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For Executives, Entrepreneurs, and other Digerati who need to know about SaaS and Web 2.0.

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:

Software Seed Investments

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:

VC Fund Performance

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.

Related Articles

VC Confab:  Please, no more Social Networks…

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.

5 Responses to “The Disruptive Entrepreneur’s Dilemma: Seeds Ain’t What They Used to Be”

  1. wallyton said

    Great thoughts here. There is just not a lot of talk about how this social networking/web 2.0 does ANYTHING but continue to lop on more information overload. Scoble seems to be starting to do that. I guess doing what he does for FastCompany vs. Calacanis is probably good for everyone.

    BEAUTIFUL closing line.

  2. Back in the bubble-before-the-bubble days, circa ’96, I consulted for a sharp VC guy in Austin, mostly by sitting in the back of the room and listening to pitches to detect technical oversights or errors. While sitting there, I heard three very funny but insightful comments:

    The entrepreneur said, “We’re going to be the Kinkos of the web.” He was asked,”Why can’t Kinkos be the Kinkos of the web?”

    Another time, the VC said,”This isn’t a company, it’s a magazine article.”

    One last one I remember was when we were telling an investor that the idea he was pitching to us was too risky. His response, “Don’t try to teach an oil man about risk. He thinks he is going to dig a hole in the ground and get rich.”

    Your blog today was a great reminder of those lessons I learned by being present (and quiet) during this exciting (but now pre-historic) time.

    So thanks!

  3. Hey, Great points and sorry for being late…Jitendra from SezWho here…Just wanted to clarify our position on the market…Unlike other companies, we are not focussed on just blog comments…We are instead looking to make the social conversation online better in all places by building context service for these conversation.

    Take a look at out demo at

    http://sezwho.com/demo.php

    Thanks, Jitendra

  4. […] without a decent seed round.  I’ve written about this for quite some time.  I’ve even published numbers that show how VC returns have gone down in almost direct proportion to seed funding drying up.  […]

  5. […] without a decent seed round.  I’ve written about this for quite some time.  I’ve even published numbers that show how VC returns have gone down in almost direct proportion to seed funding drying up.  […]

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