Keep the Faith

I spend a lot of time with internet consumer services startups. Currently, a meme circulating in this area is whether something fundamental has changed in the paths to liquidity open to startups in this space – a fundamental change that is foreboding to VC’s.  A number of recent stories in magazines and newspapers have made the “sky is falling” claim that the internet consumer services world has fundamentally changed, and that VC’s who work in the area are yesterday’s news. Angel investors now rule the roost and are best positioned to take advantage of this new evolutionary niche.

The truth, of course, is more nuanced. 

The argument typically goes like this: a titanic battle over the future of the web is shaping up among the major “new media” companies: Google , Yahoo! , Microsoft (MSN) , TimeWarner (AOL) , IAC/Interactive , News Corp. , etc. As the arms race among them accelerates, they will add features to their offerings by buying small start-ups (Flickr, de.licio.us, Pyra Labs, Oddpost, Picasa, et al.) who can innovate “around the edges” faster than they can.

Because most of these small companies have a cool feature, but not a lot of users (until they can access the massive distribution of one of the major players), they sell for a range of values between $10 million - $30 million. But they also don’t need to raise much money to build their cool feature. Accordingly, a $10 million - $30 million sale price can be a terrific outcome for the founders and angel investors – but terrible for a VC (who depends on a few grand slam home runs to stay in business). 

Implicit in this argument is the assertion that internet consumer services company can no longer go public, and that the only liquidity outlet for any such company is (1) to build a cool feature and a small (but fast-growing) user base of early-adopters and (2) sell to one of the major incumbents. 

Offered as compelling evidence of this is the current dearth of internet consumer services IPO’s…… 

And, no question, the IPO market is down from historical levels. On page 113 of the February issue of Wired (just out), Chris Anderson notes (“The New Boom”) that about 50 technology companies went public in 2005, compared to more than 300 in 1999. While 1999 was obviously the peak of the IPO market, each of the 10 years prior had more than 50 tech IPO’s. 

So things could be said to look bleak for VC’s and the companies they typically have financed.

But here’s an alternative view from the VC trenches.

We’re already starting to forget that almost no internet consumer services start-ups were funded in the “nuclear winter” between mid-2000 and mid-2003 (dates not precise). Only in the second half of 2003 did VC and start-up activity in this area start to revive.

Because we still remember the quick-hit, fly-by-night IPO successes of 1999-2000, we have forgotten that, in the 35 year history of Silicon Valley, it has always taken 4-6 years to build a successful and enduring start-up. And, it still does.

Therefore, it should surprise no one that there isn’t a crop of internet consumer services start-ups currently popping out the IPO chute. In fact, given that most startups in this space were founded after mid-2003, it would actually be a surprise if there were. I predict that we’ll start seeing an increasing number of IPO’s in this area in Q1 2007 (going public off 2006 financials), and accelerating through 2007-2008 -- back to historical norms. 

If I’m wrong, then I think it is fair to examine whether something fundamental has changed. 

End note: the actions by the Federal Government (Congress, the President and the SEC) aimed at the financial scandals of 2000 – 2001 (Enron, WorldCom, Tyco, et al.) have dramatically increased the costs of being a public company. This will have a depressing effect on technology IPO’s even when the crop of 2003-2004 companies matures. I think these actions have been entirely misguided, and have redounded almost entirely to the benefit of lawyers (disclosure: I used to be one) and accountants -- with no benefit to investors. More on this in a future post, but consider that (as far as I know) all of the convictions of the 2000-2001 fraudsters were won under laws that pre-dated Sarbanes-Oxley and related laws and regulations. The pre-existing laws worked fine; we just needed to enforce them. 

Write your Congressman.

Comments

This is a good perspective. I do however disagree that angel investors rule the roost. Perhaps you're right but I've had much more accessibilty and also interest from VCs, and not even necessarily for a typical round A but for a seed investment of a few hundred k. This has been confirmed by other entrepreneurs further along than I, that startups are having far greater access to VC money. Microsoft was built on Windows, AOL was built on access to the Net, and Yahoo and Google were built on search. I don't know enough about the history of IAC and News Corp to comment, but what's the next frontier?

Posted by: Scott | Jan 23, 2006 1:03:02 AM

I agree with most of what you say, but there's surely another dynamic going on here as well.

Given the relative ease and cheapness of building many of these new services, a start-up at the stage you describe has to be pretty confident that a major player does not have a number of alternatives it could acquire, before it turns down that $10-$30 million exit option. Massive distribution integrated with even a close follower can be a pretty devastating combination, so new companies may feel obliged to sell before they get crushed by a major player which has acquired another version of what they have. Selling early may be the smart and necessary thing to do.

Quite apart from the fact that a VC, able to take a portfolio view of the risk, may elect to block such an exit, with sometimes disastrous results, the VC's liquidation preferences may well mean that financially it isn't available to the team anyway.

This may well be cutting into the competitiveness of VC financing in an environment where angel financing can be raised and stretched enough to get to market and beyond.

One possible fix would be for VCs to concede that liquidation preferences be IRR-based rather than multiple-driven. With an early exit the preference would be worth less, reflecting briefer use of the capital ('time is money', etc).

As to the potential problem of VCs who won't approve a rapid exit because their portfolio needs 'big hits', the only real answer would seem to be to push far enough before raising VC that you don't have to give up control over the exit option, which for many people means using more angel financing.

Posted by: Neville | Jan 23, 2006 5:14:28 AM

Two minor additions to an excellent article. As in so many things, the reality won't be black or white but many shades of gray. There will be many examples of small companies getting started with angel investment and getting sold to bigger portals or content sites within a year or two. However it's unlikely that these companies will achieve significant scale in audience or revenue or significant valuation without a round of traditional venture investment. That growth path will be more like the four to six years that we've always experienced.

Second, there's a lot more overhead associated with an IPO now than there was six years ago starting with Sarbanes Oxley compliance and the skpeticism of runnign a public company in a post-Enron world. An active M&A market has given management teams and boards more attractive alternatives for exits.

Posted by: Peter Horan | Jan 23, 2006 2:54:41 PM

Another problem is that VCs need to invest in large chunks. When they approach an early phase company which has develoeped a cool app/site w/ $2mm invested capital, their need to deploy large sums forces the smaller company into a catch 22: you need a high valuation to withstand the dilution of the large investment and to do that you need to create an unreasnably high exit price, which then becomes your vunerable point in negotiations.

If you ask for $2mm, the VCs say "what would you do with $10mm". If you then present the case for $10 mm, you need to show a $100mm exit to give them their 10x target...a dreadful exercize.

Bottom line is that VCs have moved up the risk ladder to revenue and asset plays -- they no longer have the stomach for the true early-stage investing required to launch ideas or gain traction for an existing concept.

jh

Posted by: james haft | Jan 23, 2006 7:31:38 PM

Allen, glad you're posting again!

Posted by: Peter Maughan | Jan 26, 2006 8:27:19 AM

I disagree with the End Note.

Sarbanes-Oxley is an attempt to discourage fraud and force it to light before it becomes massive. The existing laws may provide punishment after-the-fact but do little before-the-fact.

Executives believed that they could plausibly deny knowledge of wrongdoing so existing laws were moot in discouraging fraud. With Sarbanes-Oxley, ignorance or incompetence is no longer an excuse.

Ad hoc financial controls and systems made it easier to hide fraud before Sarbanes-Oxley. With Sarbanes-Oxley, the financial controls and systems themselves have to be shown as sufficient and reliable.

Some complain that the cost of Sarbanes-Oxley is too much. But here's a quote: "According to the Financial Executives International (FEI), in a survey of 217 companies with average revenue above $5 billion, the cost of compliance was an average of $4.36 million." $4.36 million is a small price to pay at a $5 billion company to discourage fraud capable of entirely destroying that company and to implement systems such that everybody actually knows that the system that comes up with the numbers is somewhat consistent, automated and honest.

Sure, Sarbanes-Oxley isn't a panacea. It costs more money than doing nothing. Fraud isn't guaranteed to be prevented.

While some complain about Sarbanes-Oxley now, Sarbanes-Oxley is likely to help our economy and even the specific people who complain about it. Fewer frauds means more companies surviving. For executives, it means more concentration on real performance, rather than spin or tweaking the numbers. It means better, more standardized and, likely, cheaper auditing.

Posted by: Daniel Howard | Jan 30, 2006 10:26:03 AM

How about (a) there is a market for building features as companies because it can be done on less cash and the emergence of web services makes this possible (the feature mashup sold for $30m) (b) there is increasing maturity in consumer internet just as in entreprise software and that makes it harder to compete against the dominant players AND (C) we finally have in place the complete infrastructure to enable our startups to achieve critical mass quickly and therefore with good execution we can build exciting consumer propositions (dare I say B2C) that scale ? So I fully agree with the shades of grey theory and in fact there are some large businesses being built at the moment that take longer to mature (as the cliche goes lemons ripen before plums). In Europe there is a massive online tire retailer being built, the 1bn+ IPO of TOMTOM, the success of Parrot in bluetooth aftermarket devices for cars etc. All large successes in the making, and these are only the examples that spring to mind writing this post. Those who stuck to their knitting (i.e. are not trying to rebuild consumer expertise now) should reap the rewards indeed.
Good post as ever, glad you are writing.

Posted by: Fred Destin | Jan 31, 2006 12:55:41 PM

I think you are missing an important dimension of the problem in your otherwise well written post. Picture a two-by-two matrix. On the horizontal axis you have “small amount invested” on the left and “large amount invested” on the right. On the vertical axis you have “small return” on the bottom and “large return” on the top. The VC model only works in the upper right quadrant with large amount invested and large return. All other successful outcomes are financially uninteresting. That, I believe, is a problem.

So if investing large $$ and getting occasional (very) large returns is your success model why is this problematic? I will argue it is problematic for two primary reasons:
1) Investing large amounts of money at an early stage is not only risky, I think it's more often than not bad for business. Starving companies to success is in my opinion a lot more effective than pouring on the dough before you have figured out what you are really doing. Too much money early on doesn't get you all that much further. It just increases your burn-rate. Yet, the fund structure is not set up to support making many, small investments. VCs have gotten greedy. The funds are too large so they have to make larger investments.
2) Very few deals end up in the upper right quadrant. So few deals, I would contend, that the VC model is broken. The first acquisition interest I had in my last company came from Amazon in 1998. But their indication was that they were "only" willing to consider paying $25-30 million. In hindsight it would have been a great deal. Given that we were VC funded, it did not "make sense".

A friend and (VC) investor who invested in an earlier company I started proposed something interesting recently. He suggested I take the first investment for my new company from his firm and that I don't give him a board seat, have no board meetings, and he even suggested no onerous terms :-). He was effectively buying an option to participate if things went well. He was also proposing giving me $500k-1m, instead of the more common $2-5m first round. And he was planning to take this approach with ten deals in the consumer space, as opposed to two "standard model" deals. This ten-for-two model makes a lot of sense to me. Did I take his money? No, but for reasons I won’t elaborate on here.

In my latest company Plum, I made a deliberate decision not to raise money from VCs. Why? Because the overhead of managing institutional investors is too high at the early stages. I should be worrying about building great product/technology and getting my users to engage with my new service... not about what to do at my next (monthly) board meeting.

No doubt, there are deals where the old pour-on-the-money model is the right model, but personally I think that there is too much money in the Valley and that VCs ought to return to taking bigger and more frequent risks with smaller amounts of capital.

Posted by: Hans Peter Brøndmo | Feb 2, 2006 5:15:12 PM

I'll take a shot a paraphrasing the premise: "New" rconsumer internet companies innovate around the edges with cool features ... end up as bait fish for the established web players ... thus no consumer internet IPOs ... conclusion: why would a V/C play the consumer internet game if goal is IPO money tree? Allen's retort: internet nuclear winter has choked off the pipeline so there has not been a long enough thaw to see consumer internet companys emerge.

Comments

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