What Cloud Computing Offers Startups, Part 2

In a previous post, I discussed the operational and financial benefits of cloud computing for start-ups. Today I'd like to discuss another benefit that's just as important, and that has far-reaching implications for the direction of IT development in the coming years.

Cloud computing makes it easier than ever for software companies to deliver innovative, business-critical services to Small and Medium-sized Businesses (SMBs).

Until recently, most software start-ups avoided the SMB market. Selling products and services to SMBs seemed daunting for several reasons:

• Limited Budgets: SMBs are well known for having spartan IT budgets. Beyond buying basic networking gear, Microsoft Office, and perhaps an accounting system, a small business may make hardly any IT investment at all. Even larger, mid-sized businesses tend to be conservative spenders, leery of risk and demanding a clear ROI from a new product—even though it's often difficult or impossible to demonstrate an ROI with a brand new product.
  
• Distribution Overhead: Reaching SMBs has traditionally required a channel (e.g., a distributor who served SMBs in a given area or industry) or, worse, many channels and lots of advertising. Channels require a lot of attention in the form of training and support, and they take a bit out of a start-up's profit margin.
  
• Deal Flow: To achieve sufficient revenue, a start-up would need to close tens or hundreds of small deals to equal the same amount of revenue possible from one or two large enterprise sales. With limited staff, attention, and marketing funds, most start-ups (with the hearty encouragement of their investors) have preferred to pursue opportunities in the enterprise market.
  

But in the past couple of years, cloud computing has knocked down all these barriers. In fact, cloud computing solutions often start with the premise that the customer has limited time and money for managing complex, but important IT operations. The cloud computing vendor rushes in as the SMB hero, managing everything behind the scenes, while offering the customer an easy-to-use, comforting Web interface.

Old Obstacle	Cloud Computing Solution
Limited Budget	Cloud computing solutions, such as SaaS applications or hosted storage, can be delivered cost effectively. There's no need for on-premises hardware and time-consuming installation and configuration services. Customers buy just what they need, when they need it. Delivery on popular platforms such as Force.com and QuickBase greatly reduces customer-acquisition costs, which normally the vendor would have to pass along to the customer.
Distribution Overhead	Cloud computing services are marketed, sold, and delivered over the Web. Customers can discover point solutions built on cloud platforms offered by vendors they already know and trust (e.g., Amazon, Intuit, Microsoft, Salesforce.com). There's no need for a large sales team and offices scattered around the country, nor is there a need to sign on and train large numbers of resellers. Sales and marketing take place online.
Deal Flow	Through promotion in established platform communities, as well as through viral marketing, blogging, and targeted marketing efforts, vendors can find tens and then hundreds or thousands of new customers. At a time when enterprises are cutting their IT budgets, reaching SMBs who are looking for cost-saving, operational improvements and strategic advantages offered through new capabilities, seems like an attractive idea.

Cloud computing has changed the nature of the typical start-up. Instead of a capital-intensive organization building "enterprise-class" solutions for large companies, today's start-up is more likely a small, nimble team, taking full advantage of the economies offered by platforms like EC2 and open source, and delivering online services that are valuable to companies of all sizes—even another five-person company down the hall.


Photo of man and clouds by donabelandewen, Creative Commons License, some rights reserved.

What Cloud Computing Offers Startups

At the Intuit's mini-conference on "Startups and the Cloud," the discussions, which varied from investment to technology, repeatedly raised the question of what advantages, if any, cloud computing offered startups.

To answer that question, we need to know what cloud computing is. I'm going to borrow the definition developed by NIST, which Longworth Venture Partners analyst Vishy Venugopalan cited in his overview of cloud computing, which kicked off the day's events:

Cloud computing is a model for enabling convenient, on-demand network access to a shared pool of configurable computing resources (e.g., networks, storage, servers, applications, and services) that can be rapidly provisioned and released with minimal management effort or service provider interaction.

Five or ten years ago, it was not uncommon for a newly-funded start-up to spend tens or hundreds of thousands of dollars on infrastructure. Servers, disk arrays, back-up power supplies, management and monitoring software, an air-conditioned room with a raised floor—the list of capital expenditures could be impressive, and this investment needed to be made before engineers could begin any significant work developing products.

Cloud computing changes all that: it minimizes infrastructure investments, so that companies only need to invest in IT services when they're needed.

Cloud computing eliminates the need for that air-conditioned room filled with expensive server racks. It eliminates the need for the local IT manager to watch over them. And it shortens the management team's list of headaches, by sparing them the details of back-up tapes and server upgrades. IT can be provisioned cheaply and immediately—today, this afternoon, now, and development can begin right away.

Todd Hixon from New Atlantic Ventures put it this way:

Cloud computing gives you a sandbox for delivering solutions while assessing demand. It enables you to avoid needless investment in infrastructure.

Jeffrey Beir from North Bridge Venture Partners agreed:

Cloud computing allows developers to focus on the IP (intellectual property) that's unique to them.

After all, it's that unique IP that's ultimately going to make or break the company. It's the unique IP—not a rack of Dell servers in a computer room—that's going to be the quintessence of the start-up's brand, differentiating the company from the hundreds of other start-ups and thousands of larger companies already crowding the market.

By minimizing infrastructure costs and infrastructure management costs, cloud computing enables young companies to spend its precious capital on what's most essential. For young companies in this time of tight budgets and hard decisions, cloud computing is a financial and operational boon.

The Six Traits of a Fundable Entrepreneur

Yesterday afternoon in Waltham, Massachusetts, Intuit hosted on a mini-conference about the opportunities that cloud-computing offers start-ups. "Startups and the Cloud" proved to be an engaging event, packing a small auditorium on the campus of Bentley College. Sessions ranged from Longworth Venture Partners' Vishy Venugopalan's overview of the cloud computing marketplace to an open Q&A with Intuit founder Scott Cook to panel discussions with venture capitalists and CEOs about cloud computing and the changing economic environment for young companies.

The venture capitalist panel featured a seasoned team of investors:

• Jeff Bussgang from Flybridge Venture Partners
  
• Jeffrey Beir from North Bridge Venture Partners
  
• Todd Hixon from New Atlantic Ventures
  
• Shawn Broderick from
  TechStars
  

This group offered much wit and wisdom on a variety of topics. For now, I'll simply offer their composite profile of a fundable entrepreneur.

In response to a question from the audience, the panel offered this list of traits that they look for in an entrepreneur:

• Passion
  
• Domain expertise (the entrepreneur knows his or her area thoroughly, and isn't just coming up with an idea in response to a news story, for example)
  
• Unfair advantage (something that gives this team of entrepreneurs a sustainable head-start in the market)
  
• Street smarts (knowing how to get things done in difficult situations)
  
• A whip-smart mind
  
• Salesmanship
  

And Shawn Broderick offered this observation, which deserves to be mounted on a plaque over every entrepreneur's desk:

"Execution is insanely important."

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.