Sunday, April 29, 2007

Thinking Small: VC's are learning that tiny deals can go a long way

By: Ryan McCarthy

As venture capital deals go, it doesn't seem like much--just $6,000. But that was all Sam Altman needed to get his new business, a cell phone software maker called Loopt, off the ground.

And if the investment seems rinky-dink, the investor certainly isn't. The money came from Y Combinator, a Cambridge, Massachusetts-based venture firm founded by heavy-hitting Internet entrepreneur Paul Graham. What's Graham, who created the seminal Web application that eventually became Yahoo (NASDAQ:YHOO) Store, doing playing with such trifling sums? "It's gotten to the point now where the most important things you need to found a tech start-up are food and rent," he says.

Graham is not the only one who feels that way. A small but growing number of venture firms now provide seed-level funding--thousands rather than millions--to promising young start-ups. The approach differs from the usual venture capital model, in which investors take equity at the outset and demand board seats and input in day-to-day operations. But these smaller deals make particular sense in today's marketplace, the investors say. After all, tech firms now can be launched for peanuts. Thanks to declining costs for servers, more powerful coding languages, and the prevalence of free open-source software tools, brand-new start-ups can attract sizable audiences for next to nothing. And with the market awash in private equity, competition among investors for promising companies and concepts is more heated than ever. As a result, the number of seed-level deals increased almost 50 percent in 2006, according to PricewaterhouseCoopers, the National Venture Capital Association, and Thomson Financial (NYSE:TOC). "The days of throwing huge sums of money at an entrepreneur are gone," says Mark Heesen, president of the NVCA.

Y Combinator is a good example of the trend. Launched in 2005, the venture firm now dishes out between $10,000 and $20,000 per company to fund a three-month stay in Cambridge, where entrepreneurs spend their time perfecting their technology, meeting with mentors, and swapping ideas with peers. In exchange for the cash, Y Combinator takes a small stake in the companies it funds, usually about 6 percent. So far, two of its companies have been acquired, including Reddit, a news-aggregating site recently bought for an undisclosed sum by Condé Nast. Y Combinator is banking on a similar outcome for Sam Altman and Loopt.

Altman, now 22, founded the business in 2005 while he was a sophomore at Stanford. He was looking for a way to keep in touch with his friends on campus and got the idea to write software that would allow all of his friends with GPS-equipped cell phones to find one another. Altman heard about Y Combinator's newly launched program from a classmate and got in touch. Later that year, he got $6,000 from Y Combinator and left school. He spent the summer in Cambridge developing his product, listening to guest speakers, and learning the nuts and bolts of running a business. In return, he gave his investors an undisclosed amount of common stock in his company, which is based in Palo Alto.

For Altman, the trade has been more than worth it. Last September, Loopt launched its cell phone software exclusively with Boost Mobile, a subsidiary of Sprint Nextel (NYSE:S) with 3.8 million subscribers. Boost has since invested several million dollars in a TV advertising campaign to support the launch. Altman also plans to partner with several major cell phone carriers, which will roll out the service in 2007. The company is adding staff and recently raised $5 million in Series A financing from powerhouse VC firms like Sequoia Capital, which helped launch Google (NASDAQ:GOOG), Yahoo, and PayPal (NASDAQ:EBAY). "We have five people on our team, none of whom is over 23 and none of whom has any business experience," says Altman. "Y Combinator really understands what a company needs in its first three months."

Techstars, a Boulder, Colorado-based venture firm, launched a similar program last year, offering start-ups as much as $15,000 and a three-month stay in Boulder, in exchange for 5 percent equity. Charles River Ventures, one of the nation's oldest venture capital firms, has also created a seed-level program, albeit with a slightly different approach. The CRV QuickStart program, launched in 2006, provides tech start-ups with low-interest loans of an average of $250,000 called convertible notes. Should the borrower go on to raise venture capital, the loan can be converted into equity at a discounted rate (a maximum of 25 percent off). The deal also gives Charles River the option to participate in the Series A round. "What we've noticed is that there is often an inverse relationship between the amount of money entrepreneurs raise and the quality of their companies," says George Zachary, a partner at Charles River Ventures.

For entrepreneurs, of course, these deals are a mixed bag. On the plus side, you get to keep more control. Angel investors, for example, often ask for a 20 to 40 percent equity stake right off the bat and will want to have some control of operations. Y Combinator, QuickStart, and other seed investors take much smaller stakes. What's more, there's no haggling over valuation--a process that can take months when dealing with VCs or angels. And getting accepted to these programs can be painless. You simply submit a description of your business or a prototype and sign a contract, a potentially crucial time savings that can help get your product to the market faster. The downside? If your venture hits it big, giving away a sizable stake in your company for a few thousand dollars might seem like a bad deal.

Still, QuickStart was appealing to Mike Phillips, co-founder of Mobeus, a communications software company based in Cambridge. Lacking a prototype or any significant market research, Phillips knew his company would have a hard time attracting VCs or angels. Indeed, without a clear idea of how big his company could become, he was hesitant to talk to any investors, whom he knew would ask him to place a specific value on his company and be eager to start talking exit strategies.

Instead of entering a guessing game about the future prospects of his company, Phillips used $300,000 from QuickStart--a 6 percent loan that he was able to close in just two weeks--to build a prototype and research the market while working closely with Charles River. The relationship has worked well enough that Phillips has just closed a multimillion-dollar Series A round with Charles River and Sigma Partners. The funds will help Mobeus bring its software to the consumer market, which Phillips expects will happen this summer. The ease and relative calm with which the deal proceeded almost made him forget he was dealing with a venture capital firm. "It's just a much simpler deal," says Phillips. "In a way, this is more natural than a typical VC deal because it gives both sides a longer time to get to know each other."

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