A recent blog post by Y Combinator’s Paul Graham has caused a fair deal of buzz around the VC end of the blogosphere. In his essay, Graham points to a number of trends that he sees in the software/internet startup world and makes a number of predictions as to where the industry is headed.
In Graham’s view, we can expect to see a lot more startups founded by younger entrepreneurs needing a lot less funding; a standardized process on the part of investors to streamline the investment process; a more sophisticated attitude towards acquisition by major players; as well as a decrease in the importance of a college degree compared to technical skills and experience.
On the heels of the piece, we’ve seen numerous blog posts analyzing Graham’s points, focusing on the changing landscape (when it comes to Internet companies), and openly suggesting that the traditional VC model is broken and that we need to adapt ourselves to the new world order.
Graham, I believe, is spot-on with a lot of his analysis even though I don’t fully accept his conclusions. Here at Giza we’ve seen the local Internet scene develop greatly over the last couple of years. Our deal flow is filled with the types of companies Graham describes: young guys (and gals) with great ideas who don’t need a lot of funding to get started.
Our Ofek seed-stage program is designed for this environment: provide the relatively small initial sums for a company to reach pre-defined milestones and then decide whether to continue on to a major Round A. So far, we have made four investments this year under the auspices of the program, with Koolanoo Group having already graduated into a full portfolio company.
Like I said, I have a couple of caveats about Graham’s piece and the Y Combinator approach in general. A big part of it is the model and the potential scale. Y Combinator’s business model (also shared by investors such as First Round Capital) is predicated on making small investments in each particular company, then enjoying potentially good returns even on small-scale exits.
In theory, this should work fine. In practice, it runs up against issues of scale. Again in theory if you fund enough startups like this, one or two of them might be classic VC-grade home runs (say $100M plus exits). The question is how many you have to fund.
Graham talks about what happens when Y Combinator has to deal with 10,000 companies. Obviously, they’ll never be able to deal with 10,000 companies, let alone 1,000. Unless you’re planning on being a source of capital c’est tout, you need to provide some management attention to each of your portfolio companies. This is feasible for 20 or 30 companies at a time, depending on your staff size and the amount of streamlining you are able to do. It becomes increasingly hairy after that.
So you have to then wonder what types of returns – not multiples, but actual objective money – you can get from a strategy based on a few dozen companies with relatively small exit avenues.
And then there is the matter of follow-on funding: few are the companies that grow into significant Web properties without some degree of marketing. Which means that you go from investing a few hundreds of thousands of dollars to investing two or three million.
In short, big questions indeed. As a rule, I think that seed-stage investment approaches like Ofek are the right way to go for many of the Internet companies that we see. (And even then, I should point out that since the model is relatively new we have little data on the actual outcomes). Whether it will completely take over the VC biz, count me skeptical.
Shai, great insightful post. Is there a way to build VC grade business with a small investment? IMHO - no. But not because of the business - but because of the VC model. 7 years till exit is not a lot of time, and there are not a lot of hockey sticks out there.
But, can you build a strong, profitable business, that will grab a market share that worth millions and tens of millions? Yes, but not if you are pushed aggresively for exit.
I wonder if that micro investment will work. and if VCs will change their method....
Posted by: Kfir Pravda | October 21, 2007 at 11:01 PM