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July 6, 2006 |
How to work with venture capitalists when dollars are less critical
When Flickr.com was purchased by Yahoo! for a reported $50 million last year, the deal received a lot of attention in Canada because the popular photo-sharing Web service was based in Vancouver.
For entrepreneurs, however, it was the fact Flickr needed no venture capital cash that raised eyebrows. This meant Flickr’s founders, Caterina Fake and Stewart Butterfield, still owned a big chunk of the company and, as a result, did extremely well when Yahoo! made its offer.
Flickr’s acquisition shone a spotlight into the lack of VC funding among many Web 2.0 start-ups these days. Using open-source software, cheap hardware and bandwidth, and low-cost viral online marketing campaigns, many start-ups can get up and running and attract thousands of users—for less than $1 million.
This is a stark contrast to six or seven years ago when far too many dot-com companies burned through millions of dollars of venture capital to develop and launch their services.
Why the different cost environments in such a short period of time?
During the dot-com boom, there was a lot of experimentation and many companies and entrepreneurs had little experience or insight into how to create and/or operate an online business. Many dollars were given to programmers or consulting firms to create e-commerce Web sites, whereas today much of the technology can be purchased off the shelf and at a fraction of the cost.
Another huge cash drain was marketing. The highlight—or lowlight depending on your viewpoint — was the 2001 Super Bowl in which more than a dozen dot-com companies such as Pets.com and kforce.com dropped an average of US$2.2 million for each 30-second television spot. And there were glitzy launch parties with open bars and A-list celebrities. Great, but expensive.
Today, marketing can be done by a small team that uses influential bloggers and Web users to create buzz and media coverage for a new service. Skype, for example, spent almost nothing on marketing but attracted millions of users through viral campaigns.
Expertise, not dollars
The key question now facing many venture capital firms is what role, if any, do they have to play within the Web 2.0 world if money isn’t always the be-all and end-all?
Rick Segal, a partner with J.L. Albright Venture Partners, said VCs will increasingly have to provide expertise such as operational experience to the table as a way to bring value to entrepreneurs, many of whom still have more enthusiasm than experience.
“We have people who have run companies; people who have done all the “C” level jobs; people who know patents; people who know how to code and do creative financing,” he said.
Charles Chi, a partner with Greylock Partners in San Mateo, Calif., said VCs will also spend a lot of time working with entrepreneurs on product and marketing strategies.
“Often, it is a very collaborative discussion on prioritizing the list of things the company needs to develop, how much money needs to be present to get to the initial business milestone, and aligning that milestone to what the market wants,” he said.
Chi said another way VCs can support entrepreneurs is the recruitment of seasoned managers such as chief executives and senior vice-presidents to support a company’s development. With less-experienced entrepreneurs, he said, VCs will provide regular coaching and advice on tactical areas such as compensation.
Rick Nathan, president with the Canadian Venture Capital Association and managing director of Goodmans Venture Group, said VCs can play an important role in helping small companies establish relations and partnerships with larger corporations.
“If entrepreneurs are growing successfully and attracting users, eyeballs and ad revenue, and they decide to do a deal with Yahoo! or IBM, it can be very helpful to have an experienced VC on your board,” he said.
Pinching pennies
A good example of the new investment climate within the Web 2.0 market is NowPublic, which runs a community journalism Web site (www.nowpublic.com) that attracts about three million unique visitors a month. The company started up in early 2005 and has spent only $150,000 on development.
Leonard Brody, head of business development with the Vancouver-based company, said NowPublic adopted a pragmatic approach when it began to look at raising a small amount of growth capital. With the luxury of having strong interest from investors, he said, NowPublic decided it wanted to build a “dream team” of people who could bring expertise — and cash — into the company.
“I learned my lesson from Web 1.0 and the 1990s on just how important it is to have smart people around you,” he said. “Some of our angels are media-savvy, other angels are financially savvy, others are software-savvy to assist us in the building out of tools; and some are executives from large companies. We were looking for the value they could bring to us. Anyone who didn’t have it, we didn’t take their money.”
Brody said NowPublic believes the $1.4 million it raised from angel investors will be the last round of financing the company needs to become profitable. The small amount of money, he said, has much to do with the fact NowPublic’s operating costs are very low.
“We are trying to run lean and mean,” he said. “There are none of these crazy launch parties and any long-distance calls are on Skype first.”
NowPublic’s frugal approach is typical within many Web 2.0 start-ups. It is almost a point of pride to use as many free, Web-based tools as possible—whether it is Gmail or Skype, Writely (a collaborative word-processing tool) or vyew.com, a Web conferencing tool.
Many Web 2.0 start-ups have had little choice but to closely watch their costs, given the venture capital market withered after the dot-com bubble burst in 2001. The companies that survived or started post-bubble have operated in an environment in which the value of every dollar has to be maximized.
This explains why free Web-based tools, open-source software and the contracting of software development projects to low-cost regions such as India, Estonia and the Ukraine have become commonplace.
Profit is king again
One of the challenges facing VCs willing to play in the Web 2.0 market is getting an appropriate return on investment. If, for example, a VC invests $500,000 to $1 million, and the company is subsequently sold for $10 million, the return is four or five-fold but would only equate to a $1.5 million or $3 million monetary return. This, however, is not a huge return on a dollar basis, given the amount of time and resources required to nurture a start-up.
Of course, every VC is betting on a bigger return. Skype Technologies, for example, was bought by eBay last year for US$4.2 billion.
For many Web 2.0 companies and their investors, the pot of gold at the end of the rainbow is to be acquired by one of the big Internet players — Yahoo!, Google, eBay, America Online and Microsoft. Google, for example, has acquired more than 20 start-ups in the past few years, many of them before these companies even received venture capital.
Smarter VC
The active mergers and acquisitions market has encouraged investments in Web 2.0 start-ups because there is a chance they could become a strategic acquisition target.
Nathan said there are several ways for VCs to play in the Web 2.0 ecosystem. Larger VCs can carve out $25 million to $50 million mini-funds to focus on Web 2.0 opportunities. Nathan said he is also aware of smaller VCs looking to raise $25 million to $40 million funds that will allow them to make investments in the $2 million to $3 million range.
Within the Canadian VC market, one of the more active high-tech start-up players is Toronto-based Brightspark Capital Partners. The company starts companies in-house and is willing to make investments in entrepreneurs with an intriguing idea.
Tony Davis, a Brightspark partner, said the Web 2.0 environment fits right into his firm’s investment mandate because it is possible to spread capital across a variety of start-ups at attractive valuations.
“It’s great for us and it’s great for angel investors but not so good for VCs who invest in [large] series B and C rounds,” he said. “There is no room for them to play in this market.”
Brightspark has taken a pragmatic approach to the Web 2.0 market, although it has made several undisclosed investments so far.
“We will do a number of deals to see how it’s going,” he said. “But we will not bet the farm. We have memories of the dot-com bubble.”
While it is difficult not to get excited by the big payoff Flickr’s founders landed, Segal said that is comparable to winning the lottery — it’s a big strike but the lightning is rare.
This means entrepreneurs need to realize there is value in venture capital while VCs need to check their enthusiasm to avoid another round of dot-com fever. “We have seen this movie before,” he said. “My view is we will go this cycle again and the question is how do we get smarter about what we know is going to be at the other end?
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