November 2005In the next few years, venture capital funds will find themselvessqueezed from four directions. They're already stuck with a seller'smarket, because of the huge amounts they raised at the end of theBubble and still haven't invested. This by itself is not the endof the world. In fact, it's just a more extreme version of thenormin the VC business: too much money chasing too few deals.Unfortunately, those few deals now want less and less money, becauseit's getting so cheap to start a startup. The four causes: opensource, which makes software free; Moore's law, which makes hardwaregeometrically closer to free; the Web, which makes promotion freeif you're good; and better languages, which make development a lotcheaper.When we started our startup in 1995, the first three were our biggestexpenses. We had to pay $5000 for the Netscape Commerce Server,the only software that then supported secure http connections. Wepaid $3000 for a server with a 90 MHz processor and 32 meg ofmemory. And we paid a PR firm about $30,000 to promote our launch.Now you could get all three for nothing. You can get the softwarefor free; people throw away computers more powerful than our firstserver; and if you make something good you can generate ten timesas much traffic by word of mouth online than our first PR firm gotthrough the print media.And of course another big change for the average startup is thatprogramming languages have improved-- or rather, the median language has. At most startups ten yearsago, software development meant ten programmers writing code inC++. Now the same work might be done by one or two using Pythonor Ruby.During the Bubble, a lot of people predicted that startups wouldoutsource their development to India. I think a better model forthe future is David Heinemeier Hansson, who outsourced his developmentto a more powerful language instead. A lot of well-known applicationsare now, like BaseCamp, written by just one programmer. And oneguy is more than 10x cheaper than ten, because (a) he won't wasteany time in meetings, and (b) since he's probably a founder, he canpay himself nothing.Because starting a startup is so cheap, venture capitalists nowoften want to give startups more money than the startups want totake. VCs like to invest several million at a time. But as oneVC told me after a startup he funded would only take about half amillion, "I don't know what we're going to do. Maybe we'll justhave to give some of it back." Meaning give some of the fund backto the institutional investors who supplied it, because it wasn'tgoing to be possible to invest it all.Into this already bad situation comes the third problem: Sarbanes-Oxley.Sarbanes-Oxley is a law, passed after the Bubble, that drasticallyincreases the regulatory burden on public companies. And in additionto the cost of compliance, which is at least two million dollars ayear, the law introduces frightening legal exposure for corporateofficers. An experienced CFO I know said flatly: "I would notwant to be CFO of a public company now."You might think that responsible corporate governance is an areawhere you can't go too far. But you can go too far in any law, andthis remark convinced me that Sarbanes-Oxley must have. This CFOis both the smartest and the most upstanding money guy I know. IfSarbanes-Oxley deters people like him from being CFOs of public companies, that's proof enough that it's broken.Largely because of Sarbanes-Oxley, few startups go public now. Forall practical purposes, succeeding now equals getting bought. Whichmeans VCs are now in the business of finding promising little 2-3man startups and pumping them up into companies that cost $100million to acquire. They didn't mean to be in this business; it'sjust what their business has evolved into.Hence the fourth problem: the acquirers have begun to realize theycan buy wholesale. Why should they wait for VCs to make the startupsthey want more expensive? Most of what the VCs add, acquirers don'twant anyway. The acquirers already have brand recognition and HRdepartments. What they really want is the software and the developers,and that's what the startup is in the early phase: concentratedsoftware and developers.Google, typically, seems to have been the first to figure this out."Bring us your startups early," said Google's speaker at the Startup School. They're quiteexplicit about it: they like to acquire startups at just the pointwhere they would do a Series A round. (The Series A round is thefirst round of real VC funding; it usually happens in the firstyear.) It is a brilliant strategy, and one that other big technologycompanies will no doubt try to duplicate. Unless they want to have still more of their lunch eaten by Google.Of course, Google has an advantage in buying startups: a lot of thepeople there are rich, or expect to be when their options vest.Ordinary employees find it very hard to recommend an acquisition;it's just too annoying to see a bunch of twenty year olds get richwhen you're still working for salary. Even if it's the right thing for your company to do.The Solution(s)Bad as things look now, there is a way for VCs to save themselves.They need to do two things, one of which won't surprise them, and another that will seem an anathema.Let's start with the obvious one: lobby to get Sarbanes-Oxley loosened. This law was created to prevent future Enrons, not todestroy the IPO market. Since the IPO market was practically deadwhen it passed, few saw what bad effects it would have. But now that technology has recovered from the last bust, we can see clearlywhat a bottleneck Sarbanes-Oxley has become.Startups are fragile plants—seedlings, in fact. These seedlingsare worth protecting, because they grow into the trees of theeconomy. Much of the economy's growth is their growth. I thinkmost politicians realize that. But they don't realize just how fragile startups are, and how easily they can become collateraldamage of laws meant to fix some other problem.Still more dangerously, when you destroy startups, they make verylittle noise. If you step on the toes of the coal industry, you'llhear about it. But if you inadvertantly squash the startup industry,all that happens is that the founders of the next Google stay in grad school instead of starting a company.My second suggestion will seem shocking to VCs: let founders cash out partially in the Series A round. At the moment, when VCs investin a startup, all the stock they get is newly issued and all the money goes to the company. They could buy some stock directly fromthe founders as well.Most VCs have an almost religious rule against doing this. Theydon't want founders to get a penny till the company is sold or goespublic. VCs are obsessed with control, and they worry that they'llhave less leverage over the founders if the founders have any money.This is a dumb plan. In fact, letting the founders sell a little stockearly would generally be better for the company, because it wouldcause the founders' attitudes toward risk to be aligned with theVCs'. As things currently work, their attitudes toward risk tendto be diametrically opposed: the founders, who have nothing, wouldprefer a 100% chance of $1 million to a 20% chance of $10 million,while the VCs can afford to be "rational" and prefer the latter.Whatever they say, the reason founders are selling their companiesearly instead of doing Series A rounds is that they get paid upfront. That first million is just worth so much more than thesubsequent ones. If founders could sell a little stock early,they'd be happy to take VC money and bet the rest on a biggeroutcome.So why not let the founders have that first million, or at leasthalf million? The VCs would get same number of shares for the money. So what if some of the money would go to the founders instead of the company?Some VCs will say this isunthinkable—that they want all their money to be put to workgrowing the company. But the fact is, the huge size of current VCinvestments is dictated by the structureof VC funds, not the needs of startups. Often as not these large investments go to work destroying the company rather than growingit.The angel investors who funded our startup let the founders sellsome stock directly to them, and it was a good deal for everyone. The angels made a huge return on that investment, so they're happy.And for us founders it blunted the terrifying all-or-nothingnessof a startup, which in its raw form is more a distraction than amotivator.If VCs are frightened at the idea of letting founders partiallycash out, let me tell them something still more frightening: youare now competing directly with Google.Thanks to Trevor Blackwell, Sarah Harlin, JessicaLivingston, and Robert Morris for reading drafts of this.
