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In Web 1.0, a considerable amount of startup activity was centered on the notion that the internet was a "commercial" medium.

It wasn't uncommon to see an e-commerce startup raise an eight figure round of funding early on in its lifecycle.

Such funding was required because starting a pure-play e-commerce business from scratch wasn't cheap. It typically demanded the acquisition of inventory, procurement of warehousing facilities and the development of distribution networks.

In Web 2.0, startup activity is primarily centered on the notion that the internet is a "social" medium. At the risk of generalizing, consumer Web 2.0 startups have a few simple tasks - create an online service that people are attracted to, build up an audience and try to sell advertising against that audience.

Such a model creates an entrepreneurial environment in which, in theory, a college student can come up with an idea for an online service, build it, launch it and start to grow it all from his dorm room without taking a cent of funding.

Many argue that this environment has changed the dynamic between internet entrepreneurs and the venture capitalists they've typically relied upon to get their ventures off the ground.

In a Yahoo tech|ticker interview, Lane Becker and Thor Muller, founders of Web 2.0 startup GetSatisfaction, argue that Web 2.0 has done to venture capital what the internet has done to the music industry - reduced the role of the "gatekeepers."

Notwithstanding the fact that the notion that aspiring recording artists can achieve mainstream commercial success without a record label due to the internet is largely a myth, the point that Becker and Muller attempt to make is that VCs matter a whole lot less to many internet entrepreneurs than they used to and that VC funding is no longer a prerequisite for success.

While I would argue that VC funding often turns out to be a contributor to failure more than it turns out to be a contributor to success, I still believe that much of what Becker and Muller state is, like their music analogy, more myth than fact.

Comparatively speaking, it may be "cheap" to build a Web 2.0 "service" (translation: web application) but one must recognize that simply building a Web 2.0 “service” does not a business make.

Becker and Muller argue that because Web 2.0 startups theoretically have an ability to get off the ground with minimal financial resources, traditional VCs aren't always so attractive to entrepreneurs who would have otherwise flocked to them in bubbles past.

To be sure, there is some truth to this.

A number of Web 2.0 startups became popular before raising money (or a significant amount of money), which gave their founders considerably more leverage when it came time to raise larger amounts of funding.

And even newcomers have “seed stage” firms that fall somewhere between angel investors and VCs on the private equity continuum.

But let's look at the big picture:

  • There has been no shortage of Web 2.0 startups leading with $1mn+ funding rounds - particularly in the frothy years of the Web 2.0 hype (i.e. 2005-2006).
  • The Web 2.0 startup that "goes viral" before taking on funding is more the exception than the rule. Not only have few Web 2.0 startups truly "gone viral," there are far more startups that have raised funding early than there are Facebooks and Diggs. Some of them have already failed and many more inevitably will.
  • When it comes to scaling (both in terms of operations and infrastructure), one need only look at Facebook's plan to use its $100mn in debt financing on infrastructure as evidence of the fact that running a massively popular consumer internet service is not cheap.
  • Most recently, a considerable amount of funding has been raised by Web 2.0 frontrunners. Facebook alone accounted for 22% of all Web 2.0 institutional funding in 2007 as tallied by Dow Jones VentureSource, and the recent large funding rounds pulled in by a handful of players such as Slide and LinkedIn demonstrate that money is now focused on an increasingly smaller group of Web 2.0 startups that are perceived to have better shots at success.

In my opinion, the most important consideration when evaluating whether or not Web 2.0 has made an indelible mark on the world of venture capital is the fact that Web 2.0, on the whole, has not materialized into the type of business opportunity that attracted investors to it in the first place.

Perceived potential has been plentiful but realized profits have been perpetually missing in action and the fact that startups can technically be "built" more cheaply belies the fact that these companies are actually inherently more risky because the costs of scaling (for the small number that achieve mainstream popularity) have thus far been far greater than the revenues they are able to generate.

At the end of the day, I would argue that the dynamic between entrepreneurs and VCs has not really changed much at all and that the changes Web 2.0 entrepreneurs like Becker and Muller perceive are merely illusions created by all the dumb money that flocked - short-term - to fund the Web 2.0 flavor of the month.

Smart VCs (what few exist) aren't concerned that Web 2.0 startups can get off the ground without their money or that angels and seed stage firms are cutting in on their action.

Why? Because Web 2.0 has few of the characteristics smart VCs look for.

There are almost no barriers to entry, much of the technology involved is commoditized, viable business models have proven to be lacking, profits are almost non-existent and lucrative exit opportunities are quite limited.

Indications are that all but the most foolish VCs increasingly recognize this and are starting to put their money elsewhere, meaning that aspiring Web 2.0 entrepreneurs are more likely to be disrupted by VCs than VCs are by them.

Perhaps the most amusing thing about the tech|ticker interview with Becker and Muller is that despite the fact that both have sold startups in the past, and that Muller goes so far as to state that a Web 2.0 startup can be built with " no money ," GetSatisfaction has raised $500,000 from investors, including three seed stage firms and at least four "angels."

This begs the question - if Becker and Muller question whether venture capital is even "risk capital," why weren't they themselves willing to invest the $500,000 they apparently needed to launch GetSatisfaction?

The answer is quite simple - Becker and Muller, like so many other Web 2.0 entrepreneurs, talk a good game, but when it comes time to play ball, don't want to risk marking up their own court.

The truth is that when it comes to the world of startups, VCs were never " gatekeepers " to begin with because there have always been entrepreneurs willing to take greater risks, fund themselves or find creative ways to get the money they needed without selling equity to VCs.

VCs only serve those entrepreneurs who don’t want to risk their own money, don’t have money or can’t raise money without selling equity. A good, honest VC (where are you?) will actually encourage an entrepreneur to do all he reasonably can to avoid selling equity.

If there’s any lesson to be learned from this tech|ticker interview, it’s that one should never listen to an entrepreneur who argues that the VC business is being disrupted when he sold equity to fund his current startup.

Drama 2.0

Published 26 June, 2008 by Drama 2.0

237 more posts from this author

Comments (3)

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Jayne

This is my seccond website my first was not successful and was a flop. I singned up with a new company to promote my website www.motherwearclothing.co.uk .we sell maternity wear and childrens clothing. Im finding it a mine feild to advertise as there's so many scam companys out there saying there going to avertise you but getting no where.

about 8 years ago

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Thor Muller

Thanks for taking the time to rebut our argument. However, I think perhaps some key points got missed in the short video format interview, and some false assumptions creeped in.

First, our point is that the cost of getting a new web app to market has irrefutably dropped like a rock do to open source software, development frameworks, design conventions, cloud computing, etc. You don't really address this in your post, but it's the game changer that has the follow-on effects we describe.

In our case, we built our app, and were testing it with thousands of users before we closed our seed round. We did this in part by underwriting it with our own money and from cashflow from a consulting business we were transitioning from. Had we not raised the seed money, which itself is a different investment beast from a traditional full VC round, we could have funded our continued development and operations in the same scrappy way, precisely because our costs were not unduly high.

By contrast, when I started a Internet software company, Trapezo, in 1999 there was no reliable way to even launch my feature rich web app for less than millions of dollars in startup capital (in our case, $4million). We *had* to go through the financial gatekeepers to make this happen.

As a result of this massive shift in the economics there are infinitely more web apps being created, far more of which have no promise of significant financial returns. So now it's the expectation in the VC community that Web entrepreneurs have built V1 of their products, and proven at least some audience support before investors will take it seriously. While this removes the importance of gatekeepers from the initial creative process (we can build whatever we want more easily), it shifts some of the burden and very early risk to the entrepreneurs.

I'd argue that this tradeoff is well worth it!

about 8 years ago

Drama 2.0

Drama 2.0, Chief Connoisseur at The Drama 2.0 Show

Thanks for the response Thor, and for the clarification.

First, in the interview, your business partner, Lane Becker, states that building a web application now costs "no money" - just "pure time."

As per your post, the development of your web application required a personal investment and cashflow from another business. The amount required may be small, but it wasn't "no money." Frankly, in my opinion, it's the perpetual overstatements like this that have done Web 2.0 no favors.

I think it's important to note that "cheap" is still relative. The fact that young entrepreneurs will give up 5-10% equity to a seed stage investor like YCombinator for rent money demonstrates that there are lot of aspiring (or wannabe) entrepreneurs who can't afford "pure time."

Putting that aside, in my post, I don't disagree with the fact that it is "cheaper" to build a web application today. However, I disagree that this represents a game-changer.

Perhaps our difference in perspective comes from a difference in belief/understanding as to how venture capital is supposed to work.

At the risk of overgeneralizing, I believe technology venture capital was designed to be put to use best in two ways:

1. Funding technically complex startups that require large amounts of capital for R&D and that, due to their risk profiles, are reasonably unable to acquire that capital through other forms of financing. This category includes biotech and cleantech startups.

2. Funding less technically complex startups that already have a product developed, have already proven a market, have established potential for significant revenues and whose founders have, for whatever reason, decided that equity financing is the most viable means to scale. This category includes Web 2.0 startups.

You believe the fact that more internet entrepreneurs can get something off the ground before going to VCs marks a shift in the economics of venture capital.

I believe, however, that smart VCs have *always* looked to invest in startups that are beyond Step 1 in the startup lifecycle.

In other words, I would argue that VCs throwing millions of dollars at internet startups with few barriers to entry, no product and little progress has been an anomaly borne of too much money chasing too few good startups.

Silicon Valley venture capital has been broken because of the following:

1. VCs have raised far too much capital and, needing to put all that capital to work, have been willing to throw money at startups before they are ideal candidates for VC funding. Giving a $2mn Series A to a pre-launch Web 2.0 startup is not smart VC investing, yet it happened all the time because VCs lost focus of their place in the market.

2. VCs have been focusing far too much on "trends." The thinking goes something like this: "Online video is hot. Let's go out and find an online video startup for our portfolio." While "trends" are important, a smart VC looks at the strengths of each individual startup, not the hype around the market it finds itself in.

At the end of the day, the fact that entrepreneurs are now being encouraged or forced to build products and to establish some viability through execution and market acceptance before seeking VC funding actually represents a partial return to the traditional VC model.

In this model, VCs never *intended* to be "gatekeepers" and entrepreneurs (and, where applicable, their angel investors) were *expected* to shoulder early risk proving out their concepts.

Thus, there is no new paradigm today.

about 8 years ago

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