Venture Capital Firms Set Their Sights on New Ideas — Not New Technologies

Venture Capital Firms Set Their Sights on New Ideas — Not New Technologies

Published: August 08, 2007 in Knowledge@Wharton

It
has never been easier to start an Internet company. Create a web site,
begin a "viral" marketing campaign to grow word-of-mouth and acquire an
audience, garner some ad revenues, generate venture capital funding and
sell out to a web giant such as Yahoo or Google. Startup costs can be
minimized by using standard technology and by outsourcing corporate
functions such as advertising sales. The business model, at least
initially, is optional.

This blueprint is becoming increasingly common among so-called "web
2.0" companies — web-based communities that facilitate collaboration
and sharing. Companies like Facebook, the fast-growing social
networking site, and Twitter, a popular mobile messaging service,
didn’t introduce break-through technologies, but they have become
phenomenal success stories nonetheless. According to Wharton faculty
and other experts, these companies have altered the traditional venture
capital formula, which used to count technology differentiation as a
key requirement for web companies. In many cases, technology has become
a commodity, and a big idea can go a long way provided there’s a
rapidly growing audience.

Wharton management professor David Hsu
says that in today’s venture capital environment, ideas are valued more
highly than innovative technology. "Is it the technology or the idea
that matters? With the new round of companies founded in the last few
years, both are viable. The barriers to entry have been lowered. I can
grab technology off the shelf if I have a good idea."

"It is much cheaper to get a web 2.0-based company off the ground
and running," says Jeffrey Babin, a lecturer in engineering
entrepreneurship at the University of Pennsylvania. "The entrepreneur
doesn’t need as much money so he can do a lot more bootstrapping. He
can build more value before even going to a VC."

New companies face risks in this kind of environment, however: If
they are successful, firms may not be able to defend themselves against
the myriad competitors that will inevitably spring up around them, Hsu
notes.

For now, the VC funding keeps rolling in. PricewaterhouseCoopers’
Money Tree survey revealed that first-quarter venture funding was $7.1
billion, the highest level since the fourth quarter of 2001. Of that
sum, Internet-specific companies garnered $1.3 billion, the highest
level in five years. While the initial public offering market has been
difficult in recent years, buyouts are prevalent. In 2005, News Corp.
bought social networking site MySpace for $580 million. Yahoo purchased
del.icio.us and Flickr. Google acquired YouTube for $1.65 billion in
2006. In May, CBS acquired Internet radio and social music platform
Last.fm for $280 million. On August 2, Disney bought Club Penguin, a
virtual world for children, for $350 million. Those deals are just a
few among a bevy of recent acquisitions. Meanwhile, Facebook could be
worth anywhere from $4 billion to $10 billion depending on the Wall
Street analyst crunching the numbers.

Wharton management professor Gary Dushnitsky
says there is an excess of liquidity — not only from VCs, but hedge
funds and private equity firms — looking for a home. "The financing
market has changed a great deal," he says. "There used to be a few
dozen venture capital players. Now there’s pressure from hundreds of
private equity firms encroaching on VCs. The VCs feel more pressure
among stages of investment. This money has to be invested or returned."

But as VC firms look for new targets, several questions come into
play: How should companies be evaluated when they rely on technology
that is easily replicated? How much value does a big audience carry?
What’s the preferred exit strategy?

"Advances in information and communications technology have opened
up innovation in processes, products and services. There is a vast
array of opportunities. How many of these will stick remains to be
seen," says Raffi Amit, a management professor at Wharton.

Looking for Viral Growth

Amit says an evaluation of any company’s prospects starts with the
track record of its founders and management team. For instance, Joost
— which promises next-generation television service via the web — has
been able to attract funding because its founders, Janus Friis and
Niklas Zennstrom, also co-founded Skype, which was sold to eBay for
$2.6 billion in 2005. Joost raised $45 million in venture capital in
May.

After that, the evaluation comes down to the basics, Amit says —
cash burn, addressable market, competition and profit potential.

For the latest generation of web startups, other qualities need to
be considered as well, says Andrew Chung, a senior associate at
Lightspeed Ventures. Chung looks for three items when sizing up new
companies: viral growth, potential to sell advertising and transaction
revenue. "The differentiator is no longer technology — it’s more
[like] parts of a triangle," he says. "For instance, a company like
professional networking site LinkedIn has all three [of these
qualities]: It has viral growth, can sell advertising and garners
transaction revenue with subscription services."

Gaining an audience is the precursor to advertising and transaction
revenue, Chung says. Hsu notes that viral growth enhances the so-called
"network effect," in which the cost to gain an additional customer
decreases as users are added.

One of Lightspeed’s investments is Flixster, a movie site that meets
Chung’s criteria. Flixster has seven to eight million users, sells
advertising and its audience buys DVDs and other Hollywood content. In
addition, Flixster can command higher advertising rates compared to
mass market sites because of its focused audience. Other current
Lightspeed investments include MyBuys, a behavioral marketing company,
Wikio, a personalized blog and media search company, and Gmedia, a
mobile Internet commerce startup.

Chung says that not all investments turn out well, but the beauty of
the web is that losing companies are sorted out quickly. He looks for
declining traffic, an inability to monetize page views and competitors
gaining ground as signs that a company may not be worth the investment.
"The companies we invest in are on the uptick. We don’t invest in
companies that have no traction. We’re looking for guys on the way to
an inflection point. If that viral leg doesn’t hold up, you’re in
troublesome territory."

Amit notes that VC firms usually don’t give all funding to a company
at once. If a business misses key milestones, VCs won’t lose all of the
investment. "Venture capitalists overall seem much more cautious
compared to the late 1990s," says Amit. "They are conducting their due
diligence."

Business Models: When, Not If

While Wharton faculty and other experts agree that business models
are important for new ventures, the question is timing: Should web 2.0
startups focus on a business model right away? Or should a revenue
model be added later, once critical mass is achieved?

At the 2007 AlwaysOn Stanford Summit on August 1, Roger McNamee,
managing director and co-founder of venture capital firm Elevation
Partners, characterized the second view. "We are beginning the third
wave of the web — the first [was] aggregation; the second, indexed
search; and the third is finding things based on references. I haven’t
any idea what business models will emerge, but I’m confident it will be
big," said McNamee.

Mobile messaging service Twitter announced on July 26 that it had
received an undisclosed amount of funding from Union Square Ventures
and Charles River Ventures. Fred Wilson, a partner at Union Square
Ventures and one of Twitter’s investors, wrote on his firm’s blog that
business models aren’t the most important item in an early round of
funding. "The capital we are investing will go to making Twitter a
better, more reliable and robust service. That’s what the focus needs
to be right now. We’ll have plenty of time to figure out the business
model, and there are many options to choose from."

Babin largely agrees with Wilson, especially in light of the fact
that, these days, less capital is needed to launch a company. In other
words, an entrepreneur can launch a company, see what customers do and
adapt a business model accordingly. "You launch a site and then see the
answers to questions like: Can I make this interesting enough for
people to come back? What’s the interaction? Are people coming to see
something and doing something with the site?"

The answers to those questions will provide clues about what kind of
model will work, Babin says. If a number of people visit the site to
view something, perhaps advertising is the core revenue stream. If
customers engage with the site, a model based on transactions could
work.

Dushnitsky agrees that business models for web startups can be
delayed a bit. "It’s clear that whoever survives must have a business
model, but a lot has changed between 2005 and 2007. There has been a
shift from fixed costs to variable costs when starting up a venture.
That means you can almost run a company like a hobby, with a low cash
burn rate, and see what happens. The financing that went into YouTube
was a fraction of what would have been required just a few years ago.
That has shifted the timing of when you need a business model,"
Dushnitsky says.

However, Amit believes that business models are critical from the
start. "You have to worry about the business model right off the bat.
You have to think about how you will do business, enter a market and
compete."

Hsu notes that companies need to ponder a business model so they can
notify users of what’s coming in the future. Given that next-generation
Internet companies depend heavily on their "communities" of avid users,
they need to build potential revenue generators into their services. If
a web company becomes popular and then hits users up for dollars,
customers could revolt, he points out.

"It’s better to worry about business models as soon as possible,"
says Hsu. "It’s a multi-front battle. We want people to love the site,
but companies do have to worry about the revenue model early on. If you
can anticipate and be clear about a model, your users will accept it.
You can’t switch midstream."

The Exit Strategy

Once a startup gets its business model right, VCs will start
pondering their "liquidity event," or a way to cash out. In the late
1990s, the primary liquidity event was an IPO. Today, VCs are more
likely to cash out via an acquisition.

"We now have [a situation that] we didn’t have before: Yesterday’s
web startups are mature companies looking for opportunities to expand
and grow," says Dushnitsky. "In the past, we had less acquisition
opportunities. Now we have the Yahoos and Googles of the world with
cash and looking to acquire. You also have other media companies
looking to the Internet."

McNamee, however, noted during his talk at the AlwaysOn conference
that acquisitions are rare relative to the number of web startups. "How
many web 2.0 companies can be bought by Google or Fox [News Corp.]?" he
asked.

Meanwhile, companies are less inclined to pursue an IPO.
Entrepreneurs would rather stay private due to Sarbanes-Oxley
requirements and public scrutiny, according to Bill Gurley, a partner
at Benchmark Capital, which has invested in eBay, Palm Computing and
Friendster, an early social networking site that has been eclipsed by
MySpace and Facebook. "The fear I have is the lack of executives who
want to be a CEO of a public company," Gurley noted at the AlwaysOn
conference.

Many experts agree that entrepreneurs shouldn’t think about exit
strategies before they build a business. If startups evolve into viable
enterprises, the liquidity events will follow. "While we want to see
exit strategy, we want you to build a business," says Babin. "If you’re
focusing on an exit, you’re not building anything."

McNamee agrees that a longer-term view is required. "If you’re an
entrepreneur, just do the things to make your company more valuable and
be prepared to do it for a while," he said.

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