Photo: Tony Hisgett via Flickr
There has been a lot of discussion in the venture community about the declining cost of starting an IT company. A lot of very smart and thoughtful VCs, entrepreneurs, and pundits have written about this topic.But there seem to be two contradicting viewpoints in the market. One arguing that traditional early-stage VC will die out, another that indicates that the early-stage VC market is improving. Here is my attempt to rationalize the two perspectives.
Two underlying causes of this phenomenon are the declining cost of developing technologies and acquiring customers.
The cost of developing technologies has declined, as:
• Software design tools have become more advanced,
• Hardware and storage costs have decreased, and
• Infrastructure companies (e.g., hosting services) have realised increasing scale, reducing costs, and
The cost of acquiring customers has also declined, as:
• Social media (e.g., Facebook, del.ico.us) have made it easier for customers to recommend
• Internet-based advertising channels have become more targeted, track-able, and dependable.
Who This Affects
While most software and Internet companies benefit from the declining infrastructure costs, not all business models equally benefit from the changing marketing costs. Specifically, models leveraging the Internet as their primary channel for customer acquisition benefit more from this trend than models which require sales personnel, as is common for companies selling to enterprises.
Before I continue, I want to point out that my conclusions about the situation and the conclusions drawn by others appear to be based on anecdotal evidence. So, take my perspective with a grain of salt (the plural of anecdote is not “data”). Nonetheless, I hope this viewpoint will provide another chapter in the on-going dialogue on this matter.
A Potentially Superficial Contradiction
I have spoken to a handful of other VCs about this matter recently and there seems to be some consensus that the level of IT backable ventures that require substantial capital has persisted. Put another way, VCs are still seeing a lot of companies seeking full Series A, B, and C rounds. These companies need to purchase considerable advertising inventory, employ sophisticated staff to perform critical functions and build a strong business development team in order to secure partnerships with other companies. Those expenses accumulate, creating a need for multi-million dollar investments.
Furthermore, it seems likely that the need for capital is here to stay. Marketing costs are likely to increase as ad dollars continue to migrate to the web. Wages also continue to rise and we have yet to replace business development executives with software. So long as these cost centres exist there will be a need for venture capital.
On the surface, this conclusion seems to contradict the vision of pundits who expect the need for traditional levels of capital infusion to disappear over time.
While the evidence that I have heard for both sides of this trend to date has been anecdotal, both arguments seem reasonable and compelling. As a result, I began to wonder whether the trends seen by both camps are correct. I asked myself, “Do these trends have to be mutually exclusive? Is this a zero sum game?”
The Longtail of Venture: An Attempt to Rationalize
Photo: Get Venture
In an attempt to rationalize how the venture market could have both a consistent number of startups with traditional capital requirements and a host of new startups with less robust capital needs, I developed a hypothesis on the matter that appears to support both trends. I believe that companies that do not need traditional venture capital investments make up the longtail of venture. For simplicity, I am going to refer to these as the “venturetail” going forward. The fact the venturetail exists does not implicitly mean that all companies need less capital. It is possible that venturetail companies are being started in addition to companies that have traditional capital requirements.
My intuition tells me that there are two reasons why lower costs lead to more companies being started. First, some of the Internet companies being launched may not have been profitable endeavours when startup costs were higher; with lower costs more business models are economically viable. Second, the risk associated with these ventures has declined, enabling entrepreneurs who don’t want to ‘stake it all’ the opportunity to pursue a startup in their free time or without betting the house. One friend recently said to me “if you’re not starting companies in your free time you’re nuts.”
The venturetail represents, in my hypothesis, a new class of companies that is comprised of both:
• Companies that would not have been pursued when the costs were higher and the corresponding
risk to the founders greater, and
• Companies that were not economically viable in past (costs were too high to generate a profit).
If this intuition is correct it supports the idea that venturetail companies have not displaced the traditional companies, rather, the venturetail companies being launched are incremental to traditional startups.
In sum, it seems that the presence of companies that require less capital doesn’t seem to negate the need for traditional venture capital checks. Rather, a new class of startups has emerged that will be served by a different venture model. And…that’s happening. While many of the startups that might have historically fallen off the radar due to lower capital needs and potential are attracting the attention of VC dollars from traditional early-stage funds and the new band of super-angel/micro-VCs.
Starting Venture Scale Companies With Less?
Furthermore, the lower startup costs are enabling companies to prove early milestones with less capital blurring the lines between companies that only need a small amount of money to reach profitability and companies that will enter the traditional venture model down the road – both are being served by the rising class of seed investors. I don’t think, however, that this is happening to the exclusion of more traditional Series A rounds (and beyond).
It’s unclear exactly how this market will evolve going forward, but one thing is certain: lower startup costs will inevitably increase the rate of innovation…a good thing for all of us.
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