It’s a small world

When Laurel Touby tried to raise capital for her online media startup in 2000, one of the first things investors demanded was that she set a more ambitious exit goal. She’d made the mistake of saying her “magic number” for selling the company was $7 million. “They just laughed at me,” recalls Touby. “Because if I got $7 million, they’d make nothing.”

Seven years later, Touby’s backers have proven themselves correct in urging her to think bigger. Jupitermedia acquired her New York-based Mediabistro, which provides training, job listings and events for media professionals, for $23 million in July.

Although not quite the 10x return VCs crave, it was, nonetheless, a very profitable exit. Prior to the purchase, Mediabistro had raised just $1 million (and spent only half of it) from Gotham Partners and individual investor Martin Perez. In exchange, Touby says, they got about a one-third stake in the company.

While venture firms make a name by betting on the next eBay or, smaller acquisitions have been providing a more regular source of ROI in the Internet space of late. Mediabistro is one of a few dozen VC-funded Web acquisitions in the last couple of years at disclosed or rumored prices of under $40 million.

Today, budget-conscious venture investors are positioning themselves for more to come. By keeping round sizes minimal and companies lean, these shoestring investors are wagering that they can generate big profit margins from small exits.

“The myth is if you have more money, you hire more developers and you have more features. The reality is that doesn’t always work very well,” says Mike Slade, a partner at Second Avenue Partners, a Seattle firm that specializes in early stage Internet investments. The 7-year-old firm has done well backing startups like Newsvine, a developer of citizen journalism apps that boasted a team small enough to fit in one room. It sold to MSNBC in October for an undisclosed sum that Slade says provided a “very good” outcome.

Contrarian logic

If you invest at a fairly low valuation, and you turn it around in a couple of years for a few million, you’re happy as a clam.”

Mike Slade

With Facebook valued around $15 billion—and venture valuations across Silicon Valley on an upward tear—the smaller-is-better mentality represents a somewhat anomalous take on Web 2.0 investing.

Broadly speaking, venture rounds appear to be growing in size. In the San Francisco Bay Area, for example, companies that successfully raised follow-on venture funding in the first half of the year saw an average rise in valuation of more than 74%, according to a survey by Fenwick & West. The law firm called it the largest average increase since the survey launched in 2002.

In 12 cases—including seven involving Web 2.0 companies—the purchase price of the stock sold was at least three times higher than the prior round, Fenwick & West said. And investors’ willingness to support premium valuations has extended into the latter half of 2007, too, as evidenced by 200% first-day IPO gains by Chinese e-commerce portal The company commanded an initial market cap of more than $25 billion following its November debut.

Trouble is, there can only be a handful of Alibaba-scale success. The more likely outcome for a moderately successful Web startup is that it will be acquired by a larger Internet, technology or media company for, at most, tens of millions of dollars. So to profit off that kind of deal, venture investors need to keep funding levels low.

That’s the conclusion Robert Vasaly, a venture partner at San Francisco-based KPG Ventures, reached after compiling a list of smaller Web 2.0 acquisitions. Vasaly’s initial list contains more than 30 companies that took in little investment capital and produced profitable exits through acquisitions.

At the high end are companies like Grouper Networks, a developer of media-sharing apps acquired by Sony for about $60 million, and Truveo, a video search site bought by America Online for an estimated $50 million. In the middle are Web-based e-mail and news aggregator Oddpost, and recommendations site Kaboodle, which were acquired for $30 million and $35 million, respectively. Rounding out the list are small deals, such as CBS’s $10 million purchase of celebrity gossip site Dotspotter.

“These are all examples of the KPG Ventures model where even a modest exit should still produce a 10x return,” Vasaly says.

We’re not shooting for $20 million exits. We are definitely shooting for companies that can scale to be much larger than that. But if they happen to exit at that range and we make 3x to 5x on those investments, it’s not a terrible thing for us.”

Bill Tai

Keeping it simple

Fans of the smaller-is-better approach say not only are smaller startups cheaper to fund—they’re better suited to innovation in the Web 2.0 world. Second Avenue’s Slade says he favors small teams because it is easier for acquirers to integrate them. He also likes startups to have potential acquirers in mind from the start.

Several entrepreneurs backed by Second Avenue started out in big media companies and developed business plans based on the unmet needs of their former employers. For example, Newsvine’s founding team included veterans of Disney and ESPN. Another portfolio company, fantasy sport site developer Sports Technologies, was launched by a team of former employees. Sports Illustrated bought the company earlier this year for an undisclosed sum.

The strategy of developing a targeted application for a big media buyer works, Slade says, because it’s hard for large companies to innovate in-house, where they must contend with legacy systems and internal bureaucracy. Startups, by contrast, can deploy open-source tools and develop new tools much more quickly. The model also works well for VCs, says Slade, noting that: “If you invest at a fairly low valuation, and you turn it around in a couple of years for a few million, you’re happy as a clam.”

Just a year into its first fund, KPG Ventures is pursuing a similar tactic. The firm, founded by Vince Vannelli, former general partner at now-disbanded VSP Capital, and backed by private equity asset manager Adams Street Partners, has made 16 portfolio investments to date out of a fund of just $15 million, including positions in virtual world startup Doppelganger, Abazab, a service for sharing video online, and Teracent, an advertising network for specialty content sites.

To date, the fund has focused on consumer Internet. Its preferred investment size is somewhere between $500,000 and $2 million in total funding. The hope, says Vasaly, is to make a 10x return even on exits in the $20 million to $40 million range.

Sales pitch needed

Although there are companies that will [be acquired after raising $200,000 in VC], I’m not sure they happen with enough reliability that you can make a fund out of it.”

Ryan McIntyre

Such a strategy requires willing entrepreneurs, however. And as the cost of starting a company declines, selling a founder on the benefits of raising any venture money—even a small round—can present a challenge.

Today, Web entrepreneurs frequently build up sizeable traffic without tapping the venture or angel markets, notes Robert Ward, managing partner at Portland-based seed fund Capybara Ventures. He points to a recent portfolio company, Wiki-based website directory AboutUs, which penetrated Alexa Internet’s ranking of the 2000 most-visited sites even before founders raised outside capital. As is often the case with younger Web companies, its first round was for expansion, not startup capital.

Bill Tai, partner at Charles River Ventures (CRV), says he’s been pleasantly surprised by the traction some companies have achieved with minimal capital. Last year, CRV launched a program called QuickStart, which provides new businesses with convertible debt financing, typically of a few hundred thousand dollars. “We have had cases where with that amount of funding, companies have gotten to the point where they are delivering tens of thousands of dollars a day in revenue,” Tai says.

To date, QuickStart hasn’t seen any exits, but several portfolio companies are pursuing follow-on rounds. Among the most prominent is Social Media Networks, a developer of platforms for social media applications that raised $3.5 million in an October Series A round led by Charles River and joined by Netscape co-founder Marc Andreessen and SoftTech VC managing partner Jeff Clavier.

While companies can become viable on small sums, Tai says he prefers scaling up to marketing for a quick exit. “If they choose to grow at a very moderate pace, they can self-fund in some cases,” he says. “But if a company has proven their model works, that simply invites competitors to come in.”

That said, Tai sees some merit to quick exits. “We’re not shooting for $20 million exits. We are definitely shooting for companies that can scale to be much larger than that,” he says. “But if they happen to exit at that range and we make 3x to 5x on those investments, it’s not a terrible thing for us.”

Ryan McIntyre, managing director at early stage venture fund Foundry Group, says he expects small, profitable acquisitions will be the exception rather than the rule. Foundry’s model, instead, is to invest between $5 million and $15 million in a portfolio company over multiple rounds and attempt to build them into something big.

Certainly it’s possible, McIntyre says, to build a product on a $200,000 angel round and flip it for millions shortly afterward. But it’s a highly risky investment thesis. “Although there are companies that will have that lifecycle,” he says, “I’m not sure they happen with enough reliability that you can make a fund out of it.”