My VC Thought Experiment

Joe Kinsella -

Welcome to my venture investor thought experiment, where we transport you back in time for an opportunity to invest in three startups. Your goal: decide whether you would have made these investments. Like all VCs, you are looking for the Perfect Deal: a company that will IPO within four years. In search of this Perfect Deal, you need to minimize downside risk by looking for new businesses with big market opportunities, limited or no competition, high growth business models, and strong barriers to entry.

Time machine ready, set, go...

The Bookseller

So it’s early 1995. You’ve read many articles over the last few years on the coming of the “information superhighway”, and have had a few internet startups pass through your offices. Mosaic Communications Corporation was incorporated less than a year ago, and Yahoo has been founded but not yet incorporated. Over the next year, the big IPOs will be from companies like Tivoli, Citrix and Netscape. The Netscape IPO will herald the beginning of the Dotcom Boom, but you can’t know this yet; right now shrink wrap software is still king.

In walks an enthusiastic former hedge fund executive looking to raise $8M for his new company, founded in his Seattle garage. The opportunity: sell books on the internet. The concerns flow like water from your VC mind:

  • Are the projected adoption rates for the internet realistic?
  • Will consumers really be willing to purchase goods over the internet?
  • Do consumers want to purchase books on the internet?
  • Can you build a business with the thin margins of a book reseller (made thinner with the cost of shipping)?
  • What would prevent Barnes & Noble from entering this market?

The Search Engine

It’s summer 1998 and you are riding high in the Dotcom Bubble. Last year saw IPOs such as Yahoo! and Open Market; this year Inktomi and Broadcast.com. Both Geocity and eBay are in a quiet period pending an IPO. There is some early talk that we are in a bubble, but all that is just Old Economy thinking. This is the New Economy, with limitless growth and constant innovation. We work in “internet time” now.

You meet two Stanford graduate students who have spent the last two years on a research project to index the internet. While they are more academics than entrepreneurs, they have some early traction with the output of their research, a search engine. Search has proven hot over the last few years, but it’s not clear a market with Lycos, Excite, Yahoo!, Dogpile, Inktomi, HotBot, and Ask Jeeves can support another standalone business. There are also early rumors Microsoft may be entering the market, and truth be told, the founders really have no idea how to make money from their search engine.

Your VC concerns:

  • Will the search market support another competitor?
  • Can new and unproven founders compete against entrenched competitors?
  • Is this a feature (Page Rank) or a business?
  • What is the business model?
  • Can you cost-effectively compete for advertising dollars against the big boys, with their proven ad sales engines?

The Social Network for College Students

It’s early 2004 and the Dotcom Boom is barely visible in the rearview mirror. The markets have recovered from the crash, but venture investing is far off its 2000 peak. The New Economy is a thing of the past, and the Old Economy is here to stay. Gone are the days of first movers advantage, paying for eyeballs, and building brands. Now you are looking for real businesses with proven fundamentals.

You meet a Harvard dropout about to move his fledgling startup to the west coast. The startup is a social network for college students, where they gather virtually to socialize. The web site has had good traction with four colleges, but has no clear business model. Also, social networking has had a spotty investment track record since its early success in the mid-1990s (e.g. Theglobe.come, Geoecities, Tripod). Also, there are a lot of companies that look like this one (SixDegrees.com, Friendster, Myspace, Classmates.com).

The concerns:

  • How big is the market of college kids who want to socialize online?
  • Can you invest in a startup with no clear business model?
  • Can you build a viable business around monetizing the online social interactions of college students?
  • What would prevent someone else with an established brand (e.g. Yahoo, Google) from entering this market?
  • How will they differentiate against the host of startups with similar messages?

Conclusions

Welcome back to 2013. I’m sure you didn’t miss the actual names of these companies, so here are the results:

  • Kleiner Perkins invested $8M in Amazon.com in July 1995, yielding a 55,000% return.
  • Andy Bechtolsheim, co-founder of Sun, invested $100K in Google in August 1998, which by 2010 was worth $1.7 billion.
  • Peter Thiel, co-founder of Paypal, invested $500K in Facebook in the summer 2004, which he sold in 2012 for more than $1B.

How did I do? Don’t ask. ;)

Related posts: Goldilocks and the Three Startups, Reflections: 1 Year Post Funding