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Times are changing in startupland. A few years ago all the focus was on consumer internet companies that were huge and fast successes. Twitter rose to fame for microblogging — a need the world never knew it had. Foursquare’s meteoric growth was based on check-ins, a concept that most people barely understood. Gaining users on a big scale became the stuff that startup dreams were made of.
But the trend for focusing on getting big instead of watching the bottom line appeared to culminate early this year when OMGPOP sold to Zynga for $210m (s ZNGA) after rising to the top of the download charts in only six weeks, and then Instagram was sold for a billion dollars before ever making a cent. Then it was like something clicked. Perhaps it just became too unreal.
Today, the sentiment has changed. Now revenue triumphs user growth, and startups are shifting to building sales teams and partner channels again after years of investing in online marketing alone.
Investors under pressure
A major factor behind this change lies in the altered outlook of investors. Startups need funding, so they’re affected by the mood of the people with money — and today many investors are struggling to raise new funds themselves. They’re caught in the crossfire between poor returns of venture capital overall, and a delayed correlation to the general economic downturn. This has a natural impact on their confidence level, which causes them to make more conservative investments. It’s a shift is felt very clearly on the receiving end, namely startup founders.
As VCs replace bravado with skepticism, founders are met with a new and different attitude. They’re hearing less about driving growth and more about driving revenue.
This shift means a move towards B2B, subscriptions and affiliate models, rather than ad-based approaches that require huge user bases. Until recently, the goal for many startups was to build a huge independent social network, but as rival platforms grow stronger, it becomes harder and more expensive to break through. Right now the most likely path to success is building on top of social networks rather than trying to out-compete them.
Path is a great example: it was hailed the new black under the old regime, but has struggled to create its own substantial community. Meanwhile Foursquare seems to have stalled at 25 million users. On the other hand, Airbnb is great example of a post-shift company with a crystal clear business model. Similarly, hotelstonight, which sell same-day unsold hotel inventory, has become the newest big success in travel by inserting themselves into the moment of transaction. Evernote and Ancestry, meanwhile, are great examples of successful affiliate models.
It’s interesting to observe the slow but inevitable effect of the economic downturn. The first years of the crisis were still good years for startups, without too much change in sentiment from what had gone before — despite warnings that “the good times were over”. Most founders reported that there were plenty of new money going around. Super angels and micro VCs sprang up everywhere to fill the gaps poorly covered by traditional investment.
Part of the reason for this is the cyclical nature of VC funds. Most funds run over a period of 10 years, so crisis only hits VCs as their funds run out. Should this correlate with a bad economic climate, this can be a serious hindrance to their ability to raise a new fund. So what we’re seeing now is five years of accumulated hard times in raising new funds. Since the crisis kicked in in 2007 more and more funds have run out, many have not be able to raise new ones, and eventually the startups lower down the food chain start to feel the crunch.
At the same time as the trend is shifting towards revenue, we also see a reduced amount of seed stage investments. Only 4% of American venture capital in 2011 went to seed stage companies, around half as much as the year before. This means the environment for seed funding becomes more competitive, driving down valuations. This incentivizes entrepreneurs to raise smaller rounds to minimize early dilution and smaller rounds mean founders need to go further on the dollar. They can do this by staying lean, but many also supplement investment with early revenue — and since early revenue is likely to be vital in securing the next round, we’ve got ourselves a perfect circle. Everything points to revenue.
The consequences for founders are big but, I would argue, healthy. Even if your company isn’t a subscription, affiliate or B2B service, you could probably benefit from shifting closer to the transaction. A good example is Pinterest: it doesn’t sell anything itself, but its affiliate play drives more revenue per click than the alternative social networks.
If you ask me, the change in zeitgeist is a good thing for serious founders, as it channels more money into sensible models which we can build serious businesses on. Founders shouldn’t get carried away with thinking that a startup is a discipline in itself: it’s just a mini business. And business survive by generating substantial revenue. While VCs might be able to afford to write off 8 out of 10 investments, entrepreneurs cannot, since most of us don’t start 10 companies in a lifetime.
This shift is our opportunity — the opportunity to take charge and build stronger companies.