Two-thousand eight will be remembered as a watershed year for many reasons, but two are of special interest to the startup community: the meltdown in the financial markets and the emergence of cloud computing. Tighter capital means investors will be more cautious, and startups can expect lower valuations. However, the growth of cloud computing provides a possible opportunity for both investors and startups: cheap and easy experimentation.
To many in the IT industry, especially those considering starting companies, the motives of venture capitalists can seem confusing at best and devious at worst.. But like any other industry, VC has its own business model. While startup founders often think about investments simply in terms of percentage returns, VCs tend to think in terms of absolute return. Getting back $10 million on a $1 million investment is a huge percentage ROI, but getting $50 million from investing $10 million is a larger absolute return. The rational behavior of VCs thus seems irrational to others.
VCs, then, are doing two things: betting and experimenting. The bets are on the entrepreneurs creating the companies and, to a lesser extent, the ideas they have. The experiments are used to identify and explore new markets. Bets are pure risk and risk management in which the goal is to maximize upside while minimizing downside. Experiments, are about discovery, and discovery means exploring many blind alleys before finding success. Scientists run tens or hundreds of experiments that fail for every one that succeeds in revealing something new. The same is true for startups: if you are not failing, you are not innovating.
The U.S. Bureau of Labor Statistics reports that the IT industry had the lowest 2- and 4-year survival rate of any industry during the ’90s (63 percent and 38 percent). Why? The companies, like investors, must balance risk and experimentation. Many companies start with one idea, only to discard it and try several others before arriving at the idea on which they succeed. Google (s GOOG) is the most visible example of this, having launched its advertising platform years after starting their (non-monetized) search business. Many companies run out of money before discovering their successful offering.
The need for experimentation and scarcity of resources makes it essential that both VCs and startups be able to run their experiments as cheaply and efficiently as possible.
In the past, building a web-based startup required purchasing servers, colocation and bandwidth, and hiring the operations people to take care of load balancers, routers, disk storage, etc. This is a lot of expense and often companies either under provisioned or, more likely, bought too much equipment in anticipation of demand that never materialized. Most of this equipment later could be found on eBay (s EBAY), which, while good for people purchasing expensive equipment for pennies on the dollar, wasn’t the revenue building plan the investors had in mind. Such capital expenditure is clearly not conducive to rapid, frequent experimentation.
With the launch of services like Amazon Web Services, Google App Engine and Force.com, however, capital costs of infrastructure are zero, having been converted to operational costs that directly reflect actual demand. For those with applications that can work within the constraints, AppEngine and Force.com will automatically scale them on demand. The more sophisticated applications, designed from the start for horizontal scale, are better suited to the set of infrastructure primitives that make up AWS.
All of these platforms are infrastructure, but they are more than that for startups and investors: they are tools for risk reduction and experimentation. They are engines of innovation. In the new world these services create, startups using them have an enormous advantage over their competitors in their ability to experiment and adjust, and investors can get much less risk and much more exploration done with the same capital. Anyone building their own infrastructure will be seen as already failing. What many see as simply a mechanism to reduce costs is, in reality, something much more powerful. Fast, frequent failure is the most reliable path to success.
If your business plan relies on building infrastructure, it’s time you revisited it. If you don’t, your investors will.
Benjamin Black is an infrastructure troublemaker, currently at Joyent, who has blazed a trail of game-changing technology, leaving behind angry execs at Microsoft, Amazon, and Internap. Vijay Gill builds networks and infrastructure.