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).

Comments

[Andrew Fife]

The declining cost of starting a business has also raised the bar of investor expectations. Both angel groups (but not necessarily individual investors) and VCs seem to only be looking at web2.0 deals with significant user bases and/or B2B deals with finished products and revenue. It seems to me that the seed round is disappearing and that most companies need to get from friends and family money to series A type milestones in order to raise money from sophisticated investors. With the one clear exception of rock star CEOs, investors don’t seem to be funding ideas anymore.

[Jeff Clavier]

I believe that we will start seeing another track, sort of in the middle, where PE funds will take positions in promising companies, buying out a portion of founders shares, much earlier than before.

[Dharmesh Shah]

Excellent article and I concur completely with your points (both as an entrepreneur and as an angel investor).

Another byproduct of the lower funding requirement is that it allows more entrepeneurs to "bootstrap" through the early years. This in turn makes more time available to focus on the product/business instead of the capital raising process.

Though this may not seem like a big deal, in my cases, when the 6+ months spent in raising VC funding can be "redirected" to the business, it can make a big difference.

[Laurent]

This trend is very interesting and also giving a new look to the VC common question: what are the entry barriers / unique selling proposition. A very good example is Zooomr that cloned Flickr, in a few months only. Nowadays, you can build first class online apps or services grabbing open source software and having freelance developers. On the other side, you can be copied "on the fly".
In our case, we needed only very little seed money from family/friends/entrepreneurs to build a working website, to have a workable and sizeable technical backoffice, to organize a (tiny) marketing campaign and to cover all legal aspects. And when I say small amount, we needed less than $100K. This should (hopefully ... if execution is led well) bring us to a size where we can start building our revenue streams.
To summarize my thoughts and points, yes, little money is needed to launch a beta, yes, the IPO has never been a considered option, no, the risk is limeted for entrepreneurs ... So best time to try oneself as an entrepreneneur !

[Peter Cranstone]

Several years ago (2000) my partner and I built a software application that ramped from zero units to thousands a month, went global in 90 days, is used today by people like PayPal and DexOnline and continues to be the defecto standard for open source content acceleration on the Internet – the product was mod_gzip (Google search) – the total cost was $350,000

So it can be done – the key issue is “customers”. If there is market pull you can make it, the problem comes when you have to support it and then scale it. That requires a little more money. Mod_gzip worked because it was open source and free, charging for something adds a new metric, because you then have to support it and improve it.

I still believe you can build something meaningful, that creates shareholder value, solves a customer problem AND generates revenue for a very small amount. Scaling it requires people and that costs money. However I’ve learned a lot since 2000 and our current venture is almost ready for public display and has cost considerably less than 500K.

All the best,

Peter

[Fraser]

I think we're going to see a real change in the traditional venture world in the coming years.

Because of the lowering costs of starting a company we are, and will increasingly continue to, observe companies develop a lot further along their growth curve before taking venture funding.

Considering the three different stages of a start-up: innovation, commercialization and scale, I believe we're going to see traditional VCs continue to add value to, and be needed by, start-ups in the "scale" phase. Which, as you point out, is good for the VCs --- they're going to be able to invest their sizable funds into lower risk ventures. However, the importance of traditional VCs in the earlier two stages is going to become increasingly less important.

Angels, innovative VCs, etc. will be able to benefit in the earlier phases of the company by investing and supporting the company's growth.

We're also going to observe specialization companies emerge and become prominent players in the earlier stages as companies are able to specialize along business stage/process pathways rather than the traditional specialization along market, product, or industry pathways.

Jeff raises an interesting thought - that of the role of PE firms. I suspect that traditional VCs will face increased competition for deals in the third stage from PE firms.

Should be an interesting few years.

[EBONY]

I wonder what the society for the advancement of formal structures would make of this siteabout natural language parsing?

[fred]

I contest your assertion that the cost of starting companies has gone down.

Quite the opposite.

In 1992, you could start, and get traction with under 1MM.

Now, unless you are lucky, you can get a great demo for that price, but nothing more...

[David Armstrong]

Being that entreprenuer that has lightly funded on purpose, bootstrapped the rest and is focused on building a great product, I obviously agree. I do find that most investors (probably just the wannabe's) don't think you can do it. I agree it's rough, but telling someone they can't is unintentionally as good as giving them money.

[matt coffin]

couldnt agree more. especially to much larger entities as the sub $25M is seen as a replacement for r&d and larger companies prefer the deferred p&l impact

[matt coffin]

couldnt agree more. especially to much larger entities as the sub $25M is seen as a replacement for r&d and larger companies prefer the deferred p&l impact

[acne treatments]

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

[hermes bags]

couldnt agree more. especially to much larger entities as the sub $25M is seen as a replacement for r&d and larger companies prefer the deferred p&l impact