Monday, January 1, 2007

A Short History of Venture-Backed Software Startups

IMHO there have been three periods of software and related venture investing: First, during the late 70’s and most of the 80’s when the industry foundation was established and initial growth realized; second during the Internet bubble, and third, during the post-bubble period.

During the first phase of venture investing, startups absorbed little venture capital and going public was the primary exit. VC Arthur Rock, for instance, invested just $37,500 in Apple. Technology investments were made in the absence of standards, distribution channels and markets – important stuff that was invented along the way. VC “overinvesting” occurred for the first time (establishing the lemmings analogy) in an investment environment where intuition played a big role alongside a semblance of business metrics. For example, there were 150 disk drive manufacturers at one time. Startups during this period were often managed by veterans doing their first gig after leaving IBM, DEC, HP, Fairchild, Data General, Prime and others. There was a reasonable expectation of doing a “double flip”: Going public, followed by being acquired by a larger company.

In the 1990s startups absorbed larger amounts of venture money and painful recaps occurred frequently in later rounds. The management lifecycle of these companies changed: Startups were founded by technical people who were short on management (read, for the most part, sales and marketing) and/or people skills. Figuring out the business was the primary objective after funding and business basics were ignored until financial circumstances demanded a reality check. In the late ‘90’s, 2000 and 2001, IPOs no longer required profitability. Growth was the driver and profitability took a back seat as primary business measurements of the startup vehicle. VCs acting as board directors often removed founders and inserted their “own” CEOs from a stable they maintained. VCs became not only king makers in the startup world but also rock stars in their own right. Recall Bob Davoli’s cover shot in Business Week during the height of the Internet boom.

During the post-Internet bubble downturn, industries (telecommunications, for example), startups (Bowstreet, for example, founded in 1998 and in the beginning receiving $140 million in funding raised $7.5 million in new capital in 2004) and venture capture firms restructured in fundamental ways. With black eyes, VCs and entrepreneurs alike engaged in a search for the next big thing. Fewer bets were made. Portfolios were cleansed and history rewritten (some VCs said they never made Internet investments); some VCs returned capital to their LPs; some raised less money; some changed their investments focus, and some closed or combined with other funds. This restructuring took several years but eventually millions, in fact billions, of dollars flowed back into VC by 2005 and 2006.

While re-funding of venture capital firms happened the economics of venture capital shifted: The magnitude of the return on the one deal out ten that was super-successful became less. The mostly likely exit was acquisition, not an IPO. Almost all exits resulted in moderate returns for the investors. In addition, a blockade had been erected around IPO’s in the form of corporate governance. Sarbanes-Oxley (SOX) was created to address the excesses of investment bankers AND venture capitalists. While SOX introduces accountability on both Boards and CEO's, it also imposes onerous legal and accounting expenses and processes on startups, entrepreneurs and venture management. The SOX-based Board of Directors is more active and renders a CEO less independent, effectively making a CEO a member of middle management. This is not attractive to most startup CEO's.

Today’s software startups no longer require huge amounts of capital and people. That is one of the attractions of Web 2.0: Put in a few dollars, flip the companies in a year or less. These companies have a technical and business founder. The rank and file come with various backgrounds and experience. Resources are sparse at first but that does not matter because time-to-market is fast and cash-flow follows. These companies either sell directly to customers along the Internet’s “long-tail” or use a mix of inside-and-outside sales forces – with an emphasis on the latter. None of these companies will go public. There may be an opportunity for a "roll-up" but more likely these ventures will be purchased by companies who need Web 2.0 technology to remain competitive. It should be clear to everyone that YouTube, purchased by Google for $1.65 billion, was the exception – the only video-downing site. There will many more pretenders, but most of the exits of this startup vintage will in the tens or low hundreds of millions.

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