The New Dual Track
There have been a number of wonderful blog posts debating whether this is a good or bad time to start a business. Fundamentally, I believe that the reason the debate is occuring is because there have been some fundamental changes to the risk/reward ratio involved in business formation.
When I started my first business (Infonautics Corporation) in the early ‘90’s, the cost to “get in the game” for an IT business was $4 - 5M (ie, first round was $4M). It took that amount to buy the expensive sun hardware, build a datacenter, write the custom software, and build the appropriate infrastructure to grow a business. When I started Half.com in the late ‘90s, our first round of VC was about $2.5M – we didn’t have to build our own datacenter, hardware costs were coming down, and although we had to write custom software we were able to use development tools that made it faster and cheaper.
In recent years, however, it’s gotten much cheaper to launch a software/Internet company. The power of open-source software, cheap Intel-based servers, a plethora of robust development environments, ASP-based services to handle backoffice processes (ie, at Half.com we had to build a help desk – now startups can use an ASP) --- combined with the rise of offshore development – have dramatically reduced the costs to “get in the game”.
This allows companies to bring a product to market for much less than was previously required. Companies are able to launch a product or service for under $1M. This changes the game for the entrepreneur – primarily because of the cap table.
If a company previously needed $4M to get off the ground, they would raise venture funding – which would leave them with a post-money valuation typically between $8 and $12M. In order for the VC to get a “win”, their target return would prevent the company from ever considering an exit below, say, $100M. (ie, no early-stage VC would call an exit at $36M – or a 3x return – a “big win”). These VC economics typically led companies to work toward exits in 3-7 years – to allow them to “grow into” the valuations required by the VC.
However, if today’s entrepreneur is able to get a company off the ground with $500K - $1M, they have additional options. For example, if an entrepreneur is able to raise $500K at a $2M pre-money valuation (or a $2.5M post), they have the option of considering an exit between the $15M and $50M range. Indeed, a sale at a price of $18M would provide investors with an 8x return (assuming a 1x liquidation preference). Moreover, at valuations in the $15-50M range, acquirers are willing to buy “technologies” or “market positions” – as opposed to businesses. (ie, to justify acquisition prices of >75M companies must buy revenues and pipeline, but at lower prices acquirers are essentially making a buy-versus-build decision on a technology or market positioning).
I call this the new “dual track” option. (Where previously, dual-track refered to filing an S1 to go public with hopes of attracting an acquisition offer before your IPO). Companies can get further with seed or angel money now. Thus, in addition to looking for venture funding, entrepreneurs are now considering a strategic sale at an earlier juncture. This is a growing trend. If you look at the 30 “lightly-funded” companies (ie, companies that had not raised a large institutional venture round) that launched at DEMO 2004 – five of them were sold within eight months of the conference for values that reportedly were between $10-40M within one year (Oddpost to Yahoo, Stata Labs to Yahoo, Mailblocks to AOL, Turntide to Symantec, MagniFire to F5).
This trend has definite implications for entrepreneurs, angel investors and venture investors alike. And, I believe, requires a candid conversation between the entrepreneur and his/her prospective funders. While I know that there are no guarantees - and that plans change once a business is launched -- it is important for me to know, going in to a deal, what the entrepreneur's ideal outcome is.
A few additional comments:
• Companies must still build a product or customer base of real value. (ie, if a company is built solely with a “flip” in mind – chances are that it will be able to take neither track (ie, no VC and no buyer).
• I believe that this trend could actually be a benefit for venture funds in the long run. Since companies can get further along on seed-stage capital, VC’s are seeing business with reduced risk. VC’s can see actual product/market acceptance prior to investing. This also plays nicely with the fact that VC’s need to deploy larger amounts of capital (given their fund sizes).