Venture Capital Firms Set Their Sights on New Ideas -- Not New Technologies

Courtesy Knowledge@Wharton

It has never been easier to start an Internet company. Create a web site, begin a "viral" marketing campaign to grow word-of-mouth and acquire an audience, garner some ad revenues, generate venture capital funding and sell out to a web giant such as Yahoo or Google. Startup costs can be minimized by using standard technology and by outsourcing corporate functions such as advertising sales. The business model, at least initially, is optional.

This blueprint is becoming increasingly common among so-called "web 2.0" companies -- web-based communities that facilitate collaboration and sharing. Companies like Facebook, the fast-growing social networking site, and Twitter, a popular mobile messaging service, didn't introduce break-through technologies, but they have become phenomenal success stories nonetheless. According to Wharton faculty and other experts, these companies have altered the traditional venture capital formula, which used to count technology differentiation as a key requirement for web companies. In many cases, technology has become a commodity, and a big idea can go a long way provided there's a rapidly growing audience.

Wharton management professor David Hsu says that in today's venture capital environment, ideas are valued more highly than innovative technology. "Is it the technology or the idea that matters? With the new round of companies founded in the last few years, both are viable. The barriers to entry have been lowered. I can grab technology off the shelf if I have a good idea."

"It is much cheaper to get a web 2.0-based company off the ground and running," says Jeffrey Babin, a lecturer in engineering entrepreneurship at the University of Pennsylvania. "The entrepreneur doesn't need as much money so he can do a lot more bootstrapping. He can build more value before even going to a VC."

New companies face risks in this kind of environment, however: If they are successful, firms may not be able to defend themselves against the myriad competitors that will inevitably spring up around them, Hsu notes.

For now, the VC funding keeps rolling in. PricewaterhouseCoopers' Money Tree survey revealed that first-quarter venture funding was $7.1 billion, the highest level since the fourth quarter of 2001. Of that sum, Internet-specific companies garnered $1.3 billion, the highest level in five years. While the initial public offering market has been difficult in recent years, buyouts are prevalent. In 2005, News Corp. bought social networking site MySpace for $580 million. Yahoo purchased del.icio.us and Flickr. Google acquired YouTube for $1.65 billion in 2006. In May, CBS acquired Internet radio and social music platform Last.fm for $280 million. On August 2, Disney bought Club Penguin, a virtual world for children, for $350 million. Those deals are just a few among a bevy of recent acquisitions. Meanwhile, Facebook could be worth anywhere from $4 billion to $10 billion depending on the Wall Street analyst crunching the numbers.

Wharton management professor Gary Dushnitsky says there is an excess of liquidity -- not only from VCs, but hedge funds and private equity firms -- looking for a home. "The financing market has changed a great deal," he says. "There used to be a few dozen venture capital players. Now there's pressure from hundreds of private equity firms encroaching on VCs. The VCs feel more pressure among stages of investment. This money has to be invested or returned."

But as VC firms look for new targets, several questions come into play: How should companies be evaluated when they rely on technology that is easily replicated? How much value does a big audience carry? What's the preferred exit strategy?

"Advances in information and communications technology have opened up innovation in processes, products and services. There is a vast array of opportunities. How many of these will stick remains to be seen," says Raffi Amit, a management professor at Wharton.

Looking for Viral Growth

Amit says an evaluation of any company's prospects starts with the track record of its founders and management team. For instance, Joost -- which promises next-generation television service via the web -- has been able to attract funding because its founders, Janus Friis and Niklas Zennstrom, also co-founded Skype, which was sold to eBay for $2.6 billion in 2005. Joost raised $45 million in venture capital in May.

After that, the evaluation comes down to the basics, Amit says -- cash burn, addressable market, competition and profit potential.

For the latest generation of web startups, other qualities need to be considered as well, says Andrew Chung, a senior associate at Lightspeed Ventures. Chung looks for three items when sizing up new companies: viral growth, potential to sell advertising and transaction revenue. "The differentiator is no longer technology -- it's more [like] parts of a triangle," he says. "For instance, a company like professional networking site LinkedIn has all three [of these qualities]: It has viral growth, can sell advertising and garners transaction revenue with subscription services."

Gaining an audience is the precursor to advertising and transaction revenue, Chung says. Hsu notes that viral growth enhances the so-called "network effect," in which the cost to gain an additional customer decreases as users are added.

One of Lightspeed's investments is Flixster, a movie site that meets Chung's criteria. Flixster has seven to eight million users, sells advertising and its audience buys DVDs and other Hollywood content. In addition, Flixster can command higher advertising rates compared to mass market sites because of its focused audience. Other current Lightspeed investments include MyBuys, a behavioral marketing company, Wikio, a personalized blog and media search company, and Gmedia, a mobile Internet commerce startup.

Chung says that not all investments turn out well, but the beauty of the web is that losing companies are sorted out quickly. He looks for declining traffic, an inability to monetize page views and competitors gaining ground as signs that a company may not be worth the investment. "The companies we invest in are on the uptick. We don't invest in companies that have no traction. We're looking for guys on the way to an inflection point. If that viral leg doesn't hold up, you're in troublesome territory."

Amit notes that VC firms usually don't give all funding to a company at once. If a business misses key milestones, VCs won't lose all of the investment. "Venture capitalists overall seem much more cautious compared to the late 1990s," says Amit. "They are conducting their due diligence."

Business Models: When, Not If

While Wharton faculty and other experts agree that business models are important for new ventures, the question is timing: Should web 2.0 startups focus on a business model right away? Or should a revenue model be added later, once critical mass is achieved?

At the 2007 AlwaysOn Stanford Summit on August 1, Roger McNamee, managing director and co-founder of venture capital firm Elevation Partners, characterized the second view. "We are beginning the third wave of the web -- the first [was] aggregation; the second, indexed search; and the third is finding things based on references. I haven't any idea what business models will emerge, but I'm confident it will be big," said McNamee.

Mobile messaging service Twitter announced on July 26 that it had received an undisclosed amount of funding from Union Square Ventures and Charles River Ventures. Fred Wilson, a partner at Union Square Ventures and one of Twitter's investors, wrote on his firm's blog that business models aren't the most important item in an early round of funding. "The capital we are investing will go to making Twitter a better, more reliable and robust service. That's what the focus needs to be right now. We'll have plenty of time to figure out the business model, and there are many options to choose from."

Babin largely agrees with Wilson, especially in light of the fact that, these days, less capital is needed to launch a company. In other words, an entrepreneur can launch a company, see what customers do and adapt a business model accordingly. "You launch a site and then see the answers to questions like: Can I make this interesting enough for people to come back? What's the interaction? Are people coming to see something and doing something with the site?"

The answers to those questions will provide clues about what kind of model will work, Babin says. If a number of people visit the site to view something, perhaps advertising is the core revenue stream. If customers engage with the site, a model based on transactions could work.

Dushnitsky agrees that business models for web startups can be delayed a bit. "It's clear that whoever survives must have a business model, but a lot has changed between 2005 and 2007. There has been a shift from fixed costs to variable costs when starting up a venture. That means you can almost run a company like a hobby, with a low cash burn rate, and see what happens. The financing that went into YouTube was a fraction of what would have been required just a few years ago. That has shifted the timing of when you need a business model," Dushnitsky says.

However, Amit believes that business models are critical from the start. "You have to worry about the business model right off the bat. You have to think about how you will do business, enter a market and compete."

Hsu notes that companies need to ponder a business model so they can notify users of what's coming in the future. Given that next-generation Internet companies depend heavily on their "communities" of avid users, they need to build potential revenue generators into their services. If a web company becomes popular and then hits users up for dollars, customers could revolt, he points out.

"It's better to worry about business models as soon as possible," says Hsu. "It's a multi-front battle. We want people to love the site, but companies do have to worry about the revenue model early on. If you can anticipate and be clear about a model, your users will accept it. You can't switch midstream."

The Exit Strategy

Once a startup gets its business model right, VCs will start pondering their "liquidity event," or a way to cash out. In the late 1990s, the primary liquidity event was an IPO. Today, VCs are more likely to cash out via an acquisition.

"We now have [a situation that] we didn't have before: Yesterday's web startups are mature companies looking for opportunities to expand and grow," says Dushnitsky. "In the past, we had less acquisition opportunities. Now we have the Yahoos and Googles of the world with cash and looking to acquire. You also have other media companies looking to the Internet."

McNamee, however, noted during his talk at the AlwaysOn conference that acquisitions are rare relative to the number of web startups. "How many web 2.0 companies can be bought by Google or Fox [News Corp.]?" he asked.

Meanwhile, companies are less inclined to pursue an IPO. Entrepreneurs would rather stay private due to Sarbanes-Oxley requirements and public scrutiny, according to Bill Gurley, a partner at Benchmark Capital, which has invested in eBay, Palm Computing and Friendster, an early social networking site that has been eclipsed by MySpace and Facebook. "The fear I have is the lack of executives who want to be a CEO of a public company," Gurley noted at the AlwaysOn conference.

Many experts agree that entrepreneurs shouldn't think about exit strategies before they build a business. If startups evolve into viable enterprises, the liquidity events will follow. "While we want to see exit strategy, we want you to build a business," says Babin. "If you're focusing on an exit, you're not building anything."

McNamee agrees that a longer-term view is required. "If you're an entrepreneur, just do the things to make your company more valuable and be prepared to do it for a while," he said.

Web 2.0 And The CEO

Quickly: Six things about marketing in the world of Web 2.0 that the CEO should know.

by George F. Colony

I often get to sit down with large company CEOs to talk about new technology. These days, the topic of conversation frequently turns to Web 2.0 — how to sell insurance, or aircraft parts, or cars when the 30-second TV spot and the one-page newspaper ad are dying. Here's what I tell them:
ONE: YOUR COMPANY IS INSIDE-OUT IN AN OUTSIDE-IN WORLD

Imperious CEOs often have trouble with this one. They still see their company dictating pricing, product configurations, and service levels — a one-way street, with the company lording over subservient customers. The mentality is: "We'll do what we want to do and the world will love it." It's this sort of logic that results in GM focusing on trucks ("Hey, it's good for our profit!") in an age of $3 gas, and Airbus building the A380 ("It's bigger than the 747!") when the hub-and-spoke airline topologies are crumbling. Customers are changing too fast, they have seemingly unlimited choice, and, to borrow a phrase, they want what they want.

Advice to the CEO: It's now a two-way conversation. Listen, respond, and talk intelligently. Stop dictating to customers. It's your customers, not you, that have the power.
TWO: YOUR COMPANY HAS A BAD WEB SITE

I always hate to break the news, but hey, who will? After eight years of evaluating more than 1,000 large corporate Web sites, Forrester found only 3% with passing grades. The vast majority are hard to use, confusing, poorly designed, and cast an unfavorable shadow over the brand. So, Mr./Ms. CEO, don't get confident that your company is great at marketing or selling online: it's not. Go to your Web experts and ask them two simple questions: 1) Do we use scenario design? 2) Do we use personas? If the answers to these questions are "no," you are building your site inside-out — a recipe for Web junk. Enable your team to make it right.
THREE: YOU SHOULD BE ASKING YOUR CUSTOMER ONE QUESTION

In an age when the buyer has the upper hand, gauging satisfaction is critical. Get your marketers to throw out those 30-question customer surveys and focus on one question: "Would you recommend this product or service to a friend or colleague?" It will yield something called the Net Promoter score, used by Enterprise Rent-A-Car and Intuit among others to understand and improve satisfaction. Net Promoter is a simple, powerful tool that will help focus your company on winning and retaining customers. Read Fred Reichheld's book, The Ultimate Question. He's the guy who came up with Net Promoter scoring.
FOUR: YOU DON'T OWN YOUR CUSTOMER; YOUR CUSTOMER OWNS YOU

My father always bought Fords. And he bought them through bad (The Pinto) and good (The Comet). The company owned him, regardless of its quality, design, or pricing. Web 2.0's transparency means that a company gets fired at the slightest drop in service or failure in design. Or, more maddeningly, as a result of a bad online report or a tough, pointed blog entry. The antidote to this world is No. 4 above (know the customers better than the competition) and No. 1 above (be outside-in). You've got to earn the respect and allegiance of your customers every day — both of which can wither with unparalleled speed (see Dell and the flaming batteries, circa 2006). By the way, what did Dell do about its problem? It employed some classic Web 2.0 strategies — listening to its customers and talking to them via a blog. This spring it launched Ideastorm, where customers make suggestions and vote on them. The result: Dell's Net Promoter scores are back on the rise.
FIVE: BITS WANT TO BE FREE — BITS WANT TO BREAK THE LAW

The first part of this quote is from Nick Negroponte, Chairman Emeritus of MIT Media Lab. The point is that digital is highly fluid and it abhors restrictions. The second part of this quote is mine. You may try to restrict your digital content through laws, rules, digital rights management, and/or security systems. The cold reality remains that customers, citizens, consumers want what they want, regardless of how you may try to restrict them. They see the power of digital and its inherent flexibility. They know that it can do amazing things and they could care less about artificial, archaic restrictions that are designed to protect somebody's 50-year-old business model. So, Mr./Ms. CEO, wake up and face the brutal truths and get on with inventing the future. Stop trying to litigate and legislate your way back to 1992.
SIX: GREAT MARKETING + GREAT TECHNOLOGY = THE ONLY WAY FORWARD

Web 2.0 has forever changed the relationship between your company and your customer. Who best to understand and forge the new relationship? Marketing. Who best to create the technology to get it done? Your business technology/IT group. So, there is only one path: Marketing and technology in your company must work together to design and implement your Web 2.0 strategy. And you, and only you, can get the dogs and cats to interbreed. It's an unnatural act, but one that must occur before your company can become an opportunist, rather than a victim, in the world of Web 2.0.

Ignore my advice at your peril. We are still living in primitive times — we are cave dwellers in loin cloths, sitting around campfires, chewing on bones. After Web 2.0 will come Web 3.0 followed by Web 4.0. We are at a beginning, not an end. Don't dump the problem in your successor's lap: Deal with it now.

George

P.S. I encourage you to post comments on the discussion board . I'll keep an eye on the board to clarify, answer questions, and offer additional analysis. Thanks in advance for your input.