SAN FRANCISCO — Call it the Facebook effect. Until recently, investors had been all too eager to pour millions into any web startup with rapid growth, regardless of whether it made money or even had plans to do so down the road.
But after Facebook’s rocky initial public offering and flame outs at Zynga and Groupon, venture capitalists are entering a picky phase.
David O. Sacks, a Silicon Valley executive who sold Yammer to Microsoft for $1.2 billion last year, summed up the challenges in a bearish note on Facebook last August.
“I think Silicon Valley as we know it may be coming to an end,” Sacks wrote. “To create a successful new company,” he said, entrepreneurs have to find an idea that “has escaped the attention of the major Internet companies, which are better run than before.” To attract follow-up money, new companies now have to prove themselves for less than $5 million.
On top of that, they must be “protectable from the onslaught of those big companies once they figure out what you’re on to,” Sacks said. “How many ideas like that are left?”
Sacks’ comments were widely debated within Silicon Valley. One of his most vocal critics was Marc Andreessen, the co-founder of Netscape and Andreessen-Horowitz, a venture capital firm, who said on Facebook that the opportunities for startups were “unending.”
But startups are finding that their supply of capital is not.
No longer favored are e-commerce startups, which face logistical hurdles and require a lot of money. The celebrated shift to smart phones, once welcomed with an outpouring of investments, is now making some investors nervous as monetization proves harder for mobile devices than it did for the web.
Investors have also grown weary of startups and applications that rely entirely on Facebook, Twitter and LinkedIn for customers, now that those companies are focused on their own bottom lines. And Silicon Valley is discovering that while it may be easier than ever to start a company, it is harder than ever to build an enduring business.
Younger startups are beginning to feel the pinch.
CB Insights, a research firm, analyzed 4,056 initial, or “seed,” investments made in tech startups in the United States since 2009. It found that more than 1,000 startups that attracted seed financing from angel investors - wealthy investors who put in money from their own pockets - will find themselves orphaned this year when venture capitalists reject requests for more money. As a result, $1 billion in angel investments could evaporate.
That carnage hardly compares to the bursting of the dot-com bubble in 2000, when $3 trillion evaporated on the Nasdaq, but it is enough to give Internet investors and entrepreneurs pause.
CB Insights predicts that Internet startups will be the hardest hit because, while they attracted more seed money than enterprise and hardware companies, they will most likely have a harder time securing follow-up investments.
Part of the problem is simple math. Angel investors seed businesses with small sums, often less than $1.5 million. But to grow a business, entrepreneurs eventually have to solicit financing from the venture capitalists who invest on behalf of endowments, pension funds, foundations and the like. And while the number of angels eager to write checks has increased, the number of active venture capitalists has decreased.
But investors say it is not just the bottleneck that is to blame. The realities of building an enduring business are starting to sink in.
“The valuations got ahead of themselves,” said Rich Wong, a venture investor at Accel Partners. “Where people only paid attention to multiple quarters, now they are looking more than a year ahead for projected results.”
Wong said e-commerce companies in particular were drawing closer scrutiny. Investors who took note of Amazon’s $1.2 billion acquisition of Zappos and its $540 million purchase of Quidsi, the owner of Diapers.com, poured millions into e-commerce sites, only to discover that they are difficult to run.
Gilt Groupe, a flash deal site for fashion, raised some $220 million in capital but is still not profitable. Last year, the company was forced to cut staff. It is scaling back on smaller brands such as Gilt Taste and Park & Bond, and it has put Jetsetter, its popular online travel site, up for sale. Fab.com, a daily deal site for design, raised money at a lower valuation than it had planned because of Facebook’s troubled IPO.
ShoeDazzle, Kim Kardashian’s shoe site, raised $66 million and Lot18, a flash deal site for wine, raised $45 million from investors impressed with their user growth. Both companies were forced to make staff cuts last year.
“I am skeptical of ‘Commerce 2.0,’ which has come to mean daily deals and discounts,” said Peter Fenton, a venture partner at Benchmark Capital. Fenton said flash sites such as Gilt “are capital-intensive, face structural challenges to their margins, and if they do go public, they trade at low multiples. Plus, I seriously question their ability to compete with a juggernaut like Amazon.”
Likewise, investors are becoming skeptical of social games and applications that build on social networks such as Facebook, Twitter and LinkedIn. These social networks are themselves are feeling pressure to monetize.
For example, Facebook made tweaks to its news feed algorithm last fall that reduced the number of users who can view Facebook status updates.The company said it made the tweaks to serve its users more-relevant content, but advertisers complained that the changes cut the audience for their posts in half.
The real impetus for the change, advertisers say, was to force companies to use Facebook’s new promotion feature, which gives users the option to pay to ensure their updates reach a wider audience.
BranchOut, a professional network that culled data from LinkedIn and Facebook, raised $85 million from venture investors but had to change its business model in 2011 after LinkedIn cut off access to its data. Tweetro, a Twitter application for Windows 8, was removed from the market in November after it outgrew Twitter’s new third-party user limits.
“Investors are getting smarter about the sources of traffic,” said Brian O’Malley, an early investor at Battery Ventures. “Companies that rely heavily on Twitter and Facebook, or mobile, are having a tougher time.”So which consumer startups are likely to survive the chopping block?
“People are looking more seriously at engagement metrics,” O’Malley said. “What percent of your users are coming back? How engaged are they? Are they a ‘sticky’ user ?”
Business, Pages 23 on 01/21/2013