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

[Simon]

Very interesting and insightful post! :)

To paraphrase your argument, the timing and allocation of capital has changed but the aggregate amount has stayed relatively the same. Start-up costs for Web 2.0 companies are low but as you gather critical mass, your costs rise, approaching or equaling those of Web 1.0 companies. The lower up-front costs and ability to scale into the investments reduce risk for venture capitalists and help entrepreneurs conserve equity.

Good points!

The only problem I see with this argument is that the ability to do more for less has also reduced entry costs. This means that there is more competition. Increasing numbers of competitors, funded with capital from non-traditional entrants such as hedge funds, means that there is no shortage of redundant, well-funded start-ups.

So, perhaps this phenomena has not taken risk out of the equation so much as shifted it, similar to the way in which Web 2.0 has changed the allocation and timing of costs but not changed the aggregate amount?

Simon - Venture Capital Brazil

[Work At Homes]

Wow a big difference in investment cost. The returns margin a bigger. Well I might have to keep you in mind incase I come up with some great WEB2.0 ideas.

[David B.]

I'm not a VC but it seems that it's a threat, Fred, for the reasons you just pointed out. Large companies are learning to simply acquire these companies a couple rounds earlier and save themselves a fortune. Further, why build a huge infrastructure and then have to integrate only a portion of it later? You're obviously doing well, but if it was me, I would be worried.

[Mike L]

Fred,

You hit a home run with this post - one of your best this year. The model has definitely changed, and it is an opportunity - for many.

I've enjoyed the updates on Italy as well. If you are still in Tuscany, try to visit San Gimignano and/or Volterra - great little hilltop towns.

[CoryS]

Fred,

You and many VC's are very smart to recognize and discuss this reality with start up founders for a couple reasons.

On top of your insights, we have also been advised to think about our goals on getting "smart money" as compared to "cheap money" with the differences coming from the mentoring and connection needs of the company beyond just the financial infusion.

Great opportunities for entrepreneurs and investors alike.

[Josh]

Well said. I couldn't agree with you more about the differences that you mentioned between the technologies and funding patterns needed for Web 1.0 and 2.0.

As a software developer and Web 2.0 entrepreneur, I'm taking full advantage of the LAMP setup, open-source technologies, and all the other abundant resources that the Internet provides to blossoming companies nowadays.

I also do think that your graphs are fairly accurate, especially as a generalization showing the growth of investment needed over time for current Internet startups. Sure, you can save a lot on everything from cheaper servers to easier code implementation, but you can't escape all the sales, marketing, and related costs that will creep up once you go post-production.

[mark]

great post, you explained very clearly the role of vc (to a guy that knew nothing about it.

[Trevor]

Great Article!

As a member of the "expensive sales force" at a web 2.0 company that has embodied your chart, I can agree with you that a typical web 2.0 company's cost needs increase at something like an exponential curve to get underway. That said, I also agree with many of the other commenters who argue with you over your proposed sum that starting a web 2.0 company costs. I imagine that my company has progressed well beyond the middle of your chart, with distributed servers and overseas programming assistance for some of our larger projects, but we've cost nowhere near twenty million.
Still, that only proves your point further, since the VC's who've already invested in us and provided us with working capital haven't had to risk nearly as much as they would have in the web 1.0 days.

[Sujay Jayaram]

I just wanted to say how much I learnt from this post. I am the founder of WeddingPath.com, a web 2.0 online wedding planning site/community, and I have to agree that (due to the initiatives of things like Open Source and Creatives Common Licensing) I had an opportunity to build something in my 'spare time' that would never have been possible at the height of the dot com without many hundreds of thousands of punds investment.

As our main customer offering is also a viral marketing tool (Free personal wedding websites - see http://www.weddingpath.com/web/membersgallery/Page for examples of the content generated by our users), we have managed to get to the stage where we receive 2 million page imps per month (from innocuous launch two years ago), having done NO marketing or PR at all!

We are now going through the fun of generating revenue having had no need for outside investment.

Web 2.0 is allowing people such as myself to indulge in a much more 'fun' form of enterprise!

[Chad Brownstein]

To each his own, there are startups that needed fundings and there are those who were able to survive on its own. I think web 2.0 is both a blessing and a curse. There are a lot of innovative startups that needs financing because they could not do it on their own.

But generally, whether or not web 2.0 is a blessing or not will (I think) rest on the CEO of the startup. If they are willing to risk everything they have then venture capitalists are not needed anymore, but if they are somewhat short on cash -- then this is where funding comes in.

[merchant]

I don't really think that the ability to do more for less has also reduced entry costs. This means that there is more competition.I also do think that your graphs are fairly accurate, especially as a generalization showing the growth of investment needed over time for current Internet startups. it is really hard 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).

[merchant]

I don't really think that the ability to do more for less has also reduced entry costs. This means that there is more competition.I also do think that your graphs are fairly accurate, especially as a generalization showing the growth of investment needed over time for current Internet startups. it is really hard 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).

[saumitra shanker]

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