Fred has written a good post discussing the benefit to VCs of web 2.0. Fred argues that when you combine the well understood point that the start-up capital cost for web ventures has fallen significantly with the argument that the total capital required remains equivalent, that web 2.0 is a “gift” to VCs because:
1) Over the life of the investment VCs can invest their required amount / deal; however,
2) The capital efficient start-up requires less money upfront, lowering the risk for the VC.
“All that area between the red and blue lines is risk that has been taken out of the equation for VCs and equity that should largely accrue to entrepreneurs. It’s a huge gift to the entire web startup ecosystem.”
And that reminded me to revisit a previous post at Disruptive Thoughts, What Riya Did Wrong, and follow-up on the comments left by Riya’s CEO,
See, there’s a nice graph that compliments the one from Fred. It has time on the x-axis and risk on the vertical:
It’s not rocket science: a venture is riskiest at the start, and as it grows risk decreases (assumptions are validated, lessons are learned, etc.).
What Riya did wrong was follow the traditional approach – brainstorm a good idea and go out and raise a boat-load of cash ($19 M!).
Munjal obviously painted an exciting future and was able to trade (cheap) equity for (expensive) funding. The problem was, at such an early-stage, with no assumptions validated and the business model not tested, this was the riskiest time for Riya.
Munjal is right when he commented on my post:
you are actually right we could have done more business model validation on Riya 1.0. The reality though on the fund raising is something different. You couldn’t even dream of building or even pitching a next gen image search engine without significant resources
The issue isn’t that Riya could have “built the next gen image search engine” without significant resources – I don’t doubt that that is extremely expensive and requires real funding. The point is that validating is entirely different than building. And costs considerably less.
If Riya had taken some alternative form of financing (Angel syndicate, early-stage VC financing from an innovative firm, CRV Quickstart loan, etc.) the company could have gone out and tested the business model – mitigating risk and working their way to a validated business plan.
Spending the smallest amount of capital required to take out the expensive risk in the business plan would have left Munjal with considerably more equity in the company as he would have been exchanging relatively more expensive equity for cheaper funding.
Fred’s correct when he says that Web 2.0 is a gift for VCs. The changes over the past 6 years, in both tech and investing, have also produced a gift for entrepreneurs. They can move down the risk curve and raise the large sums of money ($19M!) at points where they’ll accrue/maintain ownership over larger amounts of (more valuable!) equity.
Less risk for the VC. More equity maintained by the entrepreneur. Sounds like a great situation for both.