There has recently been a lot of discussion in the venture community about the declining cost of starting an IT company. Lots of very smart and thoughtful VCs have written about this topic. Here’s a link to one popular article on the subject.  However, there seem to be two contradicting viewpoints in the market.  One that arguing that traditional early-stage VC will die out, another that indicates that the early-stage VC market is improving.  This is my attempt to rationalize the two perspectives.

Underlying Causes
While I think the various pundits have identified the presence of companies that do exemplify lower capital needs, there seems to be limited exploration into all the trends that are driving this change.

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 realized increasing scale, reducing costs and improving quality.

The cost of acquiring customers has also declined, as:

• Web 2.0 services (e.g., Facebook, del.ico.us) have made it easier for customers to recommend products, and
• 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.

Anecdotal Evidence
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. 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 there has been no decline in the number of IT ventures that require substantial capital. Put another way, VCs are still seeing lots 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 centers 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 ($2-5MM Series A rounds) 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
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.

[Diagram]

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 endeavors 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.

The venturetail represents, in my hypothesis, a new class of companies that is comprised of both:

• Companies that would have been pursued when costs were higher but are now benefiting from substantially reduced costs, 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 are being launched in addition to traditional startups.

In sum, it seems that the presence of companies that require less capital doesn’t seem to negate the need for venture capital. Rather, it’s possible that a new class of startups has emerged that will be served by a different venture model. 

[Diagram]

It's unclear exactly how this market will evolve.  However, my hope is that this hypothesis will help to rationalize some of the latest market trends.

Comments

[Adam Carson]

Great post Mark,

I like the 'venturetail' concept and agree that there is a new class of startups that have very different needs from traditional vc-backed models. The incubator seems to be the new model that is currently paving the road ahead. There are a few incubator's out there...do you know if they are providing returns? Any insight into their success? Do you think there is room for more of them?

[Mark Davis]

Adam,

I think it's a bit too early to tell how successful this model will be in this new venture environment.

Maybe some of the other readers have a perspective on this?

-Mark

[Bob Warfield]

Mark, you've hit some nails on the head, but there's still more complexity.

As you mention, Enterprise software does not seem to benefit as much as consumer web software. I've talked about this on my blog before:

http://smoothspan.wordpress.com/2007/10/18/lack-of-good-platforms-is-stunting-saas-and-business-web-20/

It may be that the business equivalanet of the Lamp stack would greatly ameliorate the technology costs, but we've yet to see that. In addition, it is still very early days understanding how businesses market to one another using the web. SaaS companies are perhaps furthest along there, and indeed, it costs less for them to acquire customers:

http://smoothspan.wordpress.com/2007/07/17/its-cheaper-for-saas-companies-to-acquire-customers/

However, a much more important question is what will the distribution of investment returns look like on these long tails? At the moment, there are relatively few exits for an incredible number of Consumer Web companies. Does anyone really think there will be enough exits? Or does it seem more likely that this vein is being over mined and could play out soon?

A prudent VC will spread their bets a little more widely than to focus on any one model:

http://smoothspan.wordpress.com/2007/10/05/the-death-of-vcs-aka-wont-you-paint-my-fence/

Cheers!

BW

[Nate Westheimer]

One of the best posts so far.

I've been feeling this for a while. "Changes" in technology costs and customer acquisition models have been making it easier to "back load" startup costs for many businesses. However, that does not mean that startup costs disappear -- and for many companies who actually make technology, this market perception that you can launch with no $$ does more harm than good.

[Jim Murphy]

Your reconciliation assumes an infinite supply of available entrepreneurs worth funding. If founders that would have sought traditional funding (and that you would have funded) start looking at tweaking their plans to take a bootstrapped or long tail style financing approach would you not feel the vacuum?

[Jason Olim]

Don't forget that capital requirements are a barrier to entry. If the cost of creating a storefront goes down and the number of storefronts goes up, the returns are automatically reduced from the competition.