Two gloomy reports were released yesterday that may have some startups questioning their fundraising chances over the near term. The National Venture Capital Association issued returns data showing lousy results and said the industry should expect more of the same over the next few quarters due to a crummy exit environment and a shrinking pool of funds. Topping it all off was the news that angel investing was down for the first half of the year. Angels put $9.1 billion into companies, a decrease of 27 percent from the same period year before, but invested in the same number of deals, meaning that the same number of financing occurred, but they were for smaller amounts.

Over at GigaOM Pro (sub. required), I’ve taken a look at what the overall capital trends might be in the venture market and laid out how that may affect startups as they seek funds. I discuss everything from the fact that less capital is going into startups to how the increasing emergence of small funds might affect them, using information taken from a paper by Industry Ventures, a secondary firm (Disclosure: Industry Ventures is an investor in True Ventures, which backs our parent company, Giga Omni Media. Om Malik, founder of Giga Omni Media, is also a venture partner at True.).

Some other key takeaways for dealing with the new environment include how startups need to be realistic about their exit opportunities and seek appropriate amounts of funding for them. Another suggestion is to aim at a market that can be reached using limited funds. Big money will still be there, but it won’t be as readily available. But rather than end on a down note, here instead are some words of encouragement from the report:

First, it’s going to be harder to get funding, but as Paul Kedrosky said via email, “All of this is conspiring to make venture capital harder to come by, which will likely only mean it’s as hard to come by as it was in the mid-1990s, when it wasn’t really that hard to come by at all, historically speaking.”

See, for companies that are realistic about their prospects, have a clear plan and don’t need too much capital, it won’t be so bad. A revenue model may not even be necessary.

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Posted by Stacey Higginbotham on GigaOM  |  Permalink  |  3 Comments
Tags: National Venture Capital Association, Startups, VC, venture capital

This year, I had the opportunity to serve as a mentor at Seedcamp. I hear pitches from wanna-be startups all the time in Silicon Valley, but the teams in London were different; the entrepreneurial dreamers that I met there typically had letters like PhD after their names. As a result, their ideas were especially innovative -– and complex. So a few pitches in, I started to ask the question: Why do you want to build a startup around this technology? Very few of them had an answer.

One of the unfortunate side effects of all the publicity and hype surrounding startups is the idea that entrepreneurship is a guaranteed path to fame and riches. It isn’t. Building a startup is incredibly hard, stressful, chaotic and –- more often than not –- results in failure. That doesn’t mean it’s not a worthwhile thing to do, just that it’s not a good way to make money.

A more rational career path for money-making is one that rewards effort, in the form of promotions, increased security, salary and status. Startups, unfortunately, punish effort that doesn’t yield results. In fact, the biggest source of waste in a startup is building something nobody wants. While in an academic R&D lab, creation for creation’s sake will often get you praise, in a startup, it will often put you out of business.

So why become an entrepreneur instead of developing technology in an R&D lab? Three reasons: change the world, make customers’ lives better and create an organization of lasting value. If you only want to do one of these things, there are better options. But only startups combine all three.

Take this fictional example of a Seedcamp attendee (actually a composite), which I will refer to as Hairbrush 2.0. At the helm of Hairbrush 2.0 are dreamers with deep AI background. Their dream is to use AI to solve some of humanity’s big problems. Originally, they thought they could make a learning engine that would accurately predict consumer preferences, and tell people what products to buy. Imagine a shopping engine that does your shopping for you. Brilliant. And also very, very hard. So like good entrepreneurs, they went searching for an easier problem to start with, namely helping people find just the right –- you guessed it — hairbrush. This idea took them right off the rails.

They were busy building their product as if they were still in a research laboratory. They hired hair-styling experts to feed their expert system. Their algorithms were world-class. And yet nobody was using it.

The worst part? They didn’t know why.

Hairbrush 2.0 didn’t have contact with customers. Not only that, nobody in the company actually had a use for the product they were building. Trust me, these guys did not brush their hair.

There’s nothing wrong with starting small on the way towards a larger or more mainstream product. But to become an entrepreneur, you have to serve customers, stay true to your vision and build an organization — all at the same time. Indeed, that constant balancing of short- and long-term priorities, vision and data, customers and employees is what makes it almost impossibly hard.

That’s not to say the Hairbrush 2.0 team is doomed. They can make up for their lack of domain expertise by putting a product out early, spending a lot of time with potential customers, and being rigorous about measuring how real-life customers interact with it. But in order to do that, they’re going to have to keep two seemingly contradictory ideas in mind at the same time: that their vision is going to change the world, and that their vision is also horribly flawed. Which parts of the vision are which? There’s no way to answer that in the lab.

Attempting to hold two contradictory ideas simultaneously is known in psychology as cognitive dissonance. Most people go out of their way to avoid this sensation. That’s a perfectly normal reaction; our brains are supposed to experience pain when we try to do the possible and the impossible at the same time. Entrepreneurs are wired differently, however. It’s not that they don’t experience pain — trust me, creating a startup is extremely painful — but that they care more about realizing their vision. And there are much easier ways to get rich.

Eric Ries is a serial entrepreneur and author of the blog Startup Lessons Learned.

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Posted by Eric Ries on GigaOM  |  Permalink  |  36 Comments
Tags: Entrepreneurs, Seedcamp, Startups

Joost, a much-vaunted online video startup, today announced that it will offer a white-label video hosting platform, thus entering a crowded market littered with the carcasses of other failed video hosts. The company is also losing its famous chief executive, Mike Volpi, whom it’s replacing with Matt Zelesko, the current vice president of engineering. And it plans to cut a portion of its workforce — between about 70 of its remaining 90 employees, according to Advertising Age. It also shut down its office in the Netherlands.

When I read about all the planned changes at the company earlier today, the first thought that crossed my mind was: Stick a fork in it; Joost is done. After all, this whole white-label video strategy is like a leaky lifeboat in the middle of the Pacific Ocean. The NewTeeVee crew sums up the situation very succinctly: “Becoming a white-label video provider was what a business did when all other strategies failed.”

As someone who has followed Joost from its very inception, when it was known as The Venice Project, I’m amazed at how badly it’s stumbled. It shouldn’t have.

It had everything going for it, including:

• Successful, Celebrity Founders: Niklas Zennstrom and Janus Friis started the company in 2006 after palming off Skype to eBay for billions of dollars.
• Proven Technology: Joltid formed the basis for music- and file-sharing service Kazaa and later Skype.
• Substantial Funding: It raised $45 million in funding from the who’s who of the tech world: Sequoia Capital, Index Ventures, Viacom, CBS and Chinese tycoon Li Ka-shing.
• Incredible Buzz: The company had incredible pre-launch buzz that helped it to convince thousands of users to download its P2P video client — something that doesn’t happen all that often on today’s web.
• Big, Famous Partners: It managed to gain early traction with content providers such as Viacom and CBS, which were also investors in the company.

So what went wrong? Quite a few things, actually. Other startups should learn from the mistakes of Joost and avoid repeating them, such as:

• Too Big, Too Fast: Joost hired too many people, too quickly. It never behaved like a startup but instead always felt like a grown-up company with too many bureaucratic layers.
• Too Geographically Spread Out: The company was based in multiple geographic locations — New York, London and The Netherlands — and as a result, each location became somewhat of a silo.
• Not Enough Focus: Remember what your mom used to say when you took too big of a bite? If you’re not careful, you’re going to choke. Startups are just like that. Unless you focus, you’re going to choke. Joost couldn’t focus on one single market — and startups need to focus on one market at a time in order to win.
• Too Much Hype Too Soon: Like many, we were one of the early fans of this startup. Its founder pedigree generated a lot of pre-release interest. Nearly 250,000 folks signed up for the beta version of the software. But when technology problems hit, the pre-release buzz turned into buzzkill.
• Slow to Fix Its Technology Problems : Joost’s P2P network had technical problems early on that resulted in user defection. The company didn’t move to address those concerns fast enough. These technology problems have continued to nag the company throughout its life, even when it switched to a browser-based focus.
• Client vs. Browser: The company took too long to realize that the client-based strategy was going to lose out to browser-based video services. Its legacy of building clients became its Achilles’ heel.
• Didn’t Press Its Early-Mover Advantage: Joost had correctly identified that it needed the blessing of the content owners, but it failed to move aggressively enough to convince them to work with its platform. The client and technology problems didn’t help matters, either.
• Big Media Dis-Connect: Its big media investors were never willing to give Joost a content edge over the competition, prompting users to tune it out in favor of other services.
• Too Many Internal Problems: The company had some serious management problems, some of which led to the firing of its CTO in January 2008.
• Hulu: It started with a simple, easy-to-use interface for its browser-based video service, offered higher-quality video and used content from its backers, NBC and Fox, to become a household name, which in turn allowed Hulu to convince other content owners to sign up for its platform. Now it owns 10 percent of online video traffic.
• Chasing Its Own Tail: Joost also made some basic mistakes, such as not having a good SEO strategy. It never quite figured out a social media strategy in order to garner viral growth, either. It was like a tech company from the 1990s — out of sync with today’s web environment.

The dark cloud of doom started to settle over the company last year, as the team at NewTeeVee noticed time and again. NewTeeVee writer Janko Roettgers offered a recipe to fix Joost last fall, but apparently it was too little, too late, even then. The company consistently failed to gain any traction, even after unveiling new APIs and a browser-based offering. In the end, however, it all boiled down to a lack of content.

Photo credit of Mike Volpi pic: Eirikso via Flickr.

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Posted by Om Malik on GigaOM  |  Permalink  |  69 Comments
Tags: #ef09_newteevee, Index Ventures, Joost, Mike Volpi, News, Online video, Sequoia Capital, Startups

In 1964, Justice Potter Stewart, who was having difficulty explaining what exactly he meant by “hard-core” pornography, famously said, “I shall not today attempt further to define the kinds of material I understand to be embraced…but I know it when I see it.” When entrepreneurs ask investors what they’re looking for in a startup, the response they get is often something along the lines of “traction.” And when asked to describe traction, most investors channel Justice Stewart, saying only, “I know it when I see it.”

Investors seek to take on the risks they can control and minimize the rest. The biggest unknown variable in the risk equation is usually the market, as in, “Is there even a market for your product?” This is especially challenging when it comes to products aimed at consumers, as you cannot possibly speak with several million people to get their feedback on a product before it’s even launched. So investors want to see enough usage of your product to give them confidence that there is both a big enough market to generate a large exit, and that you have nailed the product/market fit. That is what we mean by traction.

Misunderstanding the objective of traction, a number of Silicon Valley entrepreneurs have mastered the art of driving millions of people to a site or application regardless of whether the product solves a real problem or not. At best, this approach skews the data used to discover if a product is getting the kind of usage that would indicate there’s a big enough market for it. At worst, it’s spam.

Hackers hack everything, not just code

That things would go down this path should have been obvious. I’m not sure who kicked off this hacking traction phenomenon, but a small group of extremely bright entrepreneurs now use a very sophisticated form of multivariate testing. For example, they simultaneously test an extremely large number of variables on a registration page in order to maximize registration (the copy, size, color, font and placement of data fields; the format and text of buttons; the flow of pages), then do the same thing on the “invite friends” page (the text of the body and subject of the invite email), and so on.

This method takes advantage of latent human behaviors to drive registrations and visits — and in terms of those goals, it’s unbelievably effective. While this knowledge is still relatively well guarded, it is slowly making its way through Silicon Valley.

The insight that other pages say more about the pages they point to than such pages say about themselves (PageRank) was a revolutionary idea that led to Google Search. Machine learning has done a great deal to tune search, but machine learning without PageRank would not have resulted in Google.

Similarly, using very sophisticated optimization routines to maximize desired behaviors in a social application is a great way to make a good thing better. However, using these techniques too early can muddy the waters so that you don’t know if what you have is any good or not. If you were going down the wrong path, wouldn’t you want to know that as soon as possible?

Now that these entrepreneurs are returning to investors with “traction,” some are having trouble raising money. They are, understandably, confused. “You asked for traction — here’s your traction. Show me the money!“

Too much of a good thing

Multivariate testing and other optimization schemes can be a great way to make a good product even better, and they are underutilized by many companies. But too many startups have begun misusing such traction techniques as a strategy rather than as a tactic, inadvertently destroying the feedback needed to build a great product.

As for me, I shall not today attempt further to define the kinds of businesses I hope to invest in…but I know them when I see them.

Mike Speiser is a Managing Director at Sutter Hill Ventures. His thoughts on technology, economics and entrepreneurship will appear at this time every week.

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Posted by Mike Speiser on GigaOM  |  Permalink  |  24 Comments
Tags: Data, hacking, Startups, traction

Microsoft said Friday that more than 12,000 startups have joined its BizSpark initiative, a six-month-old effort aimed at fostering new software companies by providing applications and support. The disclosure comes on the heels of a speech earlier this week from Microsoft CEO Steve Ballmer at Stanford University, in which he talked up startup opportunities despite the difficult economy.

“These are tough economic times, but these are times that are rich in opportunity,” he said. Microsoft says a number of startups are producing Windows applications, including ZocDoc, Tweba and SquareClock. Ballmer’s remarks, however, were balanced by the software maker’s announcement the day before that it would cut 3,000 additional jobs.

In a similar vein to BizSpark, Qualcomm Ventures, the funding arm of wireless chip giant Qualcomm, earlier this week unveiled the QPrize. The competition will provide $550,000 to four startups with the best wireless, consumer and green technology business plans. Both projects seem to point to a larger effort by technology leaders to promote startup creation during these cloudy economic times.

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Posted by Ed Sutherland on GigaOM  |  Permalink  |  4 Comments
Tags: BizSpark, Microsoft, Startups

Qualcomm Ventures, the strategic capital arm of the wireless chip powerhouse, has unveiled its QPrize competition, which will award up to $550,000 to four startups from around the world. The competition is open to startups with business plans related to wireless technology in areas that include consumer and cleantech. Qualcomm Ventures will select four semi-finalists, from North America, Europe, China and India, to receive $100,000 each in convertible notes. Those startups will then compete for an additional $150,000 in convertible notes. The deadline for business plan submissions is July 31, 2009.

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Posted by Stacey Higginbotham on GigaOM  |  Permalink  |  3 Comments
Tags: Qualcomm, Startups

The crisis in the financial market is coming home to roost for startups of all kinds. Today’s Wall Street Journal has an article detailing the death or firesale of several startups in the last few weeks. It’s grim, but this is only the beginning for many venture-backed companies, as we reported back in October. Over the next few months, we’ll see continuing news of businesses giving up the ghost as their venture backers take a hard look at upcoming cash needs and decide to prune.

As Fred Wang at Trinity Ventures told me back then, it is a matter of figuring out which firms can make the best use of the remaining money in a fund, weighed against the portfolio company’s cash needs.

“It’s a little bit like poker in the sense that if the company is not burning a lot of capital and the cost of buying a card is low, it’s a little bit easier,” Wang says. “If $1 million buys them another 12 months that’s easy to call, but if the cost of a card is $5 million to $10 million then it’s a lot harder.”

Venture capital is a cyclical business that follows the fate of the stock market, so it depends on where a startup is as the cycle turns from boom to bust. Unfortunately, many of these unlucky startups are getting crushed under the wheel as it rolls through the downturn. Right now is a good time to work on an idea, but a bad time to be selling things.

However, innovation won’t just stop.VCs are still making selective investments in early stage startups at newly reasonable valuations, hoping those deals are ripe by the time the economy reaches the next boom.

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Posted by Stacey Higginbotham on GigaOM  |  Permalink  |  3 Comments
Tags: Fred Wang Trinity, Startups

By now, most agree that this recession is likely be longer, deeper and fiercer than those in the past, rendering smaller, newer companies especially vulnerable. Such vulnerability is already playing out in the public markets: Over the past three months, the Russell 2000 has fallen much further than the Dow.

There is, however, a way for startups to not only stand out in this recession, but thrive in it: By being as disruptive as possible.

The me-too business model that fared pretty well during good times will be toxic this year. Venture-backed IPOs grew scarce last year and there will likely be few in 2009; merger activity is also expected to remain sluggish. Startups with little or no revenues or a high burn rate may not make it through December.

In an economy where risk is shunned, boldness is a risk that still offers a shot at success. It’s much easier to say this than to make it happen. But there is reason to believe that 2009 will allow original ideas, and companies behind them to come forth.

Recessions dry up funding for innovation, but often innovation goes underground — or rather, back into the garage. For those that produce successful innovations, there may be fewer competitors around to copy their successes.

Some of the costs involved in starting up a business are falling. Office rents are declining. Used office furniture is available for cheap on eBay and Craigslist. Software programs that used to be costly are free, thanks to Google Apps and (with many restrictions) Microsoft’s BizSpark.

So technology, especially on the Internet, is likely to continue to evolve rapidly. Mobile devices and netbooks could invite people to spend more of their time online, expanding a captive audience for provocative new applications. The trick will be in monetizing their attention.

Recently Richard Moross, CEO of UK startup Moo.com, on the Guardian UK site outlined the kind of thinking startup founders may take in the downturn.

Be honest with yourself. Is this really a business? Is it really different? If the elevator pitch includes the words ‘Twitter’, ‘social network’ or ‘it’s web app X meets geek meme Y’ you probably need to rethink things – those days are gone. Today your idea needs to be super-relevant: do people actually need this, or are you just a solution looking for a problem?

Years of complacency have left many an apple cart ready to be tipped over. Startups that disrupt in a way that resonates with consumers and companies could emerge from this recession stronger than ever.

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Posted by Kevin Kelleher on GigaOM  |  Permalink  |  16 Comments
Tags: 2009, recession, Startups

We’ve read a few articles lately claiming that survival is not a strategy. The arguments in Anand Rajaraman’s article on GigaOM last month are sound, and if we understand them correctly include not prolonging a business that will never likely “win” or be healthy or have an exit resulting in wealth creation for the shareholders. It’s hard, or more appropriately put, impossible to argue with that logic. A quick death of a company that would otherwise die is a good thing for shareholders and employees.

That said, we think it is very hard in these times to look into a crystal ball and figure out if your company will survive beyond the current economic downturn. If you were growing aggressively before the downturn and are either moving sideways or down slightly, then there is a good chance that you can continue to grow once the economy turns around. If you have such a company (rapid growth followed by flat to down coincident with the economic downturn), then investing your capital in additional growth might be suicidal.

Surviving the economic downturn is a requirement for you to grow after the economic downturn. Capital, including both debt and equity, is not likely to be easy to come by for some time and even if you can get it, it will come at a premium (debt) or discount (equity) to what you would like to have in a more nurturing economic environment. As such, creating a “healthy” business defined by positive cash flow is paramount to survival. Being able to live off what you kill and grow for the coming months will ensure that you have a chance to thrive in the next economic boom. Moreover, you may exit the downturn with fewer competitors and a better opportunity for the “home run.”

Here are our recommendations on what you can do NOW to survive and thrive.

1. Cash is king. This was always true, even when the laws of business seemed to be turned on their head and capital flowed freely after a 5-minute presentation that included the words “software as a service.” Get to cash flow positive and stay there. Forget about the income statement — if you are spending less than you are making, then that’s all that matters today.
2. Justify your organization. Even if you are cash flow positive, you should be looking during these times to make sure that you are cutting every piece of non-performing fat from your organization. Keep the folks you need to do the work that is contributing to profitability and remove your underperformers. Interview for superior performers so that you can hire them into positions when the market turns around.
3. Eliminate debt. If you are highly leveraged and you have the money to do so, use every penny that you can muster to eliminate debt. Amazingly enough, it may be cheaper to buy your debt back and retire it if the debt is trading below the issuing value. For instance, if your debt is trading at 50 percent of the original value upon issuance and you can retire it upon purchase then every dollar you spend on purchasing debt nets you twice the benefit of paying the debt down. Even if you can’t retire it, you’ll get a portion of every dollar back that you spend on buying down your debt. Either way, use this time to make your balance sheet healthy.
4. Justify your projects. Don’t continue to throw money into projects that have extremely long payback horizons. If you are going to continue major project spend, then spend that money on items with nearer term profitability targets. As we have said before, success is a function of focusing on the right market opportunities, building the right product for that market opportunity, and building that product the right way. If you are on a sinking ship, is it better to spend your time finding a lifeboat or would you rather be balancing your checkbook?
5. Fix your product. The guiding words for your product roadmap should be focus and simplify. Focus your product features on ones that make connections. Depending on your services, these might be: helping customers connect with the information (like search engines or technical blogs), connecting with other customers (think eBay, Etsy, or Craigslist), or connecting customers with products (Amazon). The takeaway is that the part of your service that makes the connection is the valuable part. Simpler applications that are well built beat complex, full-featured applications that are buggy and confusing to the user.  Learn to say “no” to projects, and clean up the application.

Marty Abbott and Michael Fisher are partners with AKF Partners.

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Posted by Guest Column on GigaOM  |  Permalink  |  9 Comments
Tags: Startups

In these perilous economic times, the layoff memos often follow a familiar refrain: “We have cut costs by 20 percent. That gives us an additional year’s runway. Or two.” But while yes, companies can cut costs and prolong their survival, when it comes to startups, just because they can doesn’t mean they should.

I’m speaking here of venture-backed startups, which represent a small minority of companies. The sole purpose of most companies is to create a steady income stream for their owners and operators — in other words, survival. Venture-backed startups, on the other hand, are created with the sole purpose of a successful exit.

Why growth is crucial

Whether that exit comes in the form of an acquisition or an IPO, in the meantime, the lifeblood of any startup is growth, be it in terms of customers, usage, revenues or profits. Under most economic conditions, an IPO is impossible without revenue and profit growth, and we are unlikely to see that change any time soon. From an acquisition point of view, stagnant companies are valued at low multiples of revenue, say 1x-2x. And while popular meme suggests that flat is the new growth — given the downturn in the economy, the argument goes, even keeping revenues flat is sufficient — this argument does not apply to startups.

By definition, startups are supposed to be attacking nascent market opportunities and unsaturated markets, and as such should be able to grow even during a downturn. If a startup cannot find growth in this environment, it’s a clear message that the market opportunity might be better served by an established company. Of course, growth in profits or revenues are far better than just growth in usage, but even growth in usage is better than stagnation on all three fronts. There is at least the possibility that a company with strong usage growth might one day be attractive to an acquirer with a good monetization engine.

It’s no fun to work at a startup that isn’t growing. Stagnation leads to low morale, with people sitting around waiting for the axe to fall. Rather than let the company become a zombie, management would be doing their investors and employees a favor by pulling the plug and returning the remaining capital to investors.

Why VCs often don’t put companies out of their misery

Founders and executives have a lot of emotional capital invested in their companies, so when it comes to making the ultimate decision, their reluctance is understandable. What’s surprising is how often VCs let companies turn into zombies. The reason for this is a subtle misalignment of interests between VCs and their investors. As long as a startup still appears to be, on some level, alive, VCs can carry the company on their books at the valuation set by the last round of financing. Once they pull the plug, the fund will receive pennies on the dollar, a loss that has to be recorded on the books and doesn’t look good when the firm goes to raise their next fund. Every VC portfolio, therefore, has its fair share of zombies.

Another contributing factor is excessive preference overhangs. Investors receive preferred stock with the right to get back their invested capital ahead of common shareholders in an exit; in some cases they have the right to receive a multiple of their invested capital ahead of common shareholders. The total amount that investors need to receive before common shareholders can participate in an exit is called the “preference overhang.”

If a company has raised so much capital that any realistic acquisition will be below the overhang, then common shareholders stand to receive nothing from the sale — and company management has no incentive to look for such an exit. In such cases, it’s important for the VCs and management to agree to restructure the preference overhangs to make such exits attractive to management. Otherwise the company is destined to become a zombie.

Every startup founder and employee has to consider three possible outcomes: success, failure and zombiehood. Success is much better than failure, but quick failure beats wasting years of your life on a zombie. If you are a company founder, and you are considering layoffs to extend the runway (perhaps on the advice of your venture investor), you should look in the mirror and ask yourself whether you are cutting away your growth opportunity and just choosing a lingering death over a quick one.

Anand Rajaraman is a co-founder of Kosmix and Founding Partner of Cambrian Ventures. Disclosure: He is also an investor in Giga Omni Media, parent company of GigaOM.

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Europe Struggles With Three Strikes, Fox Exec Wants It Anyway NewTeeVee – by Janko Roettgers "; Desert Bus For Hope Rides Again for the Third Year NewTeeVee – by Liz Shannon Miller "; Smartbook No More — What Should We Call Them? jkOnTheRun – by James Kendrick "; Dealing With the Avalanches In Life and Business WebWorkerDaily – by Amber Riviere ";

Posted by Anand Rajaraman on GigaOM  |  Permalink  |  18 Comments
Tags: Startups, VC Investments