(My day job is investing in the public markets, but I have a small personal portfolio of private investments, mostly angel investments in Internet and software related startups. In the past six months I have spent some time helping a few of these companies raise venture capital and this is the second of three posts I am writing on some of the key trends I have observed during this process.)
In my last post (read it here), I wrote about how VCs were essentially abandoning the early stage Internet market and instead waiting to see which firms gain traction before placing any bets. As I said before, I don’t have a problem with this trend in theory because it makes rational sense given how the consumer Internet market is evolving.
However, a more personally disturbing trend that is emerging in the VC marketplace is one in which VCs are taking the behaviours they have learned in the consumer Internet space and trying to apply them to the enterprise IT space, especially to any SaaS based software/service (which is basically a huge chuck of enterprise IT start-ups these days). Indeed it is not uncommon for enterprise SaaS startups to get the same line from VCs that consumer Internet companies are getting, namely “come back and see me after you have a site up and a bunch of customers”.
A Whole Different Ball Game
At first blush, such demands don’t seem that unreasonable, after all, many of the same trends impacting the consumer Internet space, such as the decline of up front capital costs, are impacting the enterprise IT space. However, the enterprise IT space remains a very different animal from the consumer Internet space.
Three key differences between the two are:
1. Enterprise customers don’t do betas. Consumer Internet companies can recruit beta customers easily because they are literally giving something away that while useful, is still relatively trivial in the grand scheme of most people’s lives. In contrast, what enterprise manager is going to risk their career entrusting sensitive data or business processes to a site that officially declares itself as not ready for prime time? Sure they might help test the site with dummy data and provide feedback on it, but in general “beta” is not a good word when it comes to recruiting enterprise customers. This means that for any enterprise site to get real traction it has to formally launch the site and be willing to represent it as reliable, scalable, and secure from Day 1.
2. Enterprise SaaS infrastructures are inherently more expensive than consumer infrastructures. While building a reliable, scalable and secure enterprise web service is a lot cheaper than it was 5 years ago, it’s still relatively expensive. Enterprise customers tend to ask pesky questions about things like data security, disaster recovery, peak capacity, application integration, financial viability and even (gasp!) customer support. At most consumer Internet sites these questions are never asked, but enterprise sites have to put these kinds of things in place before many companies will even consider trying them. Yes, you can build an enterprise site for $250K, but no enterprises will actually use it until you support that site with a lot of expensive infrastructure and services which makes enterprise sites inherently more expensive to build and operate.
3. Enterprise services must still be sold. Most consumer sites have a very simple business model: give away your service for free and hope enough people like it that you can start to make some money from advertising, referrals, and perhaps subscription frees. In contrast, most enterprise sites have no realistic hope of ever getting significant advertising or referral revenues and thus they must charge each and every customer.
Sure, they can come up with innovative ways to lower up-front adoption costs, such as “freemium”, “try before you buy” or what have you, but at the end of the day they still have to convince companies to pay them money and that takes sales and marketing in the form of lead generation, inside sales, and pre/post sales support, at a minimum. Yes, that’s less expensive than the old model of hiring $250k/year direct sales reps to go elephant hunting, but it still costs money.
Net, net, despite the fact that enterprise IT sites look somewhat similar to consumer Internet sites, the fact remains that enterprise IT sites are still significantly more expensive to build and operate.
Shrewd or Lazy?
Given all this, the position that VCs are increasingly taking in the space, that of “come back when you a have a product and customers” is highly frustrating for enterprise entrepreneurs. Should an enterprise site be fortunate enough to build out its entire infrastructure and then recruit a bunch of customers to its platform, the question really becomes: What in the world do I need a damn VC for when the hard part of the startup is over?!?
Granted, expansion capital will still have a role, but by asking enterprise entrepreneurs to go build and operate fully functioning businesses before they will even consider making an investment, VCs are establishing an awfully high Ask, one that has some of the same implications as it does in the consumer space, namely it makes angel investors the king makers and creates a selection bias in the expansion stages towards “small ball” investments.
Personally, my problem with VCs doing this is that I don’t think it has the same rational basis as it does in the consumer space. VCs all know that you can’t just wing it with an enterprise business. They know that enterprise customers care about financial viability, customer service, and infrastructure and that all those things take money. The only thing I can come up with is that the consumer space is training VCs to be lazy investors. Why go out and do a lot of work to understand a company’s target market, gauge potential customer interest and assess the competitive landscape, when you can just declare success a crap shoot, go golfing and tell someone “call me when you have traction”.
I understand the attraction of such a stance, but whereas it has some basis in consumer Internet because it’s arguably anyone’s guess what big trend is going to hit the tween set next, within enterprise IT, there is usually a very objective set of demonstrated market needs and you know that companies will pay for products that cost effectively meet those needs. I guess what I am saying is that applying the same set of investment criteria to enterprise IT startups as you apply to consumer Internet startups strikes me as intellectually lazy and the anti-thesis of true venture capital.
All that said, I don’t believe that this is the predominant mentality within enterprise IT investing just yet. It’s just that over the course of the past year or so I have seen the trend gain more and more prominence. For the sake of innovation and a healthy enterprise IT market, here’s one trend I hope gets nipped in the bud.