It’s Cheap to Start Web Companies
When trying to raise money last year, I heard and read the same thing: it’s cheap to start a web company. Two people boostrapping a company could get it off the ground for $50k or less, two people full time could do it for $150k. Starting a web company is cheap, but the past five years have distorted what success means, and damaged the fitness of current companies.
VCs Reduce Product Management Risk for Google
The VC model has served to reduce risk for large companies looking to build new products by reducing the risk of product failure (YouTube). IPOs have not been an exit possibility in nearly a decade, so startups have looked towards big companies, like Google, Yahoo or Microsoft to acquire them. In order to get bought by one of these companies, the startup company must build a product that complement’s the acquirers current strategy in some way (not that all acquisitions made sense).
A publicly traded company would prefer buying a startup over building in house because of the need to show consistent earnings growth, the public nature of failure, and the high probability of product failure. Instead, the large company watches the market for new companies that are gaining market acceptance and then buy. The company gets the product it wanted (maybe photo-sharing), the product exists, has a user base, a good team to keep growth up, and product usage is growing fast. All of the things the company wanted, with significantly less risk.
Business Models Make You Expensive
Because the acquiring company has a working business model and cash, the startup does not need to worry about a business model. “When we’re acquired, we can use company X’s [insert feature/ad model] to monetize.” In fact, having a successful business model would raise valuations significantly as the startup would need to sell out and could wait for a better exit opportunity (Facebook).
VCs, therefore, tell entrepreneurs to start web companies that are cheap and build a product that people will use, ignoring the pesky business model that will make an exit opportunity even more difficult. This is great when capital is plentiful, but the current market conditions are shifting.
Large companies will start hoarding cash, acquisition will be put off, VCs will reduce funding, and those startups that were great startups the past five years will start to fail. Of course, a VC could provide enough capital to a company to build a product AND find a business model, but that’s expensive.
Web 1.0
In addition to building a product that people want, the startup needs to build a product people will pay to use and the then startup has to figure out the right payment model. Given the possible combinations of right product and business model, it’s actually a tough thing to do. VCs will therefore put more money into the companies that have figured this out already (late stage, Zappos maybe), eschewing the seed and early stage. Without funding fewer companies will get started, and the ones that do will need to have a semblance of a business model, making web 2.0 look more like web 1.0.
Of course, web companies aren’t sexy anymore, unless you’re selling green products.
It’s not just the web following this model. If you’re an engineer at Cisco and you have a great product idea, you don’t run it internally – you go outside and start a networking technology company. Cisco has done >100 acquisitions following this model. It does reduce their risk and provides a bigger upside for the inventor. Most of the small companies they buy are “technology” plays, and some had not shipped product yet. Others were more mature.
At some point the pendulum will swing and these founders at the Web2.0 companies will feel that they have a legit shot at building a sustainable and growing business model vs. taking a buyout. At that point, the IPO market for startups may rise up again.