Buzzwords usually make my skin crawl, but I like the term “web 2.0.” Although there isn’t yet a single, precise definition, people generally seem to be converging on a common framework (see Richard MacManus, Wikipedia, Jared Spool, Kelsey Ruger, and Danah Boyd). Part of the allure, though, is that the web 2.0 concept is still a work in progress, so we’re learning as we go–and hoping the eventual reality will meet or exceed current expectations.

I’m frequently asked if we have a specific web 2.0 investment strategy. Obviously, there isn’t an all-inclusive answer (as David Hornik jokes: “venture capitalists come in all shapes and sizes. I, for example, am short and fat”). However, there are a few key areas which I find particularly important:

• Management team. Two points here. First, the quality of early employees is particularly important (see Joel Spolsky’s insightful article on why a small core of outstanding developers is better than a larger group of less talented engineers—or read the Mythical Man Month). It’s obvious–until you recall that even just a few years ago companies were often valued based on the number of employed engineers. I don’t see that happening today. Second, the most effective teams have shared (and realistic) expectations. We’ve recently seen a few high-potential companies literally fall apart because certain founders wanted to stay small and move slowly while other employees wanted to ramp much more aggressively. At an early stage, such conflict can be fatal.
• Target markets. Part of the fun is that many–if not most–web 2.0 companies target consumers. The challenge for VCs is that many of us aren’t trained in understanding consumer behavior (which is a polite way of saying that we really don’t know what will work and what won’t; perhaps we can take solace in the fact that even industries filled with so-called consumer experts, like the movie or music businesses, still have plenty of flops). That notwithstanding, companies often to fit into one of two groups: faster, better, cheaper (FBC) or brave new world (BNW). Teams at FBC companies should deeply understand their target markets and the opportunity size should be large. BNW companies, on the other hand, may be pursuing markets that don’t yet exist. In that case, there are many relevant questions to explore, but my simplest rule of thumb is to look for two primary metrics: (1) rapid, low cost customer acquisition, and (2) data showing that existing users are spending more and more time and/or money consuming the product in question.
• Technology/product. There are a few technical layers I analyze. First, the the basics: the platform should be stable and scalable, and performance should be good (if the technology isn’t yet built out, there should be a credible plan describing architectural details). Google and other services conditioned people to expect nearly instant responses; for better or worse, that’s the world we now live in. The second layer I look at is design. The key here is to optimize the overall experience with an elegant combination of form and function (which is different and much harder than simply building a pretty GUI). Ajax is a useful platform for developing richly interactive applications (examples here), though other technologies are also good (check out Goowy, which is Flash-based). Regardless, the point it’s now possible to build browser-based, feature-rich, highly interactive applications in a way that wasn’t possible before without spending a lot of time and money. Doing so well is difficult, though, and can form a meaningful barrier to entry.
• Business model. There are a variety of viable options. Ads can drive a reasonable revenue stream, but it can be difficult to scale ad revenue without very significant traffic levels. Certain companies with stunning user growth, like MySpace, can make the math work. Most companies, though, may find it necessary to adopt an additional fee strategy to round out the business. A challenge here is that consumers have largely been conditioned to believe content is free. It will be interesting to see how NYTimes’ TimeSelect program fares (they are about to start charging $40/year for access to certain content and archives). Separately, transaction charges for product sales can work (see Connected Ventures, which manages CollegeHumor), but this can be challenging as consumer tastes change rapidly (creating inventory management issues). I probably prefer subscription-models. Once a company has exclusive access to a valuable asset, customers will often be willing to pay recurring fees, particularly if the asset improves over time. Zoominfo (we are investors) is a good example–they have a strong and growing business based on for-fee access to premium search tools and data.
• Capital requirements. It’s usually possible to build out an initial platform without spending much; I’ve talked with teams that built functional search engines with innovative features for less than $50K (there’s cheap talent at Rent A Coder!). It makes sense to spend slowly early on—especially if there are lingering business model questions. Flickr is a good case study; they successfully found a good home at Yahoo without raising any insitutional venture capital (for a related discussion, see Seth Godin’s post on how small is the new big). However, if the market is sufficiently large and well understood—and particularly if there is a short time frame to attack due to competitive pressures–raising a larger amount capital can be the right move. All that said, it’s hard to have an abstract discussion of investment levels without citing specific companies. Generally, though, web 2.0 companies are far more capital efficient than traditional enterprise software companies.

What else did I miss?

Posted by Dan Grossman on Thursday, September 15th, 2005 at 2:53 pm.