After about a decade of lean, capital-efficient startups, I believe we’re moving back toward a world of more expensive startups with higher initial capital requirements.
That’s not necessarily a bad thing, but it will change power dynamics between founders and investors and put pressure on incubator models. It means that the low-dollar-investment, high-internal-rate-of-return party enjoyed by angel investors is over.
A Few Dollars and a Dream
For the past 10 years or so, startups have had two defining characteristics. First, they cost almost nothing to start. The intersection of good open-source software, infrastructure as a service, inexpensive distribution, and some plug-and-play monetization options like Google’s Adwords or an app store put all the power in the hands of small technical teams.
If you and your buddy were coming out of college and had a little Y Combinator pizza money and the drive, most of the playing field was open to you.
Second, when something worked—as rare as that was—the ability to scale and create extreme value very quickly was unprecedented.
This mix of low capital requirements and enormous possible outcomes had very predictable, but very noticeable, implications.
At an ecosystem level, that meant there were a lot more startups. When cost goes down, volume goes up.
Founders got a lot younger and a lot more empowered. Younger because young people generally don’t have any money or credibility—which isn’t an issue when you don’t need money. More empowered because if you could code, you weren’t beholden to capital—or anyone else for that matter.
The makeup of investors and how they invested also changed dramatically. Dropping capital requirements for companies meant angels and funds wrote smaller checks, which meant far more of both classes of investors entered the fray.
This made some angels—the ones who picked well, and some who picked everything—fabulously wealthy on tiny initial investments. It also meant that some early stage funds could generate very high IRRs on their small-dollar investments if they got into the right deals.
But here was the rough part for investors. Even if the IRRs were good, it was hard to deploy meaningful amounts of capital into companies because the companies just didn’t need that much capital. That made absolute returns—what really matters if you are in the fund business—harder to achieve for most large professional investors.
The Next 10 Years
But things are changing once again. Open-source software and infrastructure as a service will remain cheap forever. But the low-hanging fruit of highly scalable software startups has mostly been eaten. The winners in areas like media, messaging, advertising, and games have been established.
The next big opportunities seem to be shaping up around things like self-driving cars, on-demand services, VR, bots, bio, drones. But such opportunities lack turnkey generic infrastructure which enables development costs to drop close to zero. They are all expensive games in which to participate.
If you want to play in most of the next exciting areas, cloud services is just part of the basic ante. And then you, as a company, are back to building layers of your own infrastructure for the real world. That means paying for hardware, human operations teams, regulators, and more. This all costs real money and takes real time.
On top of everything else, the costs of distribution have dramatically risen as online advertising matures—as has the cost for talent.
All this means that starting important and interesting things is going to cost a lot more money tomorrow than it did yesterday. That isn’t necessarily a problem. A ton of money is sloshing through the global economy looking for a return; however, it does mean that some of the dynamics of the last several years will change going forward.
Paying to Play
There is an argument that this is mostly good news for the leading financial institutions. It might be easy to raise a few hundred thousand for the foreseeable future from many different sources, but when you need many millions to get to the start line, the vast majority of angels will be mostly out of the game.
The incubators will have to evolve or perish. You can already see this with the shift in Y Combinator’s strategy towards more hard sciences, raising more money themselves, and accepting teams that have already been working on their companies for some time rather than fresh-faced undergrads, etc. The old model of a few months and a few hundred thousand dollars is rapidly becoming outmoded as a way to generate early value.
All this means that real financiers will be needed again, and they’ll get the chance to deploy real amounts of capital before valuations are totally out of control. They won’t need to compete for access to tiny, early fundraises with an open playing field of mom-and-pop players and angels.
They also likely won’t have to play FOMO whack-a-mole as much. Venture investing is mostly a fear-driven activity. Most investors are terrified of passing on something that ends up being huge. In a world where they have to make real bets rather than simply check a small box to avoid later grief, the job will get a lot harder.
At the same time, life will get a lot more difficult for angel investors. The time when a few angels could string together and support an early stage company to a meaningful scale is passing. While it is particularly hard to track the performance of angel investors, these dynamics likely mean lower returns for them in the next period.
Conclusion
The last 10 years have, in many ways, felt like an era dominated by commercialization of the internet and mobile. Most successful startups were built on the shoulders of giants—be they the iPhone or Amazon Web Services—which did almost all of the heavy capital-intensive lifting. This allowed startups to be extremely lean and mean.
This next 10 years will be even more exciting than the last. Far more important and disruptive technologies are being worked on now than there were a decade ago. The challenge, however, is that almost all of them are tackling harder and more complicated problems with less existing infrastructure on which to build.
The change in the capital-intensiveness of businesses shouldn’t be a major area of concern. But I suspect the relevance of the big funds that can write bigger checks and sustain companies over longer and more complicated gestation periods will once again rise, as will their ability to generate absolute dollar returns for LPs.