Web Startups – Does Venture Funding and Geography Still Matter? (Part 1)

There’s been some good discussions on the role of venture funding and geography for web startups over the last months. These are topics that particularly interest me for several reasons:

  1. I’ve worked with web startups, either as an individual consultant, vendor, or employee during the last five years. I also have tinkered with a number of my own projects. 

  2. I live on the East Coast, in the D.C. area, where historically this region has been known for political and non-profit organizations.
  3. I consider myself a student of demography and am interested in how today’s technology impacts the need for geographic proximity. My employer has multiple remote offices, so I have firsthand experience in understanding what it means to work in a distributed workforce.

It might seem shortsighted to focus on these two particular topics. So, let me be clear that there are many other elements of web startups to question and explore. These happen to be the most timely and relevant, both for me and the larger web community. 

Part 1 – Does Venture Funding Still Matter for Web Startups?

Entrepreneurial Incentives – Then and Now

Based on research from Professor Robert Hendershott of Santa Clara University, the NYT asked Do Web Entrepreneurs Still Need Venture Capitalists? and promptly concluded “no.” The Times does a nice job highlighting Professor Hendershott’s research but his actual paper has the data to support his claims.

Hendershott spends quite a large part of his discussion focused on conventional VC investment models as they relate to entrepreneurial incentives in the current marketplace. While staged investments are better at keeping entrepreneurs incentivized, ultimately they still promote an environment where selling a company early can be more advantageous to an entrepreneur than the risk for a larger upside. Traditionally, investor ownership stakes and liquidation preferences have offset this misalignment of incentives.

In recent times, however, less capital has been needed for companies to build technology. For example, cloud computing and cloud storage greatly reduce costs typically associated with early stage startups. With less capital needed to build technology, lower first stage investments result in entrepreneurs winding up with greater ownership into their companies. Subsequently, they would earn a larger percentage of a first round sale. Basically, historical checks are removed. Hendershott explores this unravelling more but the end game is that “[p]otentially, the venture model for finding, developing, and vetting new Web-based businesses breaks down.”

The iPhone Gold Rush

Even without Hendershott’s analysis, there are enough anecdotal iPhone success stories to see that it takes far less resources to bring a new web (or more generally “digital”) startup to market today. For those that have the business and technical skills, places like Apple’s App Store provide a large and immediate distribution channel that handles logistics like payment authorization and to a lesser extent, marketing.

The App Store represents a marketplace that significantly lowers barriers to entry (e.g., cost and time) and mitigates the risk of failure. Unsuccessful attempts to launch an application may not simply be brushed aside but they also likely won’t break the bank.

Venture 2.0

Professor Hendershottt doesn’t go as far as to say that Apple is replacing venture capitalists but he does indicate that the environment the App Store fosters “mimics” venture models. He also points to traditional VC firms like KleinerPerkins’ iFund, who are adapting to this new world.

Rather than adapting, TechStars and Y Combinator have focused on a strategy of much lower seed stage investments. By taking this very smart approach, they’ve played the odds in their favor. Hendershott actually lays out the type of mindset of investment funds like TechStars but never directly makes the connection:

“The first round investor, while also risk-averse, is presumably diversified across a portfolio of similar young firms. This makes the investor more willing, even eager, to take the chance of a complete loss in any given portfolio company in exchange for a good chance at a much higher gain in at least one portfolio company.”

Of course, the idea behind “Venture 2.0″ mostly speaks to VCs reinventing themselves to stay relevant and a factor within the web startup equation.

Future – Venture Funding for Web Startups

It would be presumptuous to believe that venture funding will play no role in the future of web startups. Hendershott carefully chooses his words when he writes (my emphasis), “entrepreneurs should recognize that venture capital may play a smaller role in their future start-ups, and plan accordingly.”

My instinct is that taking VC investment will largely relate to the preference, experience, financial stability, comfort level, and skills of the entrepreneur.

In other cases, the choice will be dictated by the idea itself. For example, a YouTube-like startup could not get off the ground without the funds to cover its large bandwidth costs. Any explosive idea will require the capital to cover the scalability of infrastructure, even with the cloud.

Now – To Raise or Not to Raise?

Since VC funding for web startups is not disappearing tomorrow, it is important to understand if or when it’s a good time to raise funding. FreshBooks CEO Mike McDerment recently penned a piece entitled five milestones to reach before raising venture capital. The first milestone is the best:

When: you don’t need the money

This may seem counter-intuitive on a whole bunch of levels, but the time to raise money is when you don’t need it. What I mean by “don’t need it” is you can carry on without it, or you have alternatives (like other people who want to invest, or a house you will mortgage). Many entrepreneurs don’t understand the value of finding their way without VC money, or they think they need the money more than they actually do, or they think they need it sooner than they do, or all of the above! (READ: the 7 ways I’ve almost killed FreshBooks) The result is they spend a lot of time too early in their businesses lifecycle focused on serving VCs instead of serving their customers. Raising money is a negotiation. You need options when you are sitting at the bargaining table – you need a path without capital, a legitimate path.

Note: I work for a venture-backed web startup and I’m thankful for that. Venture capitalists have been enabling entrepreneur dreams and big ideas for many years and as I indicate above, I generally expect their involvement to continue in some fashion, especially for non-web startups.