The Disruptive Entrepreneur’s Dilemma: Seeds Ain’t What They Used to Be
Posted by Bob Warfield on March 18, 2008
Robert Scoble has an interesting post. He muses about the difficulty one entrepreneur has getting funded versus another. Andrew Mobbs has a dream of using cell phones to replace credit cards. It’s an interesting idea. The trouble he has is a little chicken-and-egg problem. It’s a big idea that requires a fair amount of capital to test. In the old days, there were lots of deals rambling around where “a guy and a slideshow” could get a couple of million dollars to build the product and get the first customers. Yet investors these days expect you to come to them with ideas that are at least partially tested. They’ve moved out of the seed business, despite what various rounds may be called. The current paradigm expects you to develop your 1.0 product and get some initial customers signed up for it on angel money. That typically means $500K to $1M at most.
Scoble contrasts Mobbs idea with that of Omar Hamoui’s AdMob, which is a mobile advertising network. Apparently it got funded by top-tier firm Sequoia within 24 hours. Why? Because they had a product and customers before they went calling on VC’s.
The Seed Funding business has gone way South in the wake of the last Dot Com bubble bursting. I’ve written about this before and put together some data on it:
I’m sure the VC community feels like they’ve taken a less risky approach that will improve returns, but you have to wonder. Returns tanked almost in exact synchrony with the move out of seed funding:
There’s another important factor at work here that Scoble touches on. Reducing access to capital will tend to focus the deal flow around deals that can get done with minimal capital. That’s why we see so many me-too ho-hum Web 2.0 deals. It’s easy to build the software. The Valley and its current bootstrapping strategy has got everyone focused on quick experiments that don’t add a lot of value. It’s fun, but it seems to be largely a fad that isn’t discovering many new killer apps. What happened to asking whether an idea is a feature, a product, or a business? How does Fred Wilson’s new investment baby, Disqus, add lasting value? It’s an add-on to blog comments. In other words, a feature, not an application or a business. Why can’t the top 2 or 3 blogging platforms add the Disqus functionality and commoditize it out of a future? It’s not even that there’s just one of these. We also have IntenseDebate, TechStars, SezWho, and CoComment. Wow, now there are 5 companies focused on this feature for blogs?
Mathew Ingram reports that Fred Wilson says that he seesthe company as doing for comments what RSS did for blog posts and other information, and that Disqus could be the one that “unlocks comments from blogs and brings them into the mainstream” and also “surfaces the most interesting blog comments and blog commenters.” Let’s suppose they’re successful, which is a big if, because I’m not sure comments are as valuable as RSS. RSS boiled down to one company, as David Winer has lamented, and that was Feedburner.
There’s a whole passle of similar deals out there. I just signed up for the latest wunderkind, FriendFeed, becauseScoble said he’d converted and saw it as a TechMeme and Google Reader killer. Scoble got bored with TechMeme because of the sameness and big media presence (yeah, I warned you this would be the case) and he was fed up with the performance of Google Reader. “Does FriendFeed solve a problem or highlight it?” asks Josh Catone. Well, it puts things in one place, sort of. I haven’t found a way to import the OPML from Google Reader yet so I don’t know how Scoble imported his 800-1000 feeds. Perhaps he’s just quit reading them and gone totally aTwitter. But, now that you have all that stuff there, it seems like you’re tee’d up to be a total Attention Overload victim. I can’t see much in the way of tools to help you manage that. It’s just another simple minded piece of software that’s cute and was quick and cheap to build with modern web technology, but does it really help anybody? Is it profound. No.
Maybe it’s time for VC’s to move on from Web 2.0, at least if this is as fresh as it’s going to get. Marshall Kilpatrick points out that the long tail is absent from MySpace just as on Facebook. I’m not sure it’s really absent, but it is pretty slim pickings. More importantly, maybe its time to actually consider looking into funding something significant. VC’s are not unlike any other portfolio manager. If their portfolios are too highly correlated, risk increases. If they’re correlated with their whole market, their returns regress to the mean.
Who is going to do something different to change this boring status quo? What Would Warren Buffet Say About VC Investing Today? We’re missing out on a lot of good ideas simply because the initial capital required is too great for today’s model.
Time to move on, these are not the droids you’re looking for.
Fred Wilson quotes General Doriot in saying that the best returns are from seed investments:
The riskiest part of the spectrum has to date proved the most rewarding, and the greatest capital gains have been earned in companies which were started from scratch.
And yet he goes on to explain why VC’s prefer later stage investing:
Its about money. Let’s say we own 20pcnt of a company and we have to invest 5mm over five years to get to an exit. Let’s say that exit is 250mm. That’s 50mm of value for 5mm of investment or 10x. The partners in the firm get 20pcnt of 45mm or 9mm
Let’s say you buy a company for 100mm. And then you sell it three years later for 200mm. That’s 2x but a 100mm gain. The partners in the firm get 20pcnt of 100mm or 20mm.
This math doesn’t work for me. First, what VC has 20% of the company? More like 80% of the company owned for $50M by the time all rounds are counted. The company will likely go for more than $250M too if it IPO’s. And we’ve left aside all talk of the liquidation preferences that are always present in these deals. Though the 10x is probably representative.
My math would be more like 70-80% ownership for $50M over 5 years. That gets the VC’s 80% * 250M = $200M, or a $40M carried interest. Note that this is not an especially happy outcome for $50M invested–a 4:1 return. The happy outcome is an IPO at $500M or more. Now we’re looking at 80% * 500M = 400M on 50M, an 8:1, and the partner’s carry is $80M for 5 years work vs $20M for 3 years work.
The real issue is there aren’t going to be so many $100M late stage deals to join if there isn’t enough seed money to fund getting there.