We've been discussing Web 2.0 recently and, in particular, whether Web 2.0 startups are relevant to later-stage investors like us (Kennet). We have one company in our portfolio that is exploiting Web 2.0 technologies (like Ajax, XML) to deliver a method of web integration: Kapow Technologies. But Kapow itself is a traditional software business that earns its keep through the sale of licences to enterprises and developers, while benefiting from the viral effects of distributing its toolkit through the Internet. It isn't a Web 2.0 startup like Flickr (now Yahoo) or NetVibes in Europe.
In fact most of the Web 2.0 startups I'm hearing about remind me so much of the dot-com bubble, it's uncanny. Social networking, free Internet telephony (remember Freeinternet.com?), content aggregation (Excite@Home anyone?), feed aggregators and browser apps (PointCast?), etc. Here is the Wikipedia definition of a dot-com-era company:
A canonical "dot-com" company's business model relied on harnessing network effects by giving products away to build market share (or mind share). These companies expected that by operating at a loss they could build enough brand awareness to charge for their services later.
Sound familiar? Indeed: we're counting eyeballs again! Om Malik looks at the social networking bubble and, in particular, the inexperienced teams that are getting funded in his blog. In Europe we haven't quite had the same level of hype, but it's getting there. Paul Fisher at FirstCapital, the UK investment banking boutique that was first to run a European conference on Web 2.0 last fall, still bemoans the lack of funded Web 2.0 companies in his latest entry.
The main difference between the current crop of web start-ups and their dot-com predecessors is that thanks to (a) low hardware prices, and (b) standards-based technologies like Ajax and open source tools like Perl and MySQL, it is about 10 times cheaper to start a web business today than it was in 1999.
As a result many more startups come into existence and reach the product launch stage, albeit typically in beta form. If they are clever they get some magic viral dust and attract visitors, perhaps even registered users. It's at this point that they either:
- Fizzle out once the initial buzz has died away;
- Attract the attention of an investor who gives them several $million; or,
- Earn some money from existing users and start to build a growing, profitable business
Statistically speaking the majority of these businesses will fizzle out, but we're interested in the handful that build viable businesses from day 1. If the new, lower-cost startup formula indeed fosters more innovation and more attempts to start businesses, then that's all good. If it is cheaper and easier for these startups to experiment with different business models, then they are more likely to find one that is profitable. And that will generate more viable business operations and hence investment opportunities.
Since we don't fund startups it's obviously self-serving to suggest we'd like to see businesses develop to a self-sustaining level at a few million in revenues before seeking external capital. But surely for the entrepreneur that is the best possible path?! Raising capital into a functioning, cash-flow positive business means you have more choice of investors and you will suffer less dilution. And you know how to invest the new capital to generate growth; and THAT puts you in control of your future.
But if you raise a lot of capital before finding a workable business model, chances are you never will. The focus will be on building mindshare or marketshare or collecting eyeballs, with the intention of getting acquired before the need to monetise this traffic materialises. If the acquisition doesn't happen, the business disappears. The likelihood of getting acquired and make money of it is -- what? -- maybe one in ten? One in twenty? Now those odds are OK for a venture capital firm with a portfolio of a dozen or more such bets. But those are pretty crappy odds for the entrepreneur, wouldn't you say?
The Wall Street Journal gave this trend mainstream coverage yesterday in Rebecca Buckman's article on "pre-emptive financing". These funding rounds are not new, but they are only now being talked about because of their scale, with fundings for seed-stage startups reaching tens of millions of dollars (in Silicon Valley anyway). So long as there are rare, high-reward outcomes for these strategies -- like the acquisitions of Skype and MySpace -- there will be high-risk players among investors. But in my view it is the entrepreneurs who bear a disproportionate share of this risk.
So here's hoping that more of the Web 2.0 class of startups will take advantage of the current market upswing to build real businesses, control their destiny and raise capital if and when they can really use it to scale their operations.
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