Scalable Funding: Can Venture Capital Be More Like Amazon EC2?

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Scalable Funding: Can Venture Capital Be More Like Amazon EC2?

 

I'm becoming an increasingly big fan of infrastructure services like Amazon's EC2 and S3. The reason is simple: You pay for what you need at around the time that you need it. This is the point I made when recently interviewed by Erica Naoone of MIT Technology Review in an article aptly and succinctly titled "Cheap Infrastructure".

In the interview I was my usual, highly opinionated self, but this particular statement that made it into the article jumped out at me: "There's no correlation between the amount of money an entrepreneur actually needs and the money a venture capitalist puts into the business." Of course, there are some qualifiers here: I'm talking about software companies and I'm talking about the Series A investment (first institutional money). Also, if I had done the interview in writing, I likely would have said there's little correlation instead of no correlation. But, my larger point still stands. The way the system works, you often don't raise what you need, you raise what you can.

But lets shift gears just a little bit, before we get deeper into the VC funding stuff.

In the early stages of an internet startup, one thing that's always difficult is predicting the level of infrastructure that is needed to support the volume of users/customers. Entrepreneurs often overestimate how popular their software is going to be. There's also the notion that too much infrastructure is better than to little because "you only have one chance to make a first impression." Finally, there's that whole nagging thing about reliability and uptime.

The net result, before EC2/S3 and similar services, there were few options. Costs were relatively high and somewhat "spiky" (you bought a few servers, threw them into a co-lo, bought more servers, etc.). There wasn't a good way to handle this common situation: "Hey, we only have X users right now, and we expect to grow by Y%, but we need to make sure we can handle Z users just in case we get written up on TechCrunch or get on the front page of digg." You ended up compromising somewhere. Either you spent little (and dealt with spikes if/when they came as best you could) or spent too much, resulting in a fair amount of "unused capacity".

Now, back to the VC funding part. When my co-founder, Brian Halligan first kicked off HubSpot, we thought a lot about the capital needs of the company. I funded the seed round. We later successfully raised some angel funding -- about $1 million. We felt that was enough to get us to the next "milestone" (product launch). The rationale we had was reasonable: Raise a little money early, raise more money later. By raising money "closer to when we needed it", we felt we could continue to reduce the risk, increase the value of the company, and ultimately dilute less. And in fact, this is how the VC process sort of works. You raise a Series A, Series B, etc. and each round is targeted at getting a company to the next "milestone". The problem is, it's awfully "spiky" . This led us to ponder the other side of this spectrum. In theory, the "optimal" path would be for us to sell just enough shares every month based on the cash needs of the company at whatever the right "price" is at that time.

In a way, the Y Combinator folks do this as the first step. They give founders just enough to get through the first few months and build a prototype. Many of the YC startups then go on to raise follow-on funding from VCs. But at that point, the funding process looks like the usual -- it becomes "spiky" again. We don't have a pure incrementally scaling model for startup funding anywhere.

Of course this scalable funding model probably only works in theory -- and even then, it's a stretch. There are lots of reasons why this doesn't work in practice. Here are just a few:

1. There's no efficient way to appropriately "price" the shares that frequently.

2. Entrepreneurs don't want to worry about whether they'll have the cash they need next month.

3. There's likely not going to be agreement on how much cash should be burned month-to-month.

4. There'd likely be some friction and transaction costs.

There are ways to mitigate some of these challenges, but I still don't think it's practical and would work. My VC friends (and yes, I do have those), would likely agree.

But, the geeky and analytical side of me still finds the purity of this model appealing for the same reason I like Amazon's EC2. You get what you need and grow incrementally instead of spikily (yeah, I made the word up).

What do you think? Yes, the idea is crazy and wouldn't work, but just how crazy is it?

Posted by Dharmesh Shah on Sun, May 11, 2008

COMMENTS

I love the idea. We're in the situation right now where we don't really need money, but don't want to turn away all the VCs who are interested. Ideally, we'd like to scale with them and have them onboard now for the non-monetary value add. And then as we need more money and more sizeable investment, our VC exposure and funding scales accordingly.
Not sure how this would ever work in practice, but we'd be willing to be the guinea pigs!

posted on Sunday, May 11, 2008 at 8:55 PM by Shafqat


It's crazy, but sounds more crazy-brilliant than crazy-insane.



Some thoughts I'm just throwing out:



The consumer finance world has been doing this for 30-some years, in the form of credit cards and HELOCs. If you're a middle-class consumer and need money, you don't need to jump through hoops to get it. You just swipe your card and it's automatically deducted from your account, whether or not there's actually money in your account.



I'd think that your average consumer is a far worse credit risk than your average tech entrepreneur, too, yet this doesn't stop credit card companies. They figure that the good credit risks will subsidize the bad credit risks, so that they end up making a profit in the end. It seems like entrepreneurs would be even *more* incented to maximize investor payouts, because that's the only way they get paid. The key seems to be to have extremely large numbers, so that all the outliers balance out and it comes down to statistics.



Pricing the shares does seem like a problem. My first thought was to use an auction system, where there might be $X available and then firms would compete on terms to get that money. But that has two problems: 1.) It doesn't assure entrepreneurs that the cash will be available when they need it, which is one of the major points of this and 2.) there's an adverse selection problem for investors, where if they take the lowest bids, they'll likely get the *worst companies*, which doesn't do them any good. Not sure how to fix this; perhaps it could be contingent upon some valuation metrics like users or revenue or profit, but then the problem is that there're no real reliable valuation metrics for startups.

posted on Sunday, May 11, 2008 at 9:25 PM by Jonathan Tang


In a previous post you mentioned your weren't a big fan of "platform as a service", but it seems you've taken a liking to "cheap infrastructure". Aren't they kind of one in the same? Whether you develop a custom app on Google's App engine, Force or Quickbase, or just use Amazon S3 as an engine and build your own front end you still have the risks mentioned in your previous post. So are you now becoming a fan of "platform as a service" as well?

posted on Sunday, May 11, 2008 at 11:46 PM by Noel Huelsenbeck


Jonathan: Interesting analysis. I like the credit card and associated credit risk analogy.
Noel: My concern over the Platform as a Service was around "lock in" (in that article, Salesforce.com). With things like EC2, you're building your app in Java/PHP/Ruby/whatever. Though there's some integration cost, they're running a standard stack so it would not be impossible to move.
Salesforce.com's platform offering is using a proprietary language. You're building an app *on* it, not just running your app on their infrastructure. Subtle, but important difference, in my mind.
Will plan to think out loud more fully in a follow-up article sometime. It's an interesting topic.

posted on Monday, May 12, 2008 at 12:40 AM by


Certainly an interesting idea.
It reminds me of the funding - they call it 'capital structure' options available to large corporates via the bond market.
In that case, rather than having to mess with the viscittudes of specific public offerings or loans from banks, they know they can always issue another 'tranch' at whatever spread their current bonds are trading at - that is the market is constantly pricing how risky their venture is, by trading in the debt they've already issued. Then, when/if they want to borrow more money they always offer their new issue (new 'tranch') at an interest rate that prices it equal to the current most liquid spread already in the market place.
I wonder if it would be possible to have an investor (or series of investors) offering a 'line of credit' option at steadily increasing levels of interest - maybe as convertible shares to keep in the spirit of what you are doing. The pricing of these lines of credit, could then be set to something equivalent to the current trading price for their existing issues.
All this relies on a lot more liquidity in the market than actually exists around a startup though - that is the real problem.
The financing could be worked out provided there was a way to price the current risk. Some sort of web2, wisdom-of-the-crowd, reputation market thing comes to mind as a way to do this.
I dunno, interesting idea though.
Kinda like all programming languages eventually evolve towards Lisp, I think you will probably see VC/Angel capital markets slowly move towards this much more liquid, real-time priced model you describe.

posted on Monday, May 12, 2008 at 1:22 AM by Miles Thompson


Maybe the “lock in” issue is why Intuit announced it will now let you build apps in Flex on the Quickbase platform.
Maybe Google and Amazon just become a utility, like a power company. No one goes out and builds a power plant when they want to create something that uses electricity. Electricity scales and you pay for what you need. You spend all your time spend designing the TV, blender or whatever.
Personally I like the idea of leveraging someone else’s platform to “prove my concept” and limit my initial investment in the startup. Why not focus on the app and marketing? You may limit yourself from being the next Facebook but you probably have a better chance of having a viable and profitable business.

posted on Monday, May 12, 2008 at 2:41 AM by Noel Huelsenbeck


I realize I'm a little off topic with the platform comments but the idea of scalable funding is more easily implemented when you're on a scalable platform.

posted on Monday, May 12, 2008 at 2:53 AM by Noel Huelsenbeck


It's an interesting idea and yes, somewhat similar to what Y-combinator does but not isolated to first round seed funding. The problems are pretty clear though, as you've pointed out. The biggest one is that it takes a lot of work to raise capital, work that could be better spent on further developing the service or application when you're at that level. Perhaps if it could be pipelined somehow, certain requirements to meet second level funding... I don't know.
In any case, I honestly believe that this type of funding works terrifically for seed funding, especially for first time entrepreneurs and I'm glad that it's becoming more common. As web developers we just don't tend to face the million dollar obstacles that we used to in order to launch new ideas. Often 50-100k can take a pair of entrepreneurs a long ways in this environment, at which point they may be attractive enough to a 'traditional' VC to merit 'real' funding (if it's even necessary).
And as an aside, honestly, the most attractive thing about Y-combinator isn't the money; it's the connections and the learning experience that those sorts of seasoned pros (and their network) bring to the table. Funding is more than just money, after all.

posted on Monday, May 12, 2008 at 3:19 PM by nap


Dharmesh:
I would guess there is fine line between doling out appropriate amounts of much-needed and valuable VC funding and starving the process from critical cash flow. Thanks for the thought-provoking ideas on scalable funding a la Amazon EC2...

posted on Monday, May 12, 2008 at 4:22 PM by Anthony Kuhn


I think Miles is on the right track. If we're talking about debt funding, credit lines serve the purpose very well and are a known instrument. But maybe what we need is the equity equivalent of a credit line -- call it a capital line.
But since equity in a startup is not a very liquid asset (to put it mildly), I don't think we can depend on just-in-time valuations for each capital call. That would be a disservice to both the investor and the startup because there would be no good objective source for that valuation.
Instead, I think the investor (or group of investors working together) need to agree at the outset on a valuation of the startup and on some milestones that demonstrate progress on the business plan (and implicit or explicit agreement on what changes the valuation).
The investor syndicate agrees to make just-in-time funding available in an agreed maximum amount based on agreed valuation criteria. The investors have some idea what their capital will earn, and the startup knows the terms on which it will get the funding.
The only things left open are the exact calendar timing of the draws and the exact amounts of each draw.
And that, I think, might satisfy the valid need that Dharmesh expressed in his post.

posted on Tuesday, May 13, 2008 at 3:58 PM by Carl Strathmeyer


I've wondered if you could create a liquid market for shares in a startup. There is a major asymettry of information between the entrepreneurs and the investors. Investors must expend considerable effort to study a company, and it may not be worthwhile to do this continuously. If a startup was comfortable publishing a continual report of users, revenues, and cash flow, perhaps a liquid market would work.

posted on Tuesday, May 13, 2008 at 6:58 PM by Patrick Fitzsimmons


For a good data point on the illiquidity (is that a word?) of startups, just look at the brain cycles that are expended trying to come up with a fair valuation of a partnership when the firm is adding or dropping a partner. Lawyers and CPAs get rich on that sort of analysis -- even when the partnership operates in a known, mundane business category. Now complicate things by creating a startup in a new business category with no established valuation criteria. It quickly becomes clear that valuations are a subjective matter.

posted on Wednesday, May 14, 2008 at 3:00 PM by Carl Strathmeyer


If I understand you correctly, venture debt is roughly the EC2 of capital. One difference is that the startups needs to pay back the debt instead of selling equity for the cash.
Another idea would be to buy an option to sell equity for cash. This doesn't exist today for startups.

posted on Wednesday, May 14, 2008 at 8:37 PM by Nivi


Very interesting idea. It would probably work best for entrepreneurs that have a strong position in negotiating a "I don't really need your VC money" round.
The entrepreneur could agree on a pre-defined total volume of capital but only use what he actually needs, this would translate into a post-determined stock ownership of the VC. Of course it would be very hard to get the VC to agree to this, but I'd say it´s worth thinking further about it. I will.

posted on Saturday, May 17, 2008 at 9:01 PM by Daniel Heise


TEST
I composed two rather long replies to this thread but neither appeared, is there some bug?

posted on Wednesday, May 21, 2008 at 1:49 PM by mark


I'm a VC and I be dammed if you think we are going to put in the hours to due diligence every time some sissy liver web 2.0 entre needs cash. Hey smart guy thats why they created lines of credit! Shh

posted on Friday, November 14, 2008 at 9:48 PM by IBAVC


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