Clouds Brewing in the Business

This post was triggered by an interesting question that Wil Schroter from Go Big Network asked me.

Venture capital, like any asset class, has a natural cycle to it. As in the bible, it has followed roughly a seven year cycle. One can argue dates and duration, but these have roughly been 1980-87, 1987-94, 1994-2001, 2001-?. Our last cycle clearly had a significantly higher beta than the others, causing the current one to be much more moderate.  Many people have commented that the number of "quality" businesses started (taking a long-term perspective) in any given year, tends to grow in a gradual, linear fashion. While I don’t know if this is true, it certainly feels right. What causes the cycles to peak and bottom tends to be capital flows into the business and the number of companies started. The public markets and general economy are the other key factors as corporations tend to buy technology when the economy is expanding along with share price, and they tend to aggressively cut budgets when share prices plummet (to get Earnings up to offset the falling P/E).

During the last bottom in 2000-1, assuming you could raise the capital, you had a pretty open competitive landscape. Since corporations were not buying, you had a somewhat limited view of customer demand. But, you had the time to get the kinks out of your business and to do a slow roll into the market place. As a result, there are quite a few companies that are in the vanguard of their space, doing $40-80m in revenue today. They got ahead, positioned themselves well and when corporate and consumer buying came back, they took off.

Today, there is an increasing amount of capital flowing into the business. You are seeing brand name funds that had cut their fund size from $800m-1B back to $400m, now out raising another $600-700m fund. With every $4B Skype acquisition or $600m Myspaces purchase, fund size grows in $50 and $100m chunks. Consumers and corporations are also buying services and products at a healthy clip.

To make matters worse, the cost of entry for many of the new businesses is dramatically lower. So, you are seeing a 1000 Flowers Bloom. You have 20-30 different search engine plays, 10-20 podcast services, legions of anti-spam companies and many more over populated spaces. VC firms are targeted given market spaces and dropping one or two plays into them. When aggregated across the many firms around, you get a lot of plays popping up in each.

What is an entrepreneur to do? Life is not dire. There are still many great opportunities around but you need to make certain you don’t get swept up in the euphoria. Here are my two cents, in random order:
1) Build to Last: figure out if you have a product or a company. many of the quick launch companies are feature sets, packaged for a quick flip. As Jason Fried has said, building to flip is building to flop.
2) Know Thyself: determine what you do really well (what customer need you meet best) and target that with laser like focus. get happy customers using your product. swing for the fence "platform" plays are very expensive and very scary in this kind of market.
3) Burn, Baby, Burn: keep your cash burn down. these periods often become a war of attrition. you do not want to fail just short of the finish line nor cross the finish line with so much capital raised that you have no equity left. the instinct is to pour cash in to accelerate and beat the new entrants. the reality is that the market advances at its own rate and cash burn does not change it. don’t win the battle and lose the war.
4) Skate to Where the Puck Will Be: listen to the overused Gretsky quote. if the opportunity is obvious and publicized, it is obvious to everyone in Menlo, Chicago, Shanghai and Moscow. Figure out where the logical choke points are going to be in the future if current trends continue to play out. think of services (hosted or otherwise), products or plays that will solve many of these. for example, as more and more people came online, the ability to make secure/anonymous payments grew more important. Paypal figured this out early.
5) Quality is Job 1: when the dust settles, it will be the companies whose products work consistently, simply and intuitively. Don’t over engineer.

While I don’t think we are on the verge of a precipice, I would be very careful in how you approach your business, how you spend your money and how enthusiastically you drink the coolaid. I will write in the future about the risk of ad based models, but remember, if more and more plays earn their keep through advertising models, there are going to be a lot of dead bodies when the next recession hits and ad budgets are slashed. Just sip at the glass and remember that gravity still exists…