There seems to be an increasing number of large funding rounds taking place in the consumer internet space.

From Slide’s $50m to MOLI’s $30m, big money is in play.

I’ve watched recent funding announcements for a couple of reasons:

  • I’ve argued that, despite claims to the contrary, consumer internet startups today are not “frugal” in comparison to their Bubble 1.0 counterparts.

    While Slide’s $50m raise might seem small compared to all the Bubble 1.0 ecommerce companies that raised well over $100m, when one compares the true capital needs of these different breeds of companies, I think the level of overfunding is quite proportional.

  • While startups often like to claim that they’re recession-proof (or can even thrive in a recession) when the economic situation gets gloomy and startups begin to take huge chunks of capital, it is often a signal that entrepreneurs are worried about their near and mid-term prospects and want to make sure they can survive.

    While this can be a wise move, that should not distract us from recognising that this is a bearish indicator.

So I was interested when I learned that a startup I actually like, Etsy, just closed a $27m round of investment from Union Square Ventures, Hubert Burda Media and Accel Partners.

Etsy, which describes itself as “an online marketplace for buying & selling all things handmade” has a simple mission:

“To enable people to make a living making things, and to reconnect makers with buyers.”

It’s a simple business that probably isn’t going to become the next eBay, but that I expected could carve out a decent little niche.

That said, the amount of money raised by the company seems disproportionate to the size of the opportunity. As such, I think Etsy makes for an interesting case study, especially because the company’s CEO, Rob Kalin, posted an explanation about the funding on the company blog.

“We do not want Etsy itself to be a big tuna fish. Those tuna are the big companies that all us small businesses are teaming up against…Those big companies are holdovers from the days before the web existed. And any company that is being run the same way now as it was before the web came about is due for some massive restructuring or deflation.”

He added:

“This means that we now have the resources to extend Etsy’s reach in this world, to enable so many more people to make a living making things. We want Etsy to exist for hundreds of years. Our goal is for Etsy to be an independent, publicly traded company, focused on all things handmade.”

I like Etsy but it’s clear that the founders are idealistic and quite possibly out of touch with reality and the economics of mass-production. Many individuals produce hand-crafted items.

Unfortunately, it’s tough to make a living this way and mass-production is required to produce enough essential goods for a world with more than six billion people.

Furthermore, the average consumer, who himself or herself may be feeling financial pains, makes a considerable number of purchases based primarily on price.

The Cynical Drama 2.0 would note that the people who are most likely to buy “handmade” items are holier-than-thou, bourgeois liberals.

Rob goes on to note that Etsy is “almost break-even.” But here comes the catch: “it’s not enough.

Etsy needs to invest in infrastructure to keep up with the service’s usage growth, it needs to develop new features, wants to improve customer service and feels obligated to keep its employees well-fed.

Perhaps most interestingly, he also mentions that “we need to be able to make it through any hard times that hit the economy,” giving credence to my belief that large funding rounds often signal bearish economic sentiments.

All this might sound fine and dandy, but I see two major problems:

  1. Etsy has a simple business model - it charges 20 cents for a listing and takes a 3.5% cut of each sale.

    Unless it starts charging for other services and/or increases its fees, the economics of the business are fairly predictable.

    If the current pricing, metrics and projected growth figures don’t align to enable the company pay for the $5m it anticipates it will need to spend on hardware and hosting over the next two years just to keep the service running, it would appear that the company has a problem scaling the business that isn’t going to be solved long-term with a capital injection.

    Unlike advertising-dependent companies, which often scale rapidly to support volatile and hard-to-project perceived revenue ceilings, Etsy has a business model that should enable it to scale in a more sensible fashion.

    Since it apparently needs a considerable amount of capital, however, it’s clear expenses have grown more rapidly than revenues (for instance, why does the company need close to 50 employees?). This is not a good sign, especially for this type of business.

  2. In hard economic times, the odds that hordes of mainstream consumers are going to be paying a premium to buy “handmade” goods over the internet are not good.

    To the contrary; consumers are likely to turn to the Wal-Marts of the world because they can get more bang for their buck.

    Again, even in prosperous economic times, buying certain “handmade” products is typically the domain of those who have higher-than-average disposable incomes (or those searching for a piece of “art” or a “gift”).

In short, Etsy is a perfect demonstration that:

  • The claims that successful internet startups can be built a lot less expensively today than they could in Bubble 1.0 are often false. Entrepreneurs continue to build internet companies in a fashion that requires hefty capital investment and the same common problems (an inability to scale up in accordance with revenues, investments that are disproportionate to the size of the market, etc.) are just as present today as they were in the late 90s.
  • At least some of the current justification for raising large rounds of funding is based on concerns about the economy.

I certainly won’t fault any startup for taking big money based on economic concerns, as this is a survival move, but unfortunately I think a lot of these big money investments are going to end the same way the big money investments in Bubble 1.0 did.