Twilight for Ad-based and Freemium-Model Start-ups

A recent article in the New York Times breaks the news that "Angels Flee From Tech Start-ups": angel investors (wealthy individual investors) have lost money in the stock downturn and are no longer as willing to fund early stage companies. Angel investors typically make investments ranging from $10,000 to $1 million to help companies when they are just beginning. Once a company, applying its angel funding, has built a functioning prototype and perhaps even won a few customers, it can proceed to ask for more substantial funding—perhaps $1-5 million—from venture capitalists (VCs).

But, of course, getting VC funding is getting a lot harder, too. Ask anyone in a start-up these days, and they'll tell you that the spigot of VC funding has been turned almost entirely off. VCs like Sequoia Capital recognize that difficult times call for tight fiscal management (see Sequoia's famous Presentation of Doom to get a sense of the VC community's apprehension about the economy).

Even aside from the plummeting economy of the past few months, the angel/VC model for starting a company has been becoming increasingly problematic. Angels and VCs put money into a company, of course, hoping to get a substantial return, often 10x or more, on their investment. But as Om Malik pointed out in his recent post, "IPO Drought Hides Bigger Tech Woes," only a handful of companies from any industry have gone public over the past few years. He writes:

Look at some of the numbers: in 2008 there were nine IPOs in the technology, telecom and media (TMT) sector vs. 77 in 2007. In 2008, there were only six VC-backed IPOS and only one from Silicon Valley.

Without a viable IPO market, the only way a start-up can deliver a big return to investors is by being acquired. But if acquirers know the start-up has no alternative but to be acquired, they can stall negotiations and work out a low price. And large companies, of course, can only acquire so many small companies. Many small, worthy companies will likely go begging for suitors. Which is another way of saying that many VC investments, however well managed, will not deliver their expected returns.

The classic Silicon Valley model of investing in a company, growing it over some number of unprofitable years, and then exiting through an IPO or M&A activity is looking increasingly sketchy.

Here, then, is the lunar landscape start-ups find themselves inhabiting:

• A moribund IPO market
  
• Declining consumer spending
  
• Business spending curtailed
  
• Inventories growing
  
• Non-essential purchases by consumers and businesses deferred indefinitely
  

No wonder VCs are holding onto their cash. Pouring $5-20 million into a company that remains unprofitable for years just doesn't make a lot of sense in this environment.

Web 2.0 Business Models

The lack of angel and VC funding for has several implications for the types of business a software start-up can pursue. Or perhaps, without wanting to sound too catty, I should say that the lack of angel and VC may force a growing number of start-ups to behave like traditional businesses.

Far too many start-ups these days build technology (typically a Web site) and assume that they'll find the business model later, maybe much later, years later, if ever. I'm not opposed to this approach outright. Twitter came about this way because a company was willing to invest in a technology without a clear business case, and I think the communication on Twitter can be powerful and useful. But I think the high tech industry loses something—more than a lot of money, I mean—when the normal model for launching a business is, "We'll figure that out later, and besides, we can start selling ads next quarter." The industry's business acumen is becoming dull or at least severely constrained.

A friend recently directed my attention to a blog post, "Web 2.0, Revenue Models and Profitability: A Web 1.0 Comparison," which summarily points out that the Web 2.0 Emperor of Revenue is looking a tad bare:

"As we recently learned that Digg was still losing money on revenue numbers that look quite paltry, it occurred to me that Digg and some of Web 2.0's other hot young startups really aren't hot young startups anymore.


Facebook was launched in February 2004. Digg was launched in November 2004. Twitter was launched in July 2006. Facebook is almost five years old, Digg is just over four years old and Twitter is two and a half years old.


They all share a common trait: none has developed into a self-sustaining business whose financial future seems assured.


One of Web 2.0's biggest myths: it's far easier and far cheaper to get a startup off the ground today than it was a decade ago.


Citing the wide range of mature, open-source technologies and the abundance of talent available today, Web 2.0 proponents have told us that taking an idea from concept to reality, getting it launched and growing it can be a cheap affair.


If that's the case, one would logically assume that today's Web 2.0 startups would have developed into lean, mean revenue-generating machines. Instead, we see the exact opposite."

The ad revenue many of these companies generates almost seems like an afterthought to me, as though the management team was saying, "Well, we've got all these users on our site. We might has well make a little money off them by advertising." Revenue isn't built into the business; it's tacked on, literally as far as HTML goes, in the form of banner ads and text ads. These companies have a technology model, they also probably have service and community models, but they don't really have a business model, per se. The business aspect of their businesses is decidedly an ancillary concern.

Risks for Freemium Businesses

A popular business model among Web 2.0 companies is the so-called freemium model, based on a coinage by Jarid Lukin of Alacra. As Amy Shuen explains in her book, Web 2.0: A Strategy Guide, the term "freemium" was first introduced by venture capitalist Fred Wilson on his blog, A VC, where he described the model this way:

Give your service away for free, possible ad supported but maybe not, acquire a lot of customers very efficiently through word of mouth, referral networks, organic search marketing, etc., then offer premium priced value added services or an enhanced version of your service to your customer base.

The word "freemium" is a portmanteau word combining free + premium. Offer a free service, then charge for Pro services you develop over time.

From a business point of view, the freemium model has clear advantages over simple ad-based models, in that Pro features can deliver real value that customers will pay for, regardless of whatever's happening in the pricing and ROI of online ads.

But the freemium model poses its own risks, which are exacerbated by the tight money market and the widespread disappearance of discretionary spending:

• It can take quite a while to develop services to the point where add-on Pro features are worth paying for. If it takes a start-up 12 months to develop its community, 6 months for its Pro features to mature and begin gaining traction, and another 6 months for the Pro features to catch on with users (in an economy where much non-critical spending is being cut), does the start-up have enough money in the bank to survive? Have its investors run out of patience?
  
• While the company is growing its community to attract enough purchasers of Pro services, its data center needs and operating costs continue to grow. If not managed shrewdly, these mounting costs, along with increased tech support costs for Pro services, may erase any financial gains realized by revenue from Pro services.
  
• The company has to find the right dividing line between free and Pro. Give too much away, and the company won't make enough money from the Pro. Give too little away, and the company won't attract a sufficient number of free users to sustain the community and its services in the first place.
  

I think there's lots to admire about freemium sites like Flickr, but less mature, freemium-based start-ups may find themselves racing against an unforgiving clock.

What Start-ups Founded in 2009 Will Likely Look Like

Without the luxury of $5 million in the bank (or even $1 million in the bank, courtesy of angels) to grow a user base that doesn't cover its own costs, new start-ups will have to focus intensely on revenue generation and profitability from the get-go.

This is not a bad thing. It is, oddly enough, an unfamiliar thing to many people founding start-ups. The requirement for short-term revenue might even strike some founders as mind-bloggling, unfair, and needlessly constraining.

To me, such a reaction signals how dependent the high tech industry has become on VC funding—on having a sinecure, more or less, for creating and selling advanced technical solutions. I'm not against VC funding by any means, but I think it's troubling that so many people in technology have difficulty even considering building a company that, like most companies in most other industries, actually makes money sooner than later. And I think, as the Centernetworks author noted above, it gives lie to the Web 2.0 idea that it's faster and easier to build a business thanks to LAMP stacks, affordable hardware, etc. People using those technologies aren't building profitable businesses. They're delivering services to growing communities, and often as not losing money hand over fist.

Striving for short-term revenue (perhaps, 6-12 months, based on the credit limits of the founders credit cards and the balance in their savings accounts) and possibly even short-term profitability (12-24 months!) will require significant changes in the thoughts and actions of founders.

But the high tech industry has worked through transformations of similar difficulty over the past decade or so. Remember when you could take 18-24 months to develop your first product? Now it's weeks or a few months, at most. Remember rigid waterfall development cycles? Now agile development is becoming the norm. Remember lavish tradeshow booths and offset-printed brochures? Now you if you market through tradeshows at all, you're likely using a popup booth and telling people to download the PDF. Or you're reaching customers through Web seminars, forums, Twitter, and Skype. I expect that, having endured the brutal realities of 2009, a growing number technologist will come to embrace the new, old way of thinking about business and revenue.

Focusing on proximate or even immediate revenue generation has several implications for a company's business model and its founding team.

1. The company may need to begin with consultative selling, so the founding team may need to include one or more people who can sell services and manage client interactions. Instead of waiting 6-12 months to hire a salesperson, the company might include one in the founding team.
   
2. Companies will not have the luxury for long iterative development cycles; they'll still likely use agile development and iterate, but it now makes more economic sense than ever to invest in customer experience analysis, really analyzing what customers need and want, rather than trusting the founders' hunches and correcting misperceptions over a matter of 6-9 months.
   
3. Faced with curtailed spending by businesses and a wealth of sophisticated technology offerings from both large and small technology vendors, a start-up's best bet may be to focus on narrow problems specific to a particular industry. might be a good idea to tackle a difficult problem that requires domain expertise and tenacity—more expertise and tenacity than large vendors have been willing to contribute. Implication: the founding team will likely then include one or more members with deep expertise in a vertical market.
   
4. If start-ups have adequate resources, they should consider a blue ocean strategy, creating a new uncontested market that solves problems not addressed by other products and services currently available.
   

These implications and market pressures apply to start-ups that don't have the luxury of having millions of dollars in the bank. They obviously don't apply to existing companies that are already well funded. And I'm far from expecting or hoping for the demise of any big-name Web 2.0 companies like Digg or Twitter. In fact, I expect Digg and Twitter and other big-name Web 2.0 properties to survive, in part because they're important enough in the technology ecosystem, which includes the business managers who effect M&A transactions, to last until they find some sort of shelter. (I'm titled this blog post "twilight," not blackest midnight and not noon. Some entities will linger for a long time. But things that were possible earlier, will likely not be possible again soon.)

But for every Digg or Twitter, there are probably dozens of smaller, less well-known Web 2.0 companies that will find it increasingly difficult to survive. I wish them well. At the same time, I hope that most of the teams founding start-ups this year will not follow their example. Instead, I would encourage founders of new start-ups to think more like traditional business people.

If you're not taking in VC funding (because you can't get any), you don't have the pressure of delivering a 10x return in a few years. Instead, you face the different, but still daunting challenge of growing a profitable business. That's hard to do in any market, but it's a worthy undertaking, no less noble, and no less difficult.

Founders, listen: Business is hard. You're smart and motivated. Get on with it.