Web Success on the Cheap

[Kragen Sitaker]

>From the New York Times, this article "For Start-Ups, Web Success on
the Cheap", 2006-11-09, talks about how new web startups are
succeeding on low budgets.  This is one of a number of recent articles
that show how access to money is much less of a limiting factor for
innovation at present than it was before.

When one limiting factor in a situation like this becomes less
important, it allows those in control of the newly limiting factors to
capture more of the surplus value.  In this case, the article claims
that the newly-limiting factor is access to programming talent, and
the result is that programmers are retaining more control over and
ownership of the companies they start.

There are three possible reasons for a limiting factor becoming less
important like this.  One is that other limiting factors may have
become more stringent limits; the others are that the needed quantity
of the previously limiting factor has gone down, or the available
quantity has increased.  Which is the case here?

According to the article, the amount of money available has increased,
but it claims that this is not the reason access to capital has become
less important; the startups profiled used less money, not more.
(This could be because these new startups are more narrowly focused
than previously, and so the same amount of money will get spread
across more of them, but the article offers no evidence for that idea,
nor does it seem plausible.)

The number of startups also does not seem to have decreased, or anyway
the article doesn't claim so, so it does not seem that the money is
being starved due to a new lack of other resources, such as
programming talent.

The article instead claims that less money is needed for the same
results, and credits cheap hardware and bandwidth, the wide
availability of open-source software, and (essentially) AdSense.

So, in summary, cheap stuff, AdSense, and free software are making
programmers rich.

http://www.nytimes.com/2006/11/09/technology/09venture.html?ei=5090&en=1a49d4daaa73e6c9&ex=1320728400&adxnnl=6&partner=rssuserland&emc=rss&adxnnlx=1164730261-ENLUi0A/mHjxTkEWGm6hLQ

For Start-Ups, Web Success on the Cheap
Peter DaSilva for The New York Times

[photo caption: Meebo, begun by Elaine Wherry, left; Sandy Jen; and
Seth Sternberg, was financed with credit cards.]

By MIGUEL HELFT
Published: November 9, 2006

SAN FRANCISCO, Nov. 8 --- When Seth J. Sternberg and two colleagues
started Meebo, a Web-based instant-messaging service, they didn't go
looking for venture capitalists. Using their credit cards, they
financed the company themselves to the tune of $2,000 apiece. It was
enough to cover their biggest expense --- leasing a few computer
servers at $120 a month each.

Within a month of its introduction in September 2005, Meebo was
getting as many as 50,000 log-ins a day, and it needed more
servers. It decided to take a modest $100,000 from three angel
investors, wealthy individuals who typically contribute small amounts
but do not get involved in management decisions.

"We had a bunch of V.C.'s talking to us about potentially putting more
money in," Mr. Sternberg said. "We said no. A lot of things happen
when you raise a V.C. round, and they really slow you down."

Eventually, Meebo did raise money from venture investors --- about
$3.5 million from Sequoia Capital. But that was after the company was
well on its way to showing that its service was a hit; Meebo had about
200,000 daily log-ins.

In the last couple of years, hundreds of other Internet start-up
companies in Silicon Valley and elsewhere have followed a similar
trajectory. Unlike most companies formed during the first Internet
boom, which were built on costly technology and marketing budgets,
many of the current crop of Internet start-ups have gone from zero to
60 on a shoestring.

Some have gone without venture capital altogether or have raised far
smaller sums than venture investors would have liked. Many were sold
for millions before venture capitalists could even get in. That has
been a challenge for venture capitalists, who have raised record
amounts in recent years and need places to put that money to work.

"V.C.'s hate it; they want you to take big money," said Jay Adelson,
who is the chief executive of two start-ups, Digg and Revision3. Digg
took some venture money, but far less than backers offered, and
Revision3 has been running on about $850,000 raised from a group of
angel investors.

Several venture firms are seeking to adapt. Just last week, Charles
River Ventures announced it would offer loans of $250,000 to
entrepreneurs as a way to gain access to promising start-ups. Other
firms are also giving out small loans, albeit not as a part of any
formal program.

For its part, Mohr Davidow Ventures has increased the number of "seed"
investments --- small sums given to embryonic companies --- to about
10 a year from 5. And Union Square Ventures, which was formed in 2003,
has made nearly half of its investments at $1 million or less, a
departure from its initial plan to make first-round bets of $1 million
to $3 million, according to its Web site.

"I think there is in the V.C. community a sense that the rules have
changed or are changing," said John Battelle, a journalist and
entrepreneur, who is a host of a technology conference in San
Francisco this week that will include a panel on the subject. "How
does the V.C. who is set up for a model that requires millions, if not
tens of millions, revamp for a different scale?"

And as large firms try to go small, they are encountering a new crop
of competitors who are happy to bankroll start-ups on the cheap and
are fueling the current Internet boom. They include a large pool of
angel investors and a number of small venture funds whose specialty is
to invest tens of thousands of dollars, or hundreds of thousands at
most.

There is even a group called Y Combinator, whose rule of thumb for
investing in start-ups is $6,000 per employee. One of its investments,
Reddit, was acquired last week by Wired Digital, which is owned by
Condé Nast Publications, for an undisclosed sum.

"I came to the conclusion that $500,000 was the new $5 million," said
Michael Maples Jr., an entrepreneur who created a $15 million venture
fund aimed at investing in companies that required little
capital. Mr. Maples sees himself not so much as a competitor to
venture capitalists, but as someone who is filling the gap between
angels, who may invest $250,000 or so in a start-up, and venture
investors, whose typical early-stage bet is closer to $5 million.

Several forces are allowing companies to operate cheaply compared with
the first Internet boom. They include the declining costs of hardware
and bandwidth, the wide availability of open-source software, and the
ability to generate revenue through online ads.

"It's a great time to be an entrepreneur," Joe Kraus, a veteran of the
dot-com boom, wrote in a widely noted blog posting last
year. Mr. Kraus said it took $3 million to get his first start-up,
Excite.com, from idea to product, much of it spent on servers and
software, which have since become much cheaper or even free. His new
start-up, JotSpot, was started on just $100,000.

With the notable exception of YouTube, many recent acquisitions
involved Internet start-ups that simply could not effectively use
large amounts from venture capitalists or produce large returns, said
Paul Kedrosky, a venture capitalist and blogger.

"The problem is that as a V.C., these companies don't soak up enough
capital," Mr. Kedrosky said.

To succeed, a firm with a $250 million fund needs a handful of
investments from $10 million to $15 million that can return payouts of
$150 million or more, Mr. Kedrosky said. But even a twentyfold return
on a $1 million investment will not do much for the success of a large
fund, Mr. Kedrosky said.

For smaller funds, the economics are far different. For starters,
those who manage them do not earn huge management fees. Instead, they
are almost always among the largest investors in the fund, so they
will earn a return if the investments pay off.

"I think large venture funds in this economic model have a challenge,"
said Josh Kopelman, managing director of First Round Capital. Since
starting First Round in 2004, Mr. Kopelman has made about 30
investments that range from $250,000 to $500,000. Mr. Kopelman, who
made a fortune as a serial entrepreneur, is the largest investor in
First Round's $50 million fund.

Y Combinator is aiming at even smaller firms, and its approach is
decidedly unorthodox. It chooses companies for financing in two
batches of 8 to 12; one batch is selected in the winter from companies
based in Silicon Valley, the other in the summer from those in
Cambridge, Mass.

"When you change the amount of money, a lot of things change," said
Paul Graham, one of four partners in Y Combinator, who made millions
when his company, Viaweb, was sold to Yahoo in 1998. "We have to
mass-produce things. We can be more risky. We are like mice, and
V.C.'s are more like elephants. They can only make a few deals, so
each one has a whole amount of weight and worry attached to it."

As for the target investment of $6,000 for each employee, an
explanation on Y Combinator's Web site makes it clear that Mr. Graham
and his colleagues are not looking for computer science entrepreneurs
who want to be pampered: "C.S. grad students at M.I.T. currently get
$2,000/month to live on, so this represents three months' living
expenses. Though in fact most groups make it last longer."

Established venture capitalists, however, say the new crop of
capital-efficient start-ups represents an opportunity, not a problem.

"Companies have bootstrapped themselves in earlier eras," said Gary
Morgenthaler, a general partner at Morgenthaler Ventures. "There is no
shortage of companies that need venture capital and company-building
skills."

Jon Feiber, a general partner at Mohr Davidow Ventures, said it was
"incredibly good and healthy" that many Internet start-ups were able
to do more with less.

"A small percentage of those companies will lend themselves to the
model of a larger fund," Mr. Feiber said. "If your goal is to generate
something of huge value and scale, it is going to take more than
$300,000 or $400,000."

JotSpot, the company that Mr. Kraus started on $100,000, may fit that
mold. The company eventually took in $4.5 million from a pair of
venture capital firms, and last week it was acquired by Google for an
undisclosed sum.

"I think it could be a great time to be a venture capitalist,"
Mr. Kraus said in an interview. "Like in any competitive market, fear
and hope are the two competing forces." And for venture capitalists,
the success of scrappy start-ups may simply be heightening the
fear. "I think there is a lot of fear that people won't get into the
best deals," Mr. Kraus said.