Monday, March 18, 2013

Lesson #138: Why VC's Bias Technology Startups

Posted By: George Deeb - 3/18/2013

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I have had hundreds of startups reach out to me at Red Rocket looking for fund raising assistance.  Most with hungry, passionate entrepreneurs trying to build a great company in their space.  But, it is typically the technology startups that get through the filter of what I think is "fundable" by professional venture capitalists, based on my conversations with those investors.  Which leaves many of the startups in other categories (e.g., CPG, retail, restaurants, real estate, manufacturing) struggling to secure startup capital.  Today's lesson is going to address why that is the case.

RISK LARGELY LIMITED TO EXECUTION

Technology startups typically have normal business/execution risks that VC's are willing to take, especially after they have flushed out the concept seeing a material proof of concept already acheived before investing their capital.  But, think about other startups.  Restaurants and retailers have the additional risk of real estate locations (e.g., what happens if the road you are located on goes under construction).  They also have the additional inventory obsolence risk (e.g., what happens if you pick the wrong products to sell).  So, instead of taking on multiple types of risk (e.g., execution, real estate, inventory), the VC will typically take the other risks off the table, and focus on technology startups where the risks are much reduced.

LOW UPFRONT CAPITAL REQUIRED

The cost of building a technology startup has dramatically reduced over the last decade.  No longer do you need to pay for hardware, or code commonly-used tools, or pay for big support teams.  Websites today are hosted in the cloud and use open source software, taking the cost of the build-out down from the millions a decade ago to the hundreds of thousands today.  Compare that to the multi-million dollars of capital required to launch a new big box retailer or manufacturing facility or real estate development.  Or, the additional capital required to fund all the inventory that goes therein.  Or, the additional financial burden of a long term real estate lease if the business fails.  The VC's mentality is why invest big money upfront (or over time if things turn south), when you can invest little money in a tech business, for the same big upside returns.

FEWER EMPLOYEES, EASIER TO SCALE

VC's just don't like startups that are human supported businesses out of the gate.  People cost money, people are hard to recruit, human-driven businesses are just less scalable than a simple software-as-a-service business, as an example.   Why invest in a 25% gross margin business, when you can invest in a 90% gross margin business, is the mentality, when you can flow thru all those extra dollars to the bottom line.  Human driven businesses typically attract investor attention later in their development cycle, when private equity firms start to take notice, which have different investment objectives.

HIGH UPSIDE & ROI POTENTIAL

What was the last non-tech company to go public at a valuation of 10x revenues??  Most other industries are valued with much more conservative EBITDA or net income based metrics.  Compare that to a hot technology startup, which is quickly acquiring global users, is given a free pass on the bottom line, to build up a dominant market position (with a "we'll optimize the revenue model later, once the audience is built" mentality of many of the Silicon Valley venture firms).   So, if tech companies average 2x-3x revenues for their valuation, instead of 4x-8x EBITDA for their valuation, and they are given a pass on driving short term profitability, you can better understand the venture firms' natural draw to tech companies.

Hopefully, you now have a better understanding to why VC's bias tech startups.  Which means one of following two things for you: (i) focus on launching tech startups to have a maximum odds of raising venture capital; or (ii) understand going in, that most non-tech startups will need to be financed in other ways, which may or may not be easy for you.

For future posts, please follow me at:  www.twitter.com/georgedeeb

5 comments:

Paperly said...

Thanks for the blog post, George, but I attribute "lemming mentality" to VCs funding technology companies more than any of your arguments. Every start-up has inherent risks. There's no reason to believe technology companies face less risk. For example, obsolescence affects technology companies more than most any other industry. Plus, other industries have financing advantages (i.e. banks love real estate and hard assets) and the ability to scale equally as fast as technology (i.e. my business leverages social selling). So while I typically agree with your postings, I believe you got this one wrong.

- Jay Rudman, CEO, Paperly (www.Paperly.com)

George Deeb said...

No question, Jay, certain VC's are more followers than leaders. And, agreed banks like to lend against hard assets, than software. But, goal of post was to explain "why the bias to technology", rather than to suggest non-technology businesses are unfundable. So, from that perspective, I think we are both right! :-)

Startup Capital said...

I like this post, enjoyed this one thanks for posting .

Anonymous said...

Jay, I don't agree with your "lemming mentality" comment. As a growing number of VC people emerge from tech start ups, why would they start pretending to know what they don't know when there is plenty of low-hanging fruit in what they know and love.

If you don't love a sector, it is really hard to get excited about it, let alone invest in it.

Cindy Dy said...

You are an awesome blogger. This is one of the best blog I had visited so far. Hope to read more post from you in the future. Keep it up. God bless.

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