

Giving money to the founders:  In 2009, is this still absurd? - sam_in_nyc
http://paulgraham.com/vcsqueeze.html

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jorgem
In an age when anyone can do a startup, the word "startup" here on YC has
somehow been distorted to mean "small software business that was started in
the last two years on a shoe string budget."

I think the VC should instead concentrate on businesses where their investment
can make a real difference: Business plans that _require_ a factory, or
expensive custom hardware, thousands of servers, gigantic customer education,
etc.

I know it's heresy on YC, but real VC's shouldn't be involved in companies
where only $20k is required to start the business. Founders are taking the VC
for a ride when they convince them to fund extravagant startups that _should_
be started without big investment.

VC investors, if they still have cash, need to think bigger. They're not
needed for software startups.

The amount of funding required to start a business is one of the best barriers
to entry, and the VC should exploit that.

~~~
pg
Real VCs shouldn't invest in Google?

VCs should choose their investments by the expected return, not the amount of
money they require.

~~~
jorgem
No, Google is the perfect investment for VC. Most founders (or anyone for that
matter) can't afford the huge data centers that Google needs.

That server farm costs a lot, and therefore the required investment is a
_huge_ barrier to entry.

That business model is perfect for VCs, and that is where they should focus.

~~~
pg
The server infrastructure they have now costs a lot, but they've paid for that
entirely by themselves.

When they became the default search on Netscape, they had 30 computers.

~~~
nostrademons
I thought that was Excite? I don't recall Google becoming the default search
on Netscape until FireFox. I remember that when all my friends first started
telling me to use Google (1999/2000, well after they had 30 computers), we
still had to type in www.google.com to get there. And I was a die-hard
Netscape fan then.

Edit: Never mind, they switched over to Google in July 1999
(<http://searchenginewatch.com/2167331>), when it was quite possible that they
still had 30 computers.

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vc_investor
I work at a brand name venture capital firm which is actively investing.

In this market, where 'flat is the new up', I'd regard having founders cash
out at early institutional rounds as unusual. There is comparatively little
money being invested at the moment, and its a "buyers' market" which is to say
that entrepeneurs have less negotiating power at present than they did when
things were frothy.

~~~
swombat
Are you seeing any trend of investments getting smaller? E.g. would your firm
invest $200k into a promising company, or is that still out of the question
even in these "tough times"?

~~~
vc_investor
My firm would do and always has done pre-Series A stage, with a view to
building a relationship and following-on in due course. However that is and
has always been a less common strategy: most 'bulge bracket' firms (active
fund of $300-600m) don't invest such small amounts.

More generally, no, I do not see any trend in rounds getting significantly
smaller. I do see a trend in pre-money valuations coming down, of course, but
that's entirely different.

The economics of bulge-bracket VC work when you invest say ~5% of your fund in
each portfolio company, in the hope that 1/10 or 1/20 of your companies will
hit it out of the park. Total fund size equilibriates when drivers for scale
(partners' remuneration, principally, less relatively invariable overheads)
balances with diseconomies from political inference effects which kick in when
too many partners try to reach consensus and cut the cake. That's why top tier
firms with a 'plain vanilla' strategy have roughly comparable fund sizes.

FUD aside, nothing I'm seeing at the moment that gives me any reason to
believe that underlying model is 'broken' or failing (though of course '07 and
'08 vintages will be shot). Almost all successful start-ups need a lot of
money to scale beyond a certain point. Free software doesn't really change the
cost of airtime, or a VP bus dev. I'm writing anonymously so I have no real
axe to grind in saying that.

What is certainly happening in the industry is a shake-out. Good firms with
strong reputations are raising quickly and comfortably (if quietly because
it's not a time to be above the parapet), and will continue to invest without
interruption. That is because there are well-priced deals to do in this
environment, and innovation doesn't stop in a recession.

A number of 2nd tier firms, on the other hand, are finding fundraising very
difficult. Many will not survive.

Firms that are thriving seem to be investing more slowly just at the moment.
This is because there is a lot of noise in the market, and visibility is
currently low. Analogy: when it's foggy you drive slower. (Economically:
transaction costs rise as expectations less aligned, so liquidity declines.)

What is tough is the squeeze at the bottom end for start-ups. I get the
impression (though have less direct evidence of this) that there is a bit less
easy money on offer from HNWs sub $500k as many are licking wounds, etc.

~~~
netcan
Thanks for that.

I'm sure there has been a discussion of this article before. But I get the
feeling that you disagree with it's predictions. I'm interested to know which
points you think are off & why.

The conclusion was that VCs are in a worse position. Investment needs to get
smaller & to maintain their investment sizes VCs will need to buy shares from
founders.

1 - Software Startups need/want less capital because of (a) lower technology
costs (b) lower promotional costs (c) smaller teams.

2 - IPOs are less likely. This results in (a)the lower risk/reward goal of
acquisition being set as a target. (b) less capital needed for the IPO
process. _I've added in point b_

3 - Sellers' Market. (a)VCs' structure dictates investment size & fund size
(as mentioned above) creating a surplus. (b)VCs are competing with acquirors
offering a lower risk option. _I imagine the current climate dampens these_

I suppose the last point is most debatable. It may be temporary. The VC
industry may contract or move away from Software. But if 1 & 2 are correct,
this should result in smaller investments, founders cashing out or some
combination of these. Do you see these points as being incorrect? Am I missing
something else?

~~~
vc_investor
PG's argument as I read it is that there's a shift in comparative market power
towards entrepreneurs qua producers because the barriers to innovation have
fallen so their funding needs are less.

I agree that companies pursuing small opportunities (web 2.0 features,
iPhone/Facebook apps, etc.) will face little competition from funded
competitors. That's because there's little money to be made out of those
innovations. In the short term, that may even apply to situations where the
prize is large (Skype, Google, Facebook, etc.).

But in the longer term, economic systems operate in equilibrium, so you have
to think about marginal not absolute factors. In equilibrium, competition will
increase, and in turn cost of supply (of developers, airtime, etc.) will
scale, in proportion to the size of the prize. Only proprietary cost
advantages offer sustainable competitive advantage, whereas free software
tools, cloud hosting, and cheap airtime benefit all contestants equally. When
credible signalling costs are high and transparency is low, relative early
advantage tends to be self-reinforcing. So when the pie is big enough,
unfunded start-ups will find their marginal rate of growth just as constrained
by a lack of capital as it's ever been, and will lose the initiative to
better-funded rivals accordingly. Which means VCs will be just as essential in
supporting high-value product development as ever.

Of course, you might say that the rate at which the marginal utility of wealth
declines is high enough that few rational entrepreneurs will be motivated to
pursue big new product innovations given the higher likelihood of failure
compared to developing iPhone apps. In practice I tend to think that success
for most entrepeneurially-minded individuals is as much about recognition (a
positional good), as it is about absolute wealth. And again, in equilibrium,
position goods are definitively scarce, meaning the arms race for status will
continue ad infinitum.

There's an old adage about how to make money: sell bullets in the war without
end. That's what VCs do. And the invention of the taser doesn't put gun makers
out of business. On the contrary, it increases their utility.

~~~
swombat
I think the only fallacy I'd point to in that argument is the idea that "more
money helps" when building software.

In practice, I've found that adding more developers to a team actually makes
it less likely to succeed. Imho, the ideal team size for a software start-up
is three - three excellent, top-notch hackers, but just three. More than that
and the communication overheads start to hurt your early progress and
flexibility.

That's not to say that the three hackers won't want additional help later,
which is where you could come in. But that's only the case until the tools get
good enough that the three can continue as three pretty much forever.

The increased productivity of tools like Rails means that larger teams are
actually at a disadvantage. This to me is the greater threat on your industry.
In my start-up, I don't want us to grow to a mega-team of hundreds of people.
In fact, we've already had numerous discussions about having it as part of our
business model to keep the company as small as possible and outsource any work
that's not core to the business - so that we can ensure that the only people
we employ are top notch.

Otherwise, your analysis is good - but imho this factor could be the chink in
your armour.

~~~
vc_investor
Even were that uncontroversial, the cost of developers' time generally
accounts for only a small proportion of the costs of bringing product to
market.

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mattmaroon
The reason that founders cashing out on big rounds was never absurd, and will
never be absurd (though market conditions may make it less common for a time)
is that in many respects it aligns the interests of the founders with the
investors.

Money has diminishing marginal utility, and most people would be just as happy
(or unhappy) with $10m as they would with $50m. That's not true at all for VC
firms or their limited partners. Twice the profit is roughly twice as good for
them, in fact in the competitive industry, it might be more than twice as
good. If everyone is getting 15% returns, the difference between 10% and 20%
for a VC fund can be tremendous the next time they're out raising funds.

By allowing the founders to cash out, it gives them the cushion they need to
swing for the fences, rather than trying to sell their company as soon as it
will make them independently wealthy.

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sam_in_nyc
I'm curious to know if anything of this sort has happened since the article
was published.

~~~
pg
Yes, it seems to be increasingly common for founders to sell a little stock
personally in the course of a funding round. At least, it was till the market
crashed.

I don't have enough data yet to say how the recession will affect this
practice. But my guess is that if it did decrease, the decrease would be
temporary. The long term trend is that founders are increasingly powerful.
Which means they'll tend to get not just the option to sell stock (if they
want to) but other things they want, like remaining CEO.

~~~
huhtenberg
Can you elaborate on what "a little stock" is ? I.e. is it 50K, 250K, 500K,
etc in cash equivalent ?

Just curious. Thanks.

~~~
pg
The middle to higher end of that range, maybe more. It only tends to happen in
high valuation deals (usually later funding rounds) so a little stock is
usually worth a lot.

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CalmQuiet
I'd love to hear pg do a follow-up on this. Every couple years.

~~~
gcheong
I'm especially interested in seeing if companies where the founders are
allowed to cash out a bit up front actually do better and do better because
they were allowed to cash out a bit. May take a while to get that data though.

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triplefox
I think that increasingly, software-based businesses will be starkly divided
by the "application" and the "infrastructure" realm. While the former is made
by a single person or a small group and runs on preexisting systems, the
latter builds and maintains said systems, and has to pull in serious resources
to do so.

For the app-writers, it won't just be seed funding anymore - it'll be no
funding at all. The most they have to do is pay for some hosting, legal and
financial services, but their burn rate will be so tiny as to do it on part-
time wages.

As for the remainder, they'll still be operating a traditional startup with
real funding needs.

~~~
potatolicious
I don't see your model as being intrinsically separate pieces. IMHO we're
already at the stage where pushing out software is cheap, and can be done with
_zero_ investor funding. Scaling on the other hand, is still as expensive as
ever. Your next Twitter can only go so far on a single box, and there will be
a time where it's make or break - you'd have to sink some serious money into
building out infrastructure to keep growing the business.

~~~
Retric
A single box can handle a _lot_ of traffic. A well tuned web server should be
able to handle enough web pages that your making about 1$ / second in peek
times from advertising. That much revenue should let you double your number of
servers each month should you need to. EX: In 2007 Slashdot used 16 web
servers with 2 Xeon 2.66Ghz processors, 2GB of RAM, and 2x80GB IDE hard
drives. (<http://meta.slashdot.org/article.pl?sid=07/10/18/1641203>) today
that's cheep.

PS: Twitter's cost's have far more to do with SMS traffic and staff than
hosting their website.

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wschroter
The reality is that the Web is so big now that you can start smaller firms for
next to nothing in lots of niche markets. That doesn't mean VC is broken, it
just means that smaller firms can exist without it. You're not going to start
Amazon or NetFlix without follow-on capital. You can start a Web gadget
company that makes $50k just fine though.

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budu3
If I'm not mistaken the Founders Fund allows the founders to get paid.

