You can build a successful software company for about $10 million today. Why, then, do we see so many startups spending $25 million to reach profitability? Blame it on the overhang-the enormous amount of uninvested venture capital-and some venture capitalists’ unwillingness to be fiscally responsible.
The overhang has created a unique problem that persists in this new year: Software companies that have already spent too much money on shaky business propositions are being propped up by venture capitalists protecting their portfolios. These are the same VCs who once specialized in early-stage investing, many of whom now call themselves lifecycle or mid-stage investors. It’s a way of proving to a set of skeptical limited partners that they still need to hold onto the funds they raised.
As we emerge from yet another year of pain, VCs must begin to institutionalize their own set of rules for how much money is necessary to build a product and bring it to market. By offering entrepreneurs an excess amount of capital simply because the larger funds have too much of it themselves, we allow startups to avoid, or at least postpone, developing real value propositions.
Subsidizing mid-stage companies results from some very simple math. A venture capital firm with a $1 billion early-stage fund doesn’t have the bandwidth to do more than 50 deals over the life of its fund. Yet, even with a total of 50 deals, that’s $20 million invested per company.
And that’s the problem: Why would a startup-an early-stage startup, in particular-need $20 million these days? It actually needs $2 million and the discipline to stretch that out as long as possible. It’s how our industry used to do deals. We all know too much money leads to sloppy business practices and a diminishing sense of urgency to turn a profit.
Yet, $2 million is a tiny investment for a billion-dollar fund and requires far too much time and energy on the part of the partnership for too small a potential return. Thus, VCs must either apply larger amounts of capital to later stage deals-the subsidy argument-or return money to limited partners, not a very attractive proposition for most general partnerships. I tip my hat to Ted Dintersmith and Charles River Ventures for making the hard choice and giving back 60% of CRV’s $1.2 billion fund last June.
The other, more painful, choice for an industry brimming with too much capital is to literally flush the system. The pipeline for private companies remains clogged with the living dead of what we’ve funded in the past, companies without a value proposition for the customer. These companies are clogging up the queue for newer early-stage companies.
With fewer and fewer firms able or willing to invest smaller amounts in early-stage deals, we face a Catch-22. We have to either buoy the marginal mid- and late-stage companies with money that should go to early-stage startups or flush those companies and admit that we’ve got more capital than we could possibly spend.
The fact is, as most software investors know, more capital does not build a company any faster at the earliest stages of company creation. Moreover, more capital has never proven to be a guarantee of future success.
Thrift Is Good
Intuit, Microsoft and Siebel Systems weren’t built with buckets of cash. They were bootstrapped with modest amounts of investor capital. Still, Microsoft surpassed $1 million in sales less than three years after its inception in 1975. Then there are companies like Aspect Development, which was built with just $4 million in outside funding and was bought by i2 Technologies for $9.3 billion-one of the largest software acquisitions to date.
And yet we’ve seen outrageous amounts of money being plowed into software ventures. Without naming names, I can think of at least five startups that have pulled down at least $50 million apiece from venture firms, including two that have sucked up in excess of $100 million. In every case, the huge sums of money have not produced products with significant value propositions.
More With Less
Conversely, I have seen the good that can be done with fewer dollars. Managestar, a Charter portfolio company that develops software for the services industry, has spent barely more than $10 million in venture capital since its inception less than four years ago, but it has generated strong and growing revenue each year. The Walnut Creek, Calif.-based company remains one of the few surviving software firms in the asset management category, one that is large and continues to be robust. And because Managestar had less capital at its disposal, the company’s founders and employees had to make the company work with what was available. It’s a clear illustration that the consequence of less capital is actually a greater focus on the customer and efficiency.
All of this may seem counterintuitive for those with lots of money to invest, but it’s not. With a $100 billion overhang, it may not be a venture capitalist’s first instinct to give a company less than it’s asking for, but it’s the best thing we can do for our companies and for ourselves as investors. Knowing that companies can sink or swim on their own merits will further weed out the survivors of the technology shakeout and further free up the remaining excess capital for that next crop of technology startups ready to fill the deal flow pipeline.
If there’s a prediction for 2003 to be gleaned from all of this it’s that successful software companies will once again be built with far less cash. And more than likely, at least two software companies will be started with less than $2 million each this year and they will both become billion dollar-plus companies someday.
Ravi Chiruvolu, a general partner of Charter Venture Capital, is a regular technology columnist for VCJ. He specializes in enterprise software, software infrastructure, e-business and wireless technologies. Chiruvolu sits on the boards of Ellie Mae, ManageStar, Quantum3D, Talaris, Verano Winery Exchange and Xavient Technologies.