Venture Lite

The “Cloud” and other forces have slashed the cost of starting an IT company  and produced a surge in seed investing.  We discussed this in a segment of our annual meeting last week, which was attended by professional limited partners (“LPs”), individual LPs, and entrepreneurs, as well as the NAV partners.  There was strong energy and convergence in the discussion, so I think it’s worth a post.

The Supply Side of the Demand Side

Start-ups are the demand side of the venture capital business.  We’ve all heard a lot about the “Cloud”, but still the degree to which it has changed the cost (ie,  supply-side) economics of IT start-ups and their strategies is a bit surprising, probably because it’s invisible to users

The “Cloud” refers to services offered on the web that allow companies to buy virtual web, application, and database servers and store data, paying only for the amount of service consumed.  It eliminates server, database, and network infrastructure and much of the staff that support it

The Cloud has enormous momentum.  Amazon is the clear leader in cloud services, and its offering (EC2 servers plus S3 storage) is designed to be easy to adopt:  S3 stands for “simple storage system”.  It is particularly appealing to start-ups.  Sun [RIP] used to say it “put the dot in”.  Amazon EC2 is putting the 2 in Web 2.0.  The chart below shows that the number of objects stored by Amazon has grown ten-fold in three years.

Stored Objects (billions); Source: Wikipedia

The Cloud is reinforced by powerful, free technical platforms that start-ups can leverage:

  • The open-source stack of tools for Web 2.0 site development called “LAMP” (Linux operating system/Apache web server/MySQL database/PHP scripting language)
  • And, now the Facebook Open Graph API which allows any site to easily link into Facebook’s data on the relationships and “likes” of 400 million people.  Early results are showing that adopters enjoy 2x-3x increases in referral traffic from Facebook.

We surveyed use of the Cloud in the NAV  portfolio.  100% of the web based businesses use the cloud for part of their infrastructure, and over 80% use it for all of their infrastructure.

The most interesting statistic, however, is what we call “dollars to traction”.  By traction we mean either $10k/month of revenue or 100k users: the threshold of a commercial business.  Dollars to traction averages $400k for the companies that use the cloud.  In my first web start-up, in 2000, we spend about $4 million to get to traction; that cost has been cut by a factor of 5 to 10 in many cases.

Cloud plus standard platforms both lowers up-front investment and makes infrastructure and operating costs variable.  This enables new business models:

  • Software as a service (by-the-drink pricing) is easier to fund when the vendor’s up-front investment is small
  • This lowers the adoption barrier for customers:  a mid-manager can try and buy on his budget authority
  • This lowers the cost of enterprise sales:  if the product is already widely used in the enterprise, the time and effort to get the attention of top management is much less
  • Cloud based apps are ideal for collaboration by dispersed work forces.

This quantum-step lower cost of entry, combined with market opportunities in spaces like digital media, ad-tech, and mobile apps, and smart people sidelined by the recession, has brought forth a wave of innovation.

Revolution On The Supply Side

The supply side in venture capital is investors.  Supply of venture capital is contracting:  fund-raising is down ~50%, most venture funds are getting smaller, and many are winding down.  But, there has been a boom in seed investing:  angels groups are very active, despite the losses angels suffered in their portfolios in 2008-2009.  Big venture funds are starting captive incubators again.  Stand-alone incubators like Cambridge Innovation Center [full disclosure:  a partner of NAV], Techstars, and Plug-N-Play are thriving.  And new seed funds have sprouted up on the east and west coasts, gaining rapid recognition:  eg, Founders Collaborative, First Round Capital.

Seed investing is more attractive for two main reasons:

  • Risk is less because companies can get to proof of traction on the amount of money that seed investors can provide.  When bigger investors do come in, terms can be better for seed investors, and they can focus their resources to keep ownership in winners.
  • Companies with modest exit prospects can be funded all the way by seed investors, producing good returns for investors and entrepreneurs from sub-$50m exits.  One of our LPs was fresh from the Angel Investor conference, and he reported on discussion there about dispensing with VCs altogether for many deals.

We do some seed but are primarily focused on the next level up in the food chain:  companies that need ~$10m to break-even or exit, with a good chance of an exit in the ~$100m range, and a real chance of much more.  We think Venture Lite is good for us:

  • The best of these seed deals will have upside that warrants more investment than seed funds can provide
  • Our economics and philosophy align well with seed funds, strong angels, and angel groups; we’re partnered with them in about half of our recent investments.
  • We’re seeing a lot of great deal flow in our sweet spot coming from these seed investors.
  • But, deal selection is critical:  the market is producing a surge of seed deals.  To do well we need to pick the right companies at the right stage: when there is early evidence of traction but still an attractive price.

The sign of a strong market is adaptation to change.  It’s remarkable that in these difficult times the venture ecosystem is producing this renaissance of seed investing.  Viva la revolución!

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