Twenty years ago, startups had to spend much of the funds they raised from venture capital firms to buy their own hardware. Thanks to cloud computing, those days are long gone.
The introduction of cloud computing services by Amazon is seen by many practitioners as a defining moment that dramatically lowered the initial cost of starting internet and web-based startups. Cloud computing allowed startups to ‘rent’ hardware space in small increments and scale up as demand grew, instead of making large fixed upfront investments in hardware when the probability of success for the startup was still extremely low. This allowed entrepreneurs and investors to learn about the viability of startups before making large fixed investments, and hence can be seen as lowering the costs of initial experiments. Importantly, this technological shock impacted only a subset of firms. The cloud services provided by AWS provided scalable bandwidth, storage and computing resources for companies with a strong online presence such as software-as-a-service, social networks, or retail e-commerce websites.
Venture capital firms have funded countless more startups in the hope of finding a winner.
In our article, Cost of Experimentation and the Evolution of Venture Capital, we show that subsequent to the introduction of cloud computing services by Amazon Web Services (AWS) in 2006, startups founded in sectors benefiting most from the introduction of AWS raised much less capital in their first round of VC financing. On average, initial funding fell 20%, but quantile regressions demonstrate that this fall was even larger for many parts of the funding-size distribution. While startups in treated sectors raised less capital in their initial two years, total capital raised by firms in treated sectors that survived three or more years was unchanged. This is consistent with the notion that the primary effect that AWS had was on the initial fundraising by startups rather than on the cost of running the business at scale—effectively allowing startups to shift their large investments to later stages when uncertainty had been resolved.
This fall in the cost of starting businesses also impacted the way in which VCs managed their portfolios. We show that in sectors impacted by the technological shock, VCs responded by providing a little funding and limited governance to an increased number of startups, which they were more likely to abandon after the initial round of funding. The number of initial investments made per year by VCs in treated sectors nearly doubled from the pre- to the post-period, without a commensurate increase in follow-on investments. In addition, VCs making initial investments in treated sectors were less likely to take a board seat following the technological shock. The investment approach of supplying a small initial amount in a large number of startups, providing less governance, and offering follow-on funding less frequently, is colloquially referred to as one where investors “spray and pray.”
These days it is easier for a founder to raise funds than it is to get help from a VC.
The strategy does have some drawbacks, however. Among them is the concern that with the rapid-fire approach to funding, VCs have been less likely to fill their traditional role of providing advice and guidance to startups, putting less resources into firm governance.
For instance, the researchers found that for the group of firms they looked at, VCs were 14 to 21 percent less likely to place an investor on the board of directors in the first round of financing/funding.
“It shifts the governance to the later stages of the company,” says [Harvard Business School Professor Ramana] Nanda, “in part because it’s not really worth it for VCs to dedicate a lot of time and resources into that when the rate of failure is so high.” Some of that slack, he adds, has been picked up by accelerators such as Y Combinator or Techstars, which are able to provide guidance to startups as a group, offering them business and technical advice until they are able to prove themselves and grow to a size that a VC is willing to invest more time and money into ensuring their success.
Now that it is cheaper to build product, the high-technical but low-market risk that was prevalent in the startup ecosystem transformed to a low-technical but high-market risk.
Risk never disappears.
Post by Marcelino Pantoja