The Longtail Of Venture: Why Some Companies Will Continue T

The Longtail Of Venture: Why Some Companies Will Continue To Need VC And Others Won'tCenterNetworks -
There has recently been a lot of discussion in the venture community about the declining cost of starting an IT company. Lots of very smart and thoughtful VCs have written about this topic. Here's a link to one popular article on the subject. However, there seem to be two contradicting viewpoints in the market. One that arguing that traditional early-stage VC will die out, another that indicates that the early-stage VC market is improving. This is my attempt to rationalize the two perspectives.

Underlying Causes

While I think the various pundits have identified the presence of companies that do exemplify lower capital needs, there seems to be limited exploration into all the trends that are driving this change.

Two underlying causes of this phenomenon are the declining cost of developing technologies and acquiring customers.

The cost of developing technologies has declined, as:

The cost of acquiring customers has also declined, as:

Who This Affects

While most software and Internet companies benefit from the declining infrastructure costs, not all business models equally benefit from the changing marketing costs. Specifically, models leveraging the Internet as their primary channel for customer acquisition benefit more from this trend than models which require sales personnel, as is common for companies selling to enterprises.

Anecdotal Evidence

Before I continue, I want to point out that my conclusions about the situation and the conclusions drawn by others appear to be based on anecdotal evidence. So, take my perspective with a grain of salt. Nonetheless, I hope this viewpoint will provide another chapter in the on-going dialogue on this matter.

A Potentially Superficial Contradiction

I have spoken to a handful of other VCs about this matter recently and there seems to be some consensus that there has been no decline in the number of IT ventures that require substantial capital. Put another way, VCs are still seeing lots of companies seeking full Series A, B and C rounds. These companies need to purchase considerable advertising inventory, employ sophisticated staff to perform critical functions and build a strong business development team in order to secure partnerships with other companies. Those expenses accumulate, creating a need for multi-million dollar investments.

Furthermore, it seems likely that the need for capital is here to stay. Marketing costs are likely to increase as ad dollars continue to migrate to the web. Wages also continue to rise and we have yet to replace business development executives with software. So long as these cost centers exist there will be a need for venture capital.

On the surface, this conclusion seems to contradict the vision of pundits who expect the need for traditional levels of capital infusion ($2-5MM Series A rounds) to disappear over time.

While the evidence that I have heard for both sides of this trend to date has been anecdotal, both arguments seem reasonable and compelling. As a result, I began to wonder whether the trends seen by both camps are correct. I asked myself, "Do these trends have to be mutually exclusive? Is this a zero sum game?"

The Longtail of Venture: An Attempt to Rationalize

In an attempt to rationalize how the venture market could have both a consistent number of startups with traditional capital requirements and a host of new startups with less robust capital needs, I developed a hypothesis on the matter that appears to support both trends. I believe that companies that do not need traditional venture capital investments make up the longtail of venture. For simplicity, I am going to refer to these as the venturetail going forward. The fact the venturetail exists does not implicitly mean that all companies need less capital. It is possible that venturetail companies are being started in addition to companies that have traditional capital requirements.

[Diagram]

My intuition tells me that there are two reasons why lower costs lead to more companies being started. First, some of the Internet companies being launched may not have been profitable endeavors when startup costs were higher; with lower costs more business models are economically viable. Second, the risk associated with these ventures has declined, enabling entrepreneurs who don't want to 'stake it all' the opportunity to pursue a startup in their free time or without betting the house.

The venturetail represents, in my hypothesis, a new class of companies that is comprised of both:

If this intuition is correct it supports the idea that venturetail companies have not displaced the traditional companies, rather, the venturetail companies are being launched in addition to traditional startups.

In sum, it seems that the presence of companies that require less capital doesn't seem to negate the need for venture capital. Rather, it's possible that a new class of startups has emerged that will be served by a different venture model.

[Diagram]

It's unclear exactly how this market will evolve. However, my hope is that this hypothesis will help to rationalize some of the latest market trends.

This column was provided by Mark Davis. Mark is the author of Get Venture, a column designed to help entrepreneurs raise venture capital. In addition to his column, Mark is active in the venture community as an entrepreneur, advisor and venture capitalist. He currently works at DFJ Gotham Ventures, a leading early-stage IT venture capital fund based in NYC. Before entering the venture space he advised Fortune 1000 and private equity clients on the strategic and financial attractiveness of acquisition targets at both Bain & Company and KPMG LLP. Mark earned his B.A. in Economics with a minor in History at Duke University and is pursuing his MBA at Columbia Business School, where he is the Early Stage President of the Private Equity and Venture Capital Club and the Founder of the Columbia Venture Community .

Author: Mark Davis
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