New Venture Capital Models – The Rise of Business Accelerator Seed Funds (Part 2) - 01/30/2009

In my last post, I talked about the growing trend in business accelerator seed fund programs, and listed the 27 I know of so far. Compared to the thousands of private equity and venture firms in operation, this is a tiny segment of the market and an even smaller segment of total capital invested. However, in the software sector the number of these programs is growing rapidly and they are drawing a lot of attention. In this post, I want to explore four significant trends that I see driving the rise of seed fund programs.

To start, we should ask the question, “why are these programs emerging now?” There has to be a first time for everything, of course, but despite various investors and incubators offering ‘high touch’ services in the past this sort of program did not emerge in a structured, systematic way until Paul Graham started experimenting with a new model of “angel investing” back in 2005. Paul was a relatively new investor, was a creative thinker, and was not tainted by the old ways.

Paul was also an avid hacker and realized that a number of trends were working together to make the cost of launching a software company much cheaper, especially one which delivers its product or service through the web. The most important driver was the emergence of powerful, free open source solutions (LAMP) and related frameworks, and the continued rapid decrease of hardware and hosting costs. A software company today can have in one month what would have taken a year or more to build only a few years ago. Guy Kawasaki, the founder of Garage.com and a well respected start-up expert, provides a good example of launching a new company for $12,000.

Even Microsoft, with a technology platform traditionally requiring relatively expensive development tools, is adjusting to this new reality. In 2008, they introduced the BizSpark Program (note, First Ascent Ventures, LLC is a BizSpark Network Partner). With this program, young start-ups can get full-on Microsoft development tools and platform products at no cost to use for their start-ups.  I think this is a very smart move for Microsoft: a start-up launching a new product or web service with a budget of $10,000 just could not afford to get full Microsoft licenses, and Microsoft was not getting in on the ground floor of these new companies as a result.

With products cheaper to build and launch, clearly the level of funding required to test out new ideas was also getting much smaller. Unfortunately, this goes directly against recent trends regarding the flow of money into the traditional venture capital market. So much money has poured into private equity and venture capital in recent years that fund sizes have been driven higher and higher and thus average investment sizes have stayed large. Although recent economic factors have put a wet blanket over venture capital generally, the trends still point up and fund sizes remain very large by historical standards. Just recently, a Morgan Stanley report found that public pension funds are looking to increase their exposure to private equity as a category. VC funds are still being raised.

This shifting venture capital landscape is the second trend, and James Geshwiler picked up on this back in 2007, writing from his perspective working with angel investors. He was noticing a rapid rise in the number of angel groups, and an increasing pooling of angel dollars to drive more efficiency into a very inefficient segment of the market. These groups were rising to fill a void being left by the growing size of venture funds and their associated investments. Paul Graham, with YCombinator, and later David Cohen, with Techstars, and eventually a long list of others also found ways to fill this void – with a model that could operate even faster and more efficiently than the angel investors.

The third major trend opening the door for a new model was the increasing role of the Internet in providing a platform to deliver new services to the niche markets characterized by the Long Tail. The long tail represents smaller and smaller niche markets, some of which may live on happily in obscurity while others may suddenly explode in popularity according to popular culture or trends. The presence of the Long Tail, combined with a lower cost of entry to launch products or services to these niche markets, means many more web businesses can be launched and tested for given pool of dollars.

As Clay Shirkey explains so convincingly in Here Comes Everybody, open source is successful not because open source is easier or better, but because the cost of failure is so low. With the cost of failure near zero, many more ideas can be attempted and the likelihood one of them will turn out to be a big success is higher. The chance of failing is no less for any given idea. This is exactly what seed fund programs achieve with start-up companies. By putting small amounts of capital into many ideas, the cost of failure is reduced and many more ideas can be tested in the market. Some are bound to be winners. Ones that don’t make it do not go down in flames because very little capital was put at risk – the cost of failure is low. And by providing a strong support net and education program, seed fund programs do their best to shift the odds of success in their favor.

Systems that work like this are generally characterized as open systems or open platforms. Publish everything and let the appropriate filters weed out what does not make sense. Clay talked further about this in his keynote at the Web 2.0 expo last year. In the case of start-up companies, the filters are the customers. Many new products and ideas are released as free services first, in an effort to have the lowest barrier to entry and learn what works as fast as possible. Paul Graham actually recommends start-up companies think of themselves like non-profits in his Be Good essay.

Interestingly, with less capital at risk, smaller investments, and smaller fragmented markets being served, there has been an increasing prevalence of small, strategic acquisitions in the software sector – the fourth and final trend supporting the emergence of the seed fund programs. When companies can be built cheaply, they can also be sold cheaply. The traditional venture model, however, does not easily support small, modest exits - because the investments are larger, the exits also need to be larger. Angels long participated in modest exits for their portfolio companies. Seed fund programs take this to the extreme. They can put as little as $10,000 into a company, which if it sells for as little as 1M can still drive an 8x return for the investor. One 8x return can smooth over several failures.

Current market conditions generally support a continuation of smaller, more targeted M&A deals. With public equity values down, stock becomes an expensive commodity to use to buy companies. In the last quarter of 2008, 85% of deals were done with cash, according to a report by the Software Equity Group (executive summary available with registration). With more M&A targets available in the market, and the cost to acquire them lower, companies can be more active in using smaller-scale M&A to supplement their own internal innovation and find the exact “bolt-ons” that complement their strategy.

In the 3rd and final post on business accelerator seed fund programs, I will closely look at three key questions: Are these programs successful at delivering a high return for their investors? Should start-up companies apply to these programs? What does the future hold?

New Venture Capital Models – The Rise of Business Accelerator Seed Funds (Part 1) - 01/13/2009

For a while now I have been tracking the growing trend in Business Accelerator Seed Funding programs. Most people have heard of the very well-known TechStars and YCombinator programs, which serve as the benchmark by which many are compared. But these particular programs follow only one pattern for early stage “accelerating” and other models exist. […]

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