware these days than almost anything else. Yes, you can use Amazon S3 and I would encourage everyone to do so, but that alone is not going to solve all of the storage problems out there.

Before you know it, you'll be consuming cash like a web 1.0 company. It is already happening in the most successful companies in our portfolio. The chart of capital consumption of a successful web 2.0 company looks like this.

So maybe it still takes $20mm to get a web startup profitable? I think that many can and will do it for less. And few web 1.0 companies were able to do it for $20mm. So I am taking some liberties here. But it's mostly to make a point.

And the point is this. Venture capital still plays an important role in financing web entrepreneurs. But the need for capital comes later in the company formation process. And that is a very good thing for everyone involved. Because VCs can scale their capital (ie risk) exposure as the risk is mitigated from the opportunity. They can still get their $10mm per deal invested, but they will put less up at the start and more up later.

And its better for entrepreneurs because they are going to keep more of the business because they will dilute less in the early days when the valuation is lowest. And, of course, entrepreneurs now have the opportunity to cash out before they have taken a lot of venture capital.

You can see my point if I overlap these two charts.

All that area between the red and blue lines is risk that has been taken out of the equation for VCs and equity that should largely accrue to entrepreneurs. It's a huge gift to the entire web startup ecosystem. Given to us by the people who toiled in the "nuclear winter" creating a new model for building web services. We owe them a great big thank you.

So how do you play this new curve if you are a venture capital firm? Well there are a number of approaches. There is Paul Graham's Ycombinator that makes rent money available to hackers who are building new web services in return for a small piece of equity. He's doing a lot of them and playing the numbers game. There is CRV with their Quickstart program where they make loans for the initial startup money in return for a pole position on the next round. And there is First Round Capital's model which is largely that of a seed fund with staying power.

At Union Square Ventures, we take a pretty traditional approach to this opportunity. We are going to invest in just about the same number of companies per year that we would have invested in during the 90s. That's two to three per partner per year. That number has worked well in the early stage venture capital business for a very long time.

But we are going to start with smaller amounts. We'll invest between $250k and $1.5mm in the first round. And then scale up our investment as the companies need require it. I think we'll get $7mm to $10mm invested in our best companies over time. But we'll do it in a way that lets us take less risk in the early years when the opportunity is not fully formed. And that is a gift for which I am very thankful for this holiday season.

Comments

[Leon loves pictures]

Yes I agree with you, the web 2.0 business models are much more efficient and more lucky to succeed if the critical mass of users is reached quickly.

Thank you for sharing this story with me !

[James Cherkoff]

Great analysis and one that rings a big bell. The other big difference in terms of risk is time. Everyone may still be in a rush, but nothing like the IPO-driven, frenzied timelines of 1.0.

[kevin]

Great, informative article Fred.

I'm including it in my weekly roundup tomorrow over at Juxtaviews.

[ashkan karbasfroosha]

Once again: breaking down the VC biz into a science. Fantastic analysis and observations.

One thing, you mentioned you've done 50 investments thus far, you should put together a Top 5 or 10.

[Robert J. Ed]

Great stuff Fred...I'm a marketer and don't know all that much about investment and businesses in terms of a lifecycle.

I find this stuff VERY informative and cool.

[Robert J. Ed]

Great stuff Fred...I'm a marketer and don't know all that much about investment and businesses in terms of a lifecycle.

I find this stuff VERY informative and cool.

[Brandon Watson]

Am I missing something here? Fred, your first chart clearly shows $20M in funding over 16 months. Assuming a linear progression, that's $60M in 48 months, or the time you project to get to profitability.

Second, assuming that the net income loss is being reduced over time, then wouldn't this curve exhibit some sort of log scaling and an eventual plateau at profitability?

Third, what is causing the exponential capital consumption in your web 2.0 companies? There is no resource that I can think of that we require which has that kind of consumption pattern. People, bandwidth, servers, etc, are all linear in their cost structures. Well, bandwidth has some issues, but for the most part, unless you are YouTube, bandwidth is not a super big deal.

The only true unknown for most startups is the customer acquisition costs. However, as you noted, blogs and GOOG make this a much more capital efficient process.

Given these points, I have to say that your $20M number to get to profitability is way off the mark for a solid startup with a good plan and product, and a viable plan to make money. Any company can throw away $20M, but the good ones won't in the Web 20 world.

**this of course applies to web services, not any capital intensive startup like hardware.

[anushrav]

Great Stuff, Very informative but then the analysis by Robert J is compelling argument as well.
I guess, the cost reduction on H/w and PR is where the linarity converts to logrithmic, till viralling/blogs etc. take you to level where you need look in to traditional cash outflows like customer support and scaling investments.

[AlFromChicago]

Great post -- I agree with most of what your saying but not all.

I think web 2.0 services that become home runs will require capital -- as you said, at some point you need to staff up to really focus on new features and functionality, pay for bandwidth, and manage your business, and at some point you need to do this ahead of revenue, hence the need for capital.

Where I have a somewhat large disagreement with you is the aggregate need for capital over the life of these services. I think every business is going to have a choice much earlier than in 1.0 about whether to cash flow sooner vs. later, and I believe, given all the ad networks, traffic building capabilities etc., that it will be increasingly (that it IS) easy to cash flow after a very small amount of capital, say $1MM-$2MM. I think many 2.0 folks will focus on growing this cash flow as soon as possible and reinvesting it into the business, hence providing their own growth capital. I don't agree that for many of these guys the right answer is keep raising capital without the focus on cash flow first as I believe it will lead to some bad overal decisions being made.

So I guess what I am saying is I am convinced there is a need for capital, but have a hard time understanding how the per deal aggregate investment will be/should be more than in the $5MM range -- and if you are a VC that has to syndciate your deals that means its closer to $2.5 per deal. Which I think makes it tough to succeed with any kind of sizeable fund.

And maybe my disagreement is the nexus point of where the interests of the VCs and entrepreneurs diverge -- for an entrepreneur/founder having raised $3 MM and cash flowing $3MM a year may be happy, but the VC who owns 1/3 of that business may not be. And the question is how does that risk profile look, not just for the VCs, but the entrepreneurs, after the first $5 in capital --

[adam]

fantastic post....the 532651 (or whatever the number is) post of the holiday season

[Fred S]

Thanks for putting this together, though I think there may be a few things missing. First of all, the fact startups are cheaper means there are more of them. The blogs serve as a good screen, but the sheer volume of information means you're going to have to spend a lot more time finding the needles in the haystack.

To help find those needles, people turn to Techcrunch and other A-list blog for information. This information, sometimes good, is public - meaning it is harder to get jumps on promising companies. Of course, establishing yourself as *the* VC blog probably helps with leads ;)

Regarding funding needs - since companies are cheaper, there's more of a market for finance. An established VC is going to compete against everything from credit card advances to family loans to microcapital to Y combinator. The goal of VC is spreading their funds, though limited market needs may close more doors than it opens. It also increases competition. This is better for the buyers of finance, not so much the sellers of finance.

There's also a question of investment trajectory - it so happens that many of the companies starting up aren't gunning to be the next Google. They are gunning to start a successful company that will employ a bunch of people and pay health insurance and Christmas bonuses, but they aren't trying to upend Larry and Sergey. In Web 1.0, everyone was trying to upseat the king. In Web 2.0 companies saw they could niche and segment the market successfully, just as successful software businesses have been doing for years.

I believe the real problem Web 2.0 presents investors is the lack of specialized trustworthy information. The blog post promoting a company - was it pay-per-post? Techcrunch loves a company - that means every VC from Seattle to Miami is paying attention. How do you uncover those trustworthy, early leads when the blogosphere is the information filter? I think it is going to require VC's to be much more nimble, adept at finding and screening information, and web-centric. It requires outside the box (and A-list) thinking and research. It is a new epoch in a sense.

[Jeremy Wright]

Yep, seems to hit home. Great stuff Fred. I'm sure these graphs will get used in hundreds of presentations by entrepreneurs around the world ;-)

[steve]

thank you, fred, for spelling this out so crisply and clearly. another awesome post.

an unfortunate side-effect of the "web 2.0 is bad for VC":

either honestly or cynically, some shallow-thinking or scared VCs now use this idea to pressure portfolio companies to spend little or nothing -- to try get investors better-than-venture-sized-returns on as little capital as possible (because either they like the idea of squeezing ever more juice out of the orange, or else they have little faith in their investing talent and portfolios so want to reduce exposure to any one bet unless/until it is a sure thing).

i hear this going around now all the time: "why do you need $XX capital? internet startups don't need capital anymore. you're just not managing well"

its just ridiculous -- if nothing else, great companies are made up of great teams of great people, and last time i looked, storage and bandwidth get cheaper everyday, but great human beings get more and more expensive (at least, the ones who live locally and come to an office and deliver 110% etc)

[chris dixon]

Before you say web 2.0 is good/bad for VC's don't you have to talk about what is happening to valuations?

In your framework, later stage companies are less risky in web 2.0 than in web 1.0. Less risk (combined with ever increasing amount of VC money) should lead to higher later-stage valuations, which would yield lower returns for VCs.

[Mike]

You post addresses a segment of the web 2.0 market, but a large number of these businesses can be grown with organic revenues and never need VC. I’m an experienced entrepreneur. In the old days it did take many millions. And today there are some opportunities that still require millions, albeit later in the growth cycle, when much of the risk has been taken out of the equation.

But let me give you an example. I’m building a viral web 2.0 application now. I did the design, provisional patent, and passed it to developers. They are using the LAMP stack and expect it to cost about $4K to build (so assume $8K). I lease a couple servers at $400/mo. and network costs of $100/mo. at a colo. The marketing is easy and cheap with blogs, free PR, and viral nature. Then assume we need to continue to enhance it for $1K per month. Using ODesk or offshore programming this is easy. So assume the total is $10K up front and $1,500 per month, which AdSense should cover. It’s a hobby. If it hits, it can grow organically as the traffic+AdSense grow. At some point I may want to increase revenue through direct sales, but I’ll find someone on commission only, or I’ll use the revenue history to get a bank loan.

So I understand that some of these companies need the millions, but many never will. Sure it is appealing when your site traffic goes through the roof and VCs come calling with millions to make things more comfortable, but in many cases it isn’t necessary.

[Nate Westheimer]

"It's niiiice!!!!"

No, seriously, do you think this is going on beyond Web 2.0? Think about Borat... a movie that probably took very little to make, a bit more to do viral marketing, and then a ton to really market hard.

I bet that graph you made applies to movie making (at least in a certain new genre) and a bunch of other industries.

[Allen Sligar]

This was spot on and a great post Fred.

I'm a founder of one of the start-ups your graph applies to. We've gone from initial concept (May) to starting our closed Beta (Jan 5th).

I will say honestly its taken, off the top of my head, maybe 6k.

Thats co-location, software packages, etc. its really very cheap if you have a strong team.

It's all about having a stong, motivated, talented team of founders and no dead weight.

IMO after having gone to a number of 2.0 events here (Northern California, close enough to SV and SF to go, far enough away to keep our eye on the ball) there are three important factors from a Start-up/New CEO point of view:

1. Strong business model, and a tangible product/solution that SOLVES a problem, something that can be monetized, over reliance on advertising as 1.0 proved dosent go so well when those dollars dry up.

2. Strong team, with dedication and buy-in to the company's overall and long term objectives, in our case its building a benchmark data set for an entire industry, we're in it to build a company, long term, not building to sell. Well that can be a turn off for VC's interested in short term relationships...lol

3. Knowing what you dont know, minimizing ego, thats easier for experianced business people than it is for a 22 year old. However, both types of founders need one thing in an investor: Mentoring, and access to a talent pool to flesh out your team.

Mentoring and access to talent are worth more in equity to founders building a company for the long haul, than the number of zero's on a term sheet.

A firm without those qualities is wasting my time.

Long story short, your right its a golden time to be a geek working on the cheap, more options than ever, and you dont need money right away. And when you do need it you can make sure its a good fit to meet your goals.

Much better than the last time around.

[azeem]

Nicely put.

The underlying point is that there is less risk. You don't need to build scale from day one so you can postpone the really expensive stuff (whether it is salesforces, cap ex or operating agreements) until you have eliminated some customer adoption and technology risk.

I remember in 1.0 how every firm needed the same squadron of 20 engineers you describe. But these guys were thin on the ground.

So the other thing that is different is that there are tons of people who have built and run technical operations which scaled to 10m+ users the first time round. This time not only is the tech cheaper but the knowledge is more diffused. It's a rising tide.

[michael]

a delight to find you in your wheelhouse again. great post.

[Peter Cranstone]

Bravo... nothings changed. It's hard work to build a company. It takes persistence and patience and it takes capital. Anyone can hack something up in a weekend. Building measurable, sustainable, profitable revenue from volume takes capital.

Cheers,

Peter

[Ben Barren]

alot of people here are talking about "lifestyle businesses" - basically 2.0 cornerstores on the net. fred's talking about funding hypergrowth and turning them into franchise leading businesses that will be bought for ideally $1B+ by public market or acquirers. it costs serious money for staff, tech and sales, marketing once u get a growing business often year 3 in, not a part time engineering startup out of business hours with adsense.

i would have thought that web 2.0 total funding number though was slightly less eg 25% than web 1.0 : the money going out on hardware etc and CMS, CRM etc is less, so the total funding should be cheaper eg $15m vs $20m.

[leafar]

Brilliant conclusion for 2006.
Idea, execution, risk, cash & success.
Congrats to all 2006 success ... and Vcs behind them.

[Calvin]

Interesting post. Reminds me of a couple of other bits of media I consumed a little while back:

1. Peter Fenton's charts VentureBeat reported on
http://venturebeat.com/2006/09/08/when-is-the-best-time-to-raise-venture-capital/
2. John Doerr video talking about technology excellence pushing risk out in time
http://edcorner.stanford.edu/authorMaterialInfo.html?mid=1273

But aren't you supposed to be on holiday?

[AlFromChicago]

Ben -

Good point -- I was talking more about what you want to do as an entrepreneur - if you want to "go for it" and build a hypergrowth business, you'll need the significant capital -- but an option you have today I believe is to take less money and build a great sustainable business -- a nice business, but not a hypergrowth business. Each has their own risk reward tradeoff.

Agreed on total capital I would still think its closer to 10 in web 2.0.

[Sam]

Great post Fred! Too bad that's not how it is here in the deep south. I've been trying to raise early money for a startup here in Florida and I've been trying to tell these firms and angels exactly what you are saying. They just don't get it. Maybe I've just been talking to the wrong people, otherwise this is unfortunate for the Florida economy.

Sam