Angel Investing/Venture Funds: October 2009 Archives

A few years back I worked on a tiny startup that was attempting to jump on the affiliate marketing/blogging bandwagon. It was all the rage that people were making $100Ks per year just writing articles and doing a good job on driving traffic and purchases to marketers. It was a site about how geeks were cool because they were buying cool products, and so we would write about these really cool products and then drive affiliate traffic to places where you could buy them.

Our venture didn't get that far, but so many others' did. And the list is growing.

As everyone working on projects on the Net knows, the cost of building a business has dropped dramatically over the years. It started with blogging software which would could install on our own servers or use the hosted versions. Now, you can go out and find shareware for just about anything; stuff that would have cost a big company millions of dollars and a team of 100 to build in the past could now be found and deployed for a tiny fraction of that cost.

It's also easier to deploy web applications now. Previously you had to be a computer scientist to do so; now just about anyone can figure out how to deploy it, or using hosted versions just fill out a signup form and point your domain at it and you're off and running.

So now, just about anyone can throw up a website which has some advanced functionality. And people are doing it too. In the startup world, we see the internet has gotten super crowded over the last few years. Very few truly unique business/product ideas have emerged, and many are just clones of each other. Or once someone puts up a good idea, the clones emerge quickly because it's so easy and fast to put up a website. Thus, it's now less about the idea but rather how many customers you can grab and whether you can monetize that traffic to balance out your burn.

Thankfully, the internet crowd is enormous. Grabbing a small slice of that traffic and monetizing it effectively can mean a sustainable business that pays its employees a decent salary. In the past, we called these businesses microbusinesses or lifestyle businesses where a single person could make a decent living managing a website. However, in today's world, I call this phenomenon the rise of small business on the net.

Many startups we encounter have plans that we know can reach this stage. With great execution and effort, we can easily see many businesses growing to great small businesses. They will have revenue from several $100Ks a year to small millions. They have a small teams and all of them are well compensated for their work. All the employees will have great lives supported by this business.

The effort is comparable to opening up a storefront on your favorite street. In the old days, you'd go find a great physical location with lots of foot traffic. You go get a small business loan from your local bank and open up shop. Then you go and acquire customers and build your business from there. In today's world, you can do it on the internet without a physical location and tap into customers from around the globe.

From an investor's standpoint, we're finding that this creates a number of problems. Our model is dependent on finding those startups which will go big, much bigger than small business size, and find a way to return our investment with large gain through some mechanism like M&A or IPO. However, the ease at which startups can reach small business stage makes our job harder; we're seeing many businesses reach a certain level of growth and then breaking through that level is tough due to how easy it is for competitors to enter your market, and how hard it is to acquire the attention of users.

Some of us are thinking about change in the way we support some startups. I find parallels in the area of restaurant investing, where the investment is all about cash return and not ownership. What kind of restaurant would go IPO? Highly unlikely. But could we make 10-20% on our investment? Infinitely possible.

I wonder about how the structure of deals we do for internet startups might mimic restaurant investing. Instead of caring so much about ownership, perhaps we should find a way to get a healthy return on capital invested through cash flow, if the startup monetizes efficiently and does it well.

The problem with traditional investing in startups here is that these small businesses may never attract an acquirer and certainly the chance of an IPO is even more remote. Driving these small businesses to activities to return an investors' capital in that manner may take a healthy sustainable operation and turn it into something unsustainable and problematic as it reinvents itself to attract an M&A event or IPO. That seems dumb; the business is thriving and its employees well paid and happy - why destroy this?

I think the world of investing should think more about the rise of small business on the net. Many more businesses each day are showing up that are great sustainable operations supporting employees and their customers. They are never going to be superstar Googlesque success stories and we should not attempt to turn them into one. In today's crappy economy, the world needs more small businesses to show up to employ the masses and make them money. We as investors should find a way to invest in and help these companies to grow, and just be comfortable in the fact that they will never be Google but still can help us make a healthy return on our money.

I was just reading 10 Huge Successes Built On Second Ideas and it motivated me to write this post, as I've been thinking a lot about the fact that entrepreneurs often end up in a place very different from where they started. It's gonna be a bit random, but here's what I've been thinking about:

1. How we pick startups to fund.

Time and time again I hear seasoned investors talk about betting on smart people because smart people will adapt and twist and turn to make their journey worthwhile. It is less about what they're building, although that is what brought them to the investor in the first place. Rather, the bet is that the person is good enough to figure something big out of whatever it is they pitched you.

I guess it's just me, but I place more emphasis on the idea than others, as there are many smart people working on stuff that doesn't have a chance, and is almost certain to require...a second chance.

The problem I see is that money only goes so far, and second chances don't come by easily. Most people don't raise enough money to allow them to twist and turn later; they only have enough to get them to barely a market trial of their initial idea. That's why I push entrepreneurs to raise at least 2 years of capital now, while their attraction is hot. Trying to raise more money later on mediocre to poor metrics is next to impossible in today's market. Otherwise, the entrepreneur will have to (usually painfully) adjust burn to last them further into the future or...just die.

2. Helping startups change/enhance what they're doing now.

I was talking to a venture capitalist the other day who said that you had to bet on entrepreneurs who knew what to do whatever the situation, and that if you had to help them then this was a sign of trouble. I find this to be somewhat not true, as I've built my business on sitting with entrepreneurs and helping them shape their products. I've found out that even smart entrepreneurs appreciate you throwing them ideas and opportunities that they can use, especially when they are in a bind. Finding smart people is fine, but everyone needs help once in a while and it's the smart ones that know they need help and accept it.

It's happened a few times now, where startups are now figuring out what to do next. One has changed completely, and others are in the process of reinventing/rethinking what they started working on because it hasn't worked out as well as they thought it would. I find the more I insert myself in this process, whether I ply coach-like skills to help give them some process in reinvention, or I'm throwing a constant stream of ideas at them until something sticks, the faster they will get on a new and potentially better path before their money runs out.

3. Raising money is a tough process for second chances.

This is tough for a variety of reasons.

a. Dealing with existing investors can be difficult. Already you have some invested in your company. But yet, now you're out there raising more money to continue - if your metrics are mediocre, then this could mean a sideways or down round to keep working on your current idea, and you must take into account the fact that your investors already own a piece of your company, and now more money is coming in and ownership and control issues arise. They best condition would have been if they invested into a note without a cap, which I would never do, because then you have total control over what happens to them.

b. Raising money on mediocre metrics is next to impossible. If you've gotten to a point a year in and your growth is not so great with little or no revenue, it's next to impossible to get another set of investors to bet on your idea in today's economic climate. They often assume that your idea and/or team isn't right.

c. If you're working on a totally new idea that may be great, but you and new investors still have to account for the fact that there are existing investors already, and what kinds of ownership and control issues exist and how they will change. Potentially it could also mean some questions will arise as to why your previous idea tanked and if whatever those reasons were make you look bad, then it will be hard to raise more money.

4. Mentally it's hard.

Yeah it's tough as hell. You're all gung-ho on your initial idea, you've got your investors and everyone around you excited about where you started and now you gotta change. That sucks! And you often beat your head on the table trying to figure out how and where to go next.

As many smart people I've met, they have often shown that they are often not equipped to continue on these projects in the face of adversity. This is both situational and internal.

Situational means that they may have real life needs for capital, like a family to support. I say situational because dependent on their life stage, the situational needs may be completely different like, for example, during when the time they were just coming out of college.

Internal refers to elements of one's psyche to enable them to deal with the harsh realities of entrepreneurism and what it often takes to build a business. So being smart is one great metric, but it's not enough by itself. You need to be creative, adaptable, able to withstand change and adversity and find solutions in chaos. Many people can't do this. Over the last few years, I've noticed that many people think they can just start a company and it'll be an easy ride to Google style riches. Time and time again it's proven wrong to me, having been through it at Yahoo and watching countless startups now.

All I can say is second chances (or twisting/turning/adapting from their initial idea) are tough. I am one for doing a little upfront planning for having enough time to twist/turn/adapt as far as second or maybe even a third chance, since it happens very often. Raise enough money early in the process and create a plan to go for 2 years, assuming no revenue or progress. Be prepared for it mentally, celebrate when your initial plan pans out, and buckle down the hatches when you have to shift.