MediaFile

Why are cheap startups so expensive?

By Kevin Kelleher
January 13, 2012

Starting up a Web company is never easy, but at least it’s not as expensive as it used to be. Instead of buying and maintaining an IT infrastructure, as they had to do in the dotcom boom, startups now turn to cloud server services like Amazon’s. Instead of costly proprietary software, OpenOffice and Google offer cheaper (or free) options. Instead of paying office rent, employees can work from home. And the viral power of social media can bring new customers with little marketing. Open-source projects and the durability of Moore’s Law promise to lower costs even further.

But if it’s cheaper than ever to fund a startup’s growth, why are some Web companies receiving hundreds of millions of dollars in financing? And why are valuations rising quarter after quarter, to the point where some venture capitalists are complaining that certain startups have simply gotten too expensive to invest in? How is it that Web companies are becoming both cheaper and more expensive? Are VCs valuing companies on fundamentals, or following the market’s momentum?

Such questions might seem academic, except that the gap between startup costs and valuations keeps widening. The last six months alone have seen a surprising number of nine-digit venture rounds. In July, Airbnb, a home-sharing startup that had 130 employees, raised $112 million in a round that valued the company at $1.3 billion. A week later, Twitter, which had 600 employees, raised $800 million (half going to cash out early investors), valuing it at $8.4 billion. In October, online-storage company Dropbox, another small company of 70 employees, said it raised $250 million in a round valuing the company at $4 billion. And just last month, group-buying company LivingSocial closed a $176 million round, vowing to raise an even larger amount in the coming months.

There are two key reasons for such outsize venture investments – one strategic and one emotional. The strategic is that startups that have built a loyal customer base and strong word of mouth often solicit big investments to scale up in a nascent or highly competitive market. So, for example, Airbnb is building on its early success to expand internationally and bring in more users. And LivingSocial is looking for a bigger share of a group-buying market that once belonged to Groupon.

“There’s not a lot of value in second place,” Ryan Moore, a partner at Atlas Venture in Cambridge, Massachusetts, told Reuters. “If you have an interesting model, you spend aggressively and build aggressively to win in your category. There are a lot of situations out there where people are betting big.” In accepting a large investment round, a small startup may be banking on ambitious growth, or even preparing against the risk that the capital markets may slow down.

The second, more emotional reason is that these companies are raising all that money simply because people are willing to give it to them. This is especially common in early rounds, where valuing a startup relies less on metrics. As a result, the correlation between what it costs a company to grow successfully and what investors decide it’s worth has become looser, especially in Internet startups.

“You have companies raising far more money than they know what to do with, simply because valuations are high,” says Josh Goldman, a partner at Norwest Venture Partners. “They can raise money now – and put it away for a war chest or for future needs that they can’t even anticipate now – because investors are tripping over themselves to give it to them.”

Some of those investors jockeying for ownership of young, hot Web companies are people like Saudi Prince Alwaleed bin Talal, who bought a $300 million stake in Twitter last month. But it also includes many venture capitalists, who dread the regret of not getting in early on Internet stars. After VC veteran John Doerr lamented passing on Twitter in its early rounds, his firm bought a $38 billion stake in the company.

Some VCs say that investing in the hotter startups can lend a certain cachet: Back enough hot startups and the next generation will seek you out. After a certain point, the investments stop being venture capital per se and become an exercise in brand building. If that stronger brand can open the door to future investments, a higher valuation can be rationalized as a marketing investment. The risk is that such ego-driven investments represent exactly the kind of thinking that leads to market bubbles.

But the rising valuations may not be limited simply to an elite handful of tech startups. In the third quarter of 2011, 70% of startups received “up rounds” – or follow-on rounds worth more than the previous round (which typically occur 12 to 18 months apart). That figure was up from 61% in the second quarter, according to Fenwick and West. And it was closer to 75% for software and digital media startups. On average, the price per share of startups with up rounds more than doubled for early-stage companies.

The across-the-board rise in valuations may explain why some of the companies receiving investments are designing mobile apps or simple websites that may not need tens of millions of dollars to grow. Rovio, maker of the Angry Birds game, raised $42 million last year. Pinterest, a social-bookmarking site with a lot of buzz but that is still invite-only, raised $27 million. There are exceptions, however: The creator of Instapaper has shunned venture investments for his popular bookmarking app, choosing instead to spend only what his company makes to keep the company lean.

As 2012 begins, the appetite for high valuations seems to be declining. Venture firms – notably Andreessen Horowitz, which has backed Twitter, Airbnb and Zynga – say they are taking a step back from high valuations. That may be an attempt to lowball companies seeking investments or a sign that the money isn’t flowing so freely. According to Dow Jones, VC firms have consistently raised less money – $30 million over four years – than they have invested in startups. And with the IPO market giving mixed welcomes to tech offerings, that trend may well continue.

Those VCs who said they were pulling back from high-priced startups drew a sharp rebuke from a peer, Union Square Ventures’ Fred Wilson, who, in a blog post deriding “herky jerky investing,” argued that VCs are wrong to time a market: “You can’t deliver great returns to your investors by being a momentum investor during some periods and a value investor in others.” Instead, Wilson said, VCs would be wise to hold consistently to a disciplined strategy.

In venture investing, there are few things more disciplined than giving companies just the money they need to grow. But that’s a kind of discipline that seems increasingly rare.

PHOTO: A bubble floats through the air before the start of Tottenham Hotspur versus Norwich City in their English Premier League soccer match at Carrow Road in Norwich, eastern England, December 27, 2011.   REUTERS/Dylan Martinez

Comments
3 comments so far | RSS Comments RSS

So amazing to see this happening. In the past years we have seen countless start ups design, develop, market and launch their networks on a shoe string budget.

Seems like there should be some accountability for where the dollars are spent.

Sandy

Posted by socialnetworks | Report as abusive
 

“After VC veteran John Doerr lamented passing on Twitter in its early rounds, his firm bought a $38 billion stake in the company.”

Interesting read but I think you mean $38 million with and M!

Posted by jbrown05 | Report as abusive
 

I believe that crowdfunding will be a part of the solution to give a new meaning and bring more transparency to investment! 
Many new players are showing up in the 4 main crowdfunging categories but unfortunately blogs only speak about very few one. 
Just to let you know that we will launch http://www.mymicroinvest.com by March 2012, A european based platform
concentrating on equity investments for innovative start-ups. 

Hope you will like it.

Regards,

Posted by Thibaut | Report as abusive
 

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