Commodity deals are nothing to get Amp’d up about

A startup seeking VC funding to produce commodities such as corn, soybeans or pork bellies would be laughed off of Sand Hill Road faster than Britney Spears at the MTV Video Music Awards.

VCs, after all, are hunting for unique and disruptive technologies that will revolutionize the world and make lots of money in the process. Yet in the quest to find the next big thing, VCs sometimes fall into the trap of investing in startups whose offerings quickly become commoditized due to low barriers to entry.

Despite healthy customer demand and a growing market, these startups often struggle to rise or stay above the fierce competition and fail to become breakout successes. In commoditized markets, suppliers lose and buyers win. VCs should keep this equation in mind, avoiding opportunities that become quickly commoditized while seeking out startups that can leverage commodity elements to their advantage.

Econ 101

The term “commodity” usually has negative connotations when applied to a company’s product offerings. In a commoditized market, product differentiation is nonexistent, prices are low and profits are close to nil. Not all commodity businesses are bad businesses. But for a startup, you need to be on the right side of the equation.

If you are a consumer of a commodity, life is good, because there are usually several suppliers from which to choose, supply is plentiful and prices are attractive. All those work against the commodity producer, where there is usually only one way to win: by being a bigger producer than rivals and making money only because you have achieved economies of scale. Startups generally operate at the wrong end of the volume curve and thus face an up-hill battle as suppliers of commodities.

Sometimes investors gleefully predict that their hot new project is going to become wildly popular, and will soon become a commodity. That glee is probably misplaced, because if the prediction is valid, other suppliers will enter the market, leapfrogging to higher volumes and pushing down margins. The startup never has a chance to operate profitably and will not generate a return on the investors’ capital.

Crank call

It’s instructive to look at a few young businesses that have faced challenges in commoditizing markets. Vonage, the IPO that everybody loves to hate, provides telephone service. This commodity was well-established in the traditional world, but Vonage hoped to differentiate by delivering it using Voice over IP. It turned out that VoIP quickly turned into a commodity as well. Vonage managed to go public in May of last year at $17 a share, before everybody caught on, but it’s been a bloodbath since. Its shares are now trading around $1.

In the quest to find the next big thing, VCs sometimes fall into the trap of investing in startups whose offerings quickly become commoditized due to low barriers to entry.”

Bart Schachter and George Hoyem, Blueprint Ventures

Limelight Networks is another interesting example. This company provides content delivery services on the Web, competing with the more established Akamai. It went public in June at $15 and quickly rose to $23.

This “hot space” is growing rapidly as online videos gain in popularity. Limelight and Akamai provide their services to all sorts of content companies looking to deliver massive numbers of video streams quickly and cheaply. But this function is also quickly becoming a commodity. By August, Limelight stock was trading in the single digits.

Mobile telephony is now commoditized. The major U.S. networks make their networks available on a wholesale business to Mobile Virtual Network Operators, which can create and market customized services without building out an actual network. So an MVNO is on both sides of the commodity equation: It buys the commodity service wholesale and attempts to retail it at a slightly higher price. Amp’d Mobile was one such startup in this space, churning through $360 million of VC funding to target the youth market. In June, it filed for Chapter 11 bankruptcy protection.

You might think that all it takes is a strong brand to generate profits in a commodity market. Think Coke or Pepsi. But Disney has tried twice as an MVNO, using both its ESPN and Disney brands. The ESPN service got the axe last year, and now the Disney service is out of business. Even strong brands with huge financial muscle can’t avoid the curse of the commodity.

Bootstrap heaven

While commoditization of goods is bad news for the purveyor, it’s music to the consumer’s ears. It’s a great time to be a tech entrepreneur thanks to the wide range of new commodities available, such as network bandwidth, credit card processing, database software, personal computers and telephone support.

In the good old days, significant investment was required to build the foundation on which a startup would work its magic. A software startup, for example, needed desktop workstations, a server farm with storage, network connectivity, operating system software and so forth. Now, all that is available inexpensively if not for free.

Infrastructure can be leased cost-effectively both at startup inception and as the company scales, all thanks to commoditization. Servers are available dirt cheap from several suppliers, or can be leased “hot,” installed at some facility, already connected to the Net and waiting for a new application to run.

An application provider can host its service on Amazon’s “Elastic Compute Cloud,” for example, and instantiate more compute power at will. You might start running on one or two servers and add more servers in the “cloud” if you need more horsepower. It’s like buying electricity: You are charged by the server-hour and pay only for what you use. Do the math and you discover that it’s pretty attractive at almost any scale.

It’s a great time to be a tech entrepreneur thanks to the wide range of new commodities available, such as network bandwidth, credit card processing, database software, personal computers and telephone support.”

Bart Schachter and George Hoyem, Blueprint Ventures

There are even greater commoditization benefits when it comes to software. Software is expensive to develop, but replication and distribution costs are close to zero, especially over the Web. That means that lots of commoditized software is now free. The entrepreneur can access a vast library of tremendously powerful open source software without investing a dime.

Name-brand suppliers are also getting into the act by offering free versions of their software. Oracle’s “Express Edition” is limited to a 4 gigabyte database (in the hopes that you’ll upgrade to a paid version), but that’s enough to take a startup pretty far down the path.

All this is great news for the entrepreneur—and the venture investor—provided that your own invention (product or service) is truly differentiable and that your advantage is sustainable. It’s now much easier to get the project off the ground—meaning that a significant business can be built with a much more modest capital investment. But it also means that barriers to entry are lower, and that capital requirements alone may not provide any barrier at all.

Get the balance right

This commoditization discussion drives home the prudence of VCs who pursue capital-efficient startups. Doing so ensures that we end up on the favorable side of the commodity equation.

Startups that pursue commodity markets face an uphill battle. Becoming a successful, sustainable, profitable provider of a commodity means operating at huge scale, ideally bigger than any of your competitors. That means sizable investment in infrastructure and related support. For a startup, ramping from something close to zero, that’s a tremendous challenge.

Commodity markets are best addressed by businesses that already have an established infrastructure and base of assets they can leverage. In the case of VoIP, the large cable television operators already had a broadband network, a service infrastructure and millions of customer relationships. It took a relatively small investment to get into the VoIP business on a vast scale, and Vonage was left playing catch up, consuming copious amounts of investment capital as its growth stalled.

On the other hand, the availability of all sorts of technology and business building blocks at commodity prices is a tremendous boon for the right startup project. For the investor, it should mean that capital is being put to work developing truly additive value that will keep the new business differentiated from would-be competitors. It means we can get to market more quickly and with a smaller initial investment, validating the business thesis before taking down additional capital. And it means that if and when the business does succeed, the returns will be significant.

Bart Schachter and George Hoyem are managing directors with Blueprint Ventures, an investment firm that focuses on capital efficient technology startups and Corporate IP Spinouts. They may be reached at bart@blueprintventures.com and george@blueprintventures.com.