The economics behind “freeconomics” blurs the distinction between “customer” and “user”; even though the user may not bear the cost, someone does. Companies that provide services to users for free still bear the marginal costs of the free services, therefore their business models are based on finding people and companies to subsidize the free services.

If the people subsidizing “free” go away (and that includes cash cow product lines, investors, venture capital, advertisers, paying users, buyers of aggregated and structured data, etc.), then what’s free right now may not be free in the future.

While the debate around “free” tends to center on the web, the web is merely one of many networks in use today. Take the examples of telecommunications (fixed and wireless), transportation (automobile, train et. al.) and energy networks: each network contains an embedded technological and economic structure that dictates the rules and incentives behind each interaction over the network.

But these networks aren’t static, and as each network becomes structurally more like the web their fundamental economics will change.

An example? Let’s start with the “mobile web”; Aaron Chua starts the discussion with Can Amazon be the default payment API for the Web? and I add in my comment:

Touching back to the piracy issue, is the [different economics behind the "regular" web and the mobile web] a failure of pricing mechanisms or is it a failure of distribution networks and transaction costs (including non-priced transaction costs)?

The digital economy isn’t forcing prices to zero; it’s forcing prices to their marginal costs. Marginal costs are higher in mobile (and virtual) at the moment because they have different pipes, different gatekeepers, different marketmakers, creators have substantially different access to the tools of production and distribution, low standardization of interfaces, etc. All of those create higher marginal costs, and combined with the “controlled” nature of mobile and virtual, there simply isn’t the same level of competition as in the non-mobile Internet… for now.

A day will come when the difference between the “mobile web” and the “real web” are framed less by the pipes and more by the access devices and their interfaces. Viewed more broadly, as innovation changes the structure of our networks, new technological possibilities and constraints will re-frame our economic structures, behavioral incentives, business opportunities and usage behavior.

Viewed simply, tomorrow will not be like today, tomorrow’s strategies will not be today’s, and what’s free today may not be free in the future.

And what’s expensive today may be free tomorrow: literally.

Not a replacement, but an alternative for some situations. Instead of accepting what is, let’s think about what could be.

Feedback Requested: A Flexible Structure for Partnering with Entrepreneurs

Conversations around the best structures for pre-venture capital Series A investments often focus on convertible debt and preferred equity. It’s not a simple question: the “best” structure really depends on the specific situation and often comes down to a value judgment over which structure is more “fair” or “easy”.

Structures create incentives; perhaps what the venture industry needs is an alternate model to align incentives and economic models.

In response to a couple business opportunities I’ve been evaluating, I’ve been playing around with some ideas for an investment and compensation structure that could work for the type of fluid investor, consultant and entrepreneurs partnering relationships that new organizational and economic models are making more possible and more common.

Goals

• The fundamental problem: how can investors and consultants help entrepreneurs start businesses and get fairly compensated for the value they create?
• Establish the rules and create more interactions: what’s the hardest problem in starting a new venture? What decisions need to be made in the beginning?
• Create structures that enable flexibility, create more intermediate decisions and tie payments to actions, not to negotiations.
• Allow consultants and investors to contribute as needed to help entrepreneurs.

Structure
The structure has two key parts to create compensation and investment agreements for investors / consultants and entrepreneurs:

1) Compensation: Convertible Preferred Shares granted under a Kudos Model.

• Convertible Non-Participating Preferred Shares.
• Granted by the entrepreneur to the consultant / investor under a version of a Kudos Model: the entrepreneur selects the number of shares to grant every three months based on their estimate of the value created over the past three months. The entrepreneur cannot retract granted shares.
• Shares are priced at $X per share (price TBD: set at same for all shares).
• Share holder holds the decision to convert (portion or all) of shares to 1) Equity at next qualified investment round or 2) Convertible Debt at any time under the terms in the instrument detailed below.
• Shares are convertible at 1:1 ratio for shares bought by the next investor at the next round (common, preferred or whatever form of equity negotiated).
• “Next round” traditional VC sets the pricing and terms of the shares.
• The shares vest immediately.
• Cash compensation: the holder of the shares holds the option to be paid cash compensation whenever the company reports a cash flow positive month (or whenever the entrepreneur draws cash from the business), commensurate with the share holder’s % equity ownership of the company. Repayment will reduce the amount of Preferred Stock held by the Consultant / Investor. E.g. if the preferred stock holder owns 10% of the granted shares in the overall company, whenever the entrepreneur draws cash compensation from the business the preferred stock holder will be paid 10% of the cash compensation.

2) Investment: Convertible Debt

• Consultant / investor invests capital into the business through a convertible note.
• Note carries an interest rate of 10%. Interest is not paid as cash but is added to the contributed capital in the note.
• Multiple closings: the note is “open” for continued investment for one year from date of issue. This is so that the investor can continue to gauge progress and invest money into the business depending on capital needs and continued interest and commitment to the business.
• The note converts at a discount to the conversion price on the next round. The discount will be a maximum of 25% (five percent per month, depending on how long it takes to close the financing, up to the maximum) off of the per share price.
• Debt repayment: the holder of the convertible debt holds the option to be repaid portions of the debt whenever the company reports a cash flow positive month (or whenever the entrepreneur draws cash from the business). Repayment will be X% of the positive cash flow or X% of the cash flow drawn by the entrepreneur (% TBD, to be negotiated).
• No personal guarantee of the note by the entrepreneur.
• Weighted average anti-dilution protection.
• Investor holds the right to participate equally (pro-rata) in further investment rounds under the same terms as the next investors.
• Basic protective provisions: no pre-payment of the note by the Entrepreneur, pre-specified payment if there is a change of control prior to a venture round, and a cap on the amount of additional debt a company can take.

Other Terms:

• Financial statements: entrepreneur is required to send a monthly CEO update; unaudited financial statements available upon request.

Starting the conversation…

• A little confusing? Perhaps.

  As you think through the terms and the necessary improvements, consider one of my basic thoughts: How can we let continuous interactions and decisions, rather than scheduled commitments, determine the flow of attention, talent, time and capital? How can we introduce elements of game theory into our investment and operating structures?

• Valuation: Why aren’t the convertible shares or the convertible debt properly priced to a % ownership of the company at the time of grant or issuance?

  Establishing valuation at this stage really isn’t worth it. The intention is to push the valuation decision to when all parties have more information.

• Can’t the entrepreneur choose to “underpay” the consultant / investor by not granting enough shares?

  Yes, but that will make the working relationship pretty short, and that’s probably not in anyone’s interest.

• What if the entrepreneur will never be able to sell the business or achieve a qualified investment?

  The consultant / investor has the continuing option to take cash or hold shares; if the business turns out to be a cash-flow based business, then the consultant / investor will want to convert their ownership into whichever instrument maximizes their return.

  Yes, that means the investment may turn out to just be a loan.

• Keeping an accurate share register is very, very important to track the conversion options and current shares / debt structure.

  No question. And while this is a bit more complex, is it anything more than a couple extra lines in our Excel models?

• Why are the grant timelines set for every three months? Why don’t the grants only occur at investment rounds?

  Because for some “lifestyle” startups there may never be qualified investment rounds; the economic models simply won’t fit. Why three months? No particular reason, open for ideas.

• This is way more complex than the typical convertible debt or preferred equity structure; investors, entrepreneurs and lawyers understand those agreements and this type of agreement will create large legal costs for investors and entrepreneurs. Legal agreements are already too large of a transaction cost (time, money and focus) in starting businesses.

  Really? Seriously? We are nowhere close to a set of industry standard documents. A huge variety of structural decisions, terms and clauses are negotiated on a case-by-case basis. Legal fees are a pretty hefty transaction cost in raising capital and and creating option / equity structures. Is this really that much harder to structure?

  The goal of this idea is to create a standard structure and a set of interactions and less-standard decisions after the agreements are signed and the business starts, instead of focusing on the decisions before the business starts. Legal agreements are important; let’s help figure out ways to get them done sooner and quicker to let people start creating businesses.

  In addition, this structure effectively “punts” on many decisions and pushes the negotiations over pricing and other terms to the next investors, the next round or the later stages of the company, at which point the entrepreneurs and investors will be in better position to pay the necessary transaction costs and additional investors will be involved to help set terms.

• We (investor and entrepreneur) know exactly how we’re going to work together, how we’re going to balance our time and capital contributions and how the business will make money for both of us.

  If you know all of that, awesome.

  But there’s a good chance you don’t, and a better chance you’ll be wrong.

  Why create a structure that won’t allow you to adapt and change your relationship, time commitments and capital contributions over time?

Disclaimers

• It’s not meant to work for all situations. It probably won’t work for traditional angels or venture capital investors: in my mind it is best suited for the $0 to $100K “friends and family” pre-seed stages. But more importantly, it might work for consultants / investors and entrepreneurs that need a flexible, multi-facted, non-priced investment and compensation model to fit their fluid organizational model and “the great unknowns” of the future for their businesses.
• I’m not an expert. I’m not a VC. I’m not even an entrepreneur, really. But by sitting in the middle I see a both sides to similar arguments. I’m trying to imagine something different. Maybe I’m wrong: I’m fine with that, but I’m interested in learning why I’m wrong.
• This is not fully baked; it’s lacking many necessary terms, covenants, warranties and representations; I haven’t introduced the “Qualified IPO” concept,or “drag-along” rights and protective provisions on sale, I’m not sure about the nature of the convertible shares and liquidation preferences (participating? preferred or common?), maximum conversion clause, there are decisions to make on share vesting schedule, anti-dilution, Board of Directors, tax implications, etc… I’m looking for the discussion to help flesh out the details, point out holes and hopefully add new ideas that may help investors, consultants and entrepreneurs.

Inspirations and Resources:

• Yokum Taku, Startup Company Lawyer. Fantastic resource, easy to spend a day or two or ten just digging through the posts on the legal details behind venture capital investing.
• Basil Peters, The One Page Term Sheet for Angel Investors. Great resource for angel investors.
• Michael Lewkowitz, Kudos for Equity. The inspiration for the Kudos for Compensation idea.
• Ted Wang in VentureBeat, Reinventing the Series A
• NVCA Model Venture Capital Documents
• The CRV QuickStart Seed Funding Program
• Fred Wilson, CRV Quickstart
• David Cohen of TechStars, TechStars Model Seed Funding Documents
• Y Combinator Series AA Documents
• Sachin Agarwal, Quick Compare-and-Contrast of the Y Combinator and TechStars Series AA Model Documents
• TechCrunch, Y Combinator To Offer Standardized Funding Legal Docs
• Discussion on Tech Stars Documents on Hacker News
• Yokum Taku, What is upgradeable Series A preferred stock?
• Brad Feld, What’s the Best Structure for a Pre-VC Investment?
• Venture Hacks, Should I raise debt or equity?
• Dick Costolo, Convertible Debt Jeopardy
• Josh Kopelman, Bridge Loans vs. Preferred Equity
• Basil Peters, Exchangeable Shares
• Jeff Clavier, Debt or Equity in your seed round
• Julien Wallen, Web funding norms are a context, not guidance
• Mark MacLeod, Is Web 2.0 the great VC return equalizer?

Updated: Mentioned in the Wall Street Journal online Venture Dispatch column The Daily Start-Up.

By far the most interesting thing about this to me is what it means for future software M&A deals. Tweetdeck is funded by betaworks, which is also an investor in Twitter. Betaworks also sold Summize to Twitter, which became known as Twitter Search.

I’m sure the geniuses at USV and betaworks have been brewing these strategies for a while, but it’s very cool to see an M&A market built on companies that create value using an API.

My comment:

Mark MacLeod wrote about the “era of the small exit” a couple weeks ago; what we’re seeing is the result of what happens when people can create products (or even businesses?) based on creating new “skins of data” on top of platforms using public APIs.

As I commented on his site:

Not only might the M&A market might become an efficient hiring market for talent and products, but finding and executing the right acquisitions and partnerships sooner and quicker might become a more important core competence than planning and executing product extension development.

From an investor standpoint, I wonder if there is more value in funding the “skins of data” or the “platforms of data”?

I don’t think that the same investor will fund multiple skins of data on a shared platform; it creates too many conflicts of interest and consolidates the investment dollars into a single platform.

Implications? In the latest iteration of the “build v. buy” and “built to flip” debates,

• The best strategy for building product extensions is giving access to the platform via an API and 1) learning to create and share value with the ecosystem as easily as possible and, depending on the strategy, 2) buying the best products / businesses created.
• The best way to get hired might be to create your own job.
• Entrepreneurs and their investors should revisit and perhaps refocus on early exits as they are creating operational goals and capital structures.
• The best investment strategies might be to focus on either platforms or skins; but note that each strategy requires very different operational, funding and entrepreneur support strategies.

In a skittish entrepreneurial and investment climate, I am doubtful that entrepreneurs will commit the time and effort to build new platforms, especially with investors less likely to fund the gap between costs and revenues.

Until then, creating, funding and acquiring “skins of data” will likely be the locus of activity even if they do not create the most long-term value.

Back in late November and early December I wrote two posts about new platforms and new trends for entrepreneurs to leverage.

While, yes, it is all about the network, the Internet is not the only network. The idea of creating and leveraging networks doesn’t need to only apply to consumer-oriented Internet applications.

Focusing on transportation networks for a minute…

What trends can entrepreneurs leverage to create new businesses? One of many:

Stabilizing the economy is going to fall to government intervention and investment.

What will the government invest in? What themes did we see in the campaigns? Off the top of my head: Iraq, energy independence, infrastructure investment and revitalization, economic and financial stabilization. Obama has already declared his intention to create jobs by investing in transportation and energy infrastructure projects. While these may not sounds like obvious areas for startups, they are probably more meaningful than another desktop or mobile Twitter client or a new way to share photos.

What is the next platform for new businesses? Pointing out one:

Transportation

Venture capitalists and entrepreneurs have traditionally stayed away from opportunities that require big, inflexible, systemic changes to succeed. The required scale is simply to large, the risks are simply to big, the timeframes too long. But how could the government create a new platform in public transportation for entrepreneurs to leverage? How could entrepreneurs develop businesses based on existing transportation networks?

As usual, I’m not the only one thinking about the concept; Chris Timmerman of Brand Avenue, Interstate Redux highlights Karrie Jacobs of Metropolis Magazine, Rethinking the Interstate:

[Obama] has been talking up a huge economic-stimulus package and saying he’ll “rebuild our crumbling roads and bridges.” Infrastructure is suddenly a buzzword…

The Dwight D. Eisenhower National System of Interstate and Defense Highways, created when Ike signed the Federal Aid Highway Act of 1956, was a symbol of everything that was both right and wrong about this country. That we were able to plan and execute something so ambitious—more than 46,000 miles of highway—seems, at this juncture, wondrous. Of course, the system undermined our cities, encouraged suburbanization and sprawl, and solidified our dependence on the automobile. This tends to undercut the glory of the achievement.

But it’s time for us to look at the interstate system not as an aging network of highways in need of repair or replacement but instead as we might look at a navigable river.

… What if we thought of [interstates] as the backbone of a new, more diverse 21st-century transportation system? “It’s time for a different vision, Blumenauer says. “And a principle for that is how we coax more out of existing resources.”

How could the existing transportation network be leveraged?

After we went over the basic information about the product and business (a standard part of my initial data request before creating a startup financial model), I realized the crucial part in creating the financial model was going to be understanding the customer acquisition and engagement cycle. I started digging into viral marketing, viral loops and viral expansion loops to understand how to translate people’s behavior and usage of his product into a series of assumptions and equations.

Even though the estimates will undoubtedly be wrong, breaking down the operations into a series of equations forces one to take a very tactical look at product development choices and business strategies.

Maybe someday I’ll release a version of my viral loop customer acquisition and engagement model. Until then, I figured it might be valuable to share a bit of the research I found most interesting and valuable.

Yes, there are a lot of links to Andrew Chen, and as you read you’ll figure out why…

• Andrew Chen, What’s your viral loop? Understanding the engine of adoption: A viral loop is…

  …The steps a user goes through between entering the site to inviting the next set of new users.

  … Ultimately, viral loops are like induction proofs in that you are jumping to a steady state situation in which your viral widgets/emails/messages are already out there, and you are optimizing some set of steps that users have to jump through. Then, once you get this right, then you are figuring out how to build “on-ramps” into your viral loop so that you bootstrap the entire process.

• Fast Company, Ning’s Infinite Ambition:
  

  “Incorporating virality into the functionality of the product.”
  Ning grows because each new user begets more users. Every time someone sets up a social network, he has no choice but to invite friends, family, colleagues, and like-minded strangers to sign on as well. The company calculates that each person signed up for a Ning group is worth, on average, 2 people, compounded daily: On day two, that individual brings in 4 group members and on day three, 8; within a week, she has brought in 128 people. Which is how Ning has been able to grow at a daily average of more than .4% and add 500 new groups a day, doubling roughly every 137 days.

  … “double viral loop,” which spreads two ways, because every network creator is a user and any user can become a network creator.

  Andrew Chen: Viral marketing is not a marketing strategy:
  

  Viral marketing is not a marketing strategy
  Successful viral products don’t have viral marketing bolted on once the product has been developed. It’s not a marketing strategy. Instead, it’s designed into the product from the very beginning as part of the fundamental architecture of the experience.

  Viral marketing is not a product feature
  No single feature determines the virality of the product – instead, it’s part of a viral loop that connects a disparate set of functions into a cohesive motivation for the user to tell their friends. If the fundamental product doesn’t drive a viral motivation from its users, then it’s very hard to force it.

  Viral marketing is a fundamental product design discipline
  Instead of:

  We have product X, how do we virally spread it?

  … we ask:

  We have viral loop X, what’s the right product to put into it?

  The skillset for effective viral marketing
  Because of the above issues, “viral marketing” is not really something that ought to be in the domain of soft-skill folks like PR, advertising, and marketing people. Nor is it in the world of hardcore technical folks that can architect systems but not consumer interactions.

  Instead, it’s something that needs to bridge both soft and hard skills. You need an interesting combination of skills, including:

  1. Understanding the motivations behind user behaviors
  2. Understanding and exploiting the technical loopholes to create viral loops

  I think that the fundamental compartmentalization of these two skillsets is what ultimately drives huge companies being worse at viral products than startups.

  Eric Ries, Engagement loops: beyond viral:

  On synthetic notifications:

  The most blunt instrument is to simply reach out and contact your customers on a regular basis. …true ROI of a synthetic notification has to balance ROI, customer fatigue, and the engagement effects of the campaign itself.

  On organic notifications:

  … the mechanics of sending users notifications when new friends of theirs join the site is a great organic re-engagement tactic. From the point of view of the existing customer, it goes beyond reminding them that the site exists; it also provides social validation of their choice to become a member in the first place.

  The ultimate form of engagement is when the company doesn’t have to do anything explicit to make it happen

  Connecting engagement and viral loops:

  The two loops are intimately connected, in a figure-eight pattern. Customers exit the viral loop and become part of the engagement loop. As your engagement improves, it becomes easier and easier to get customers to reenter the viral loop process and bring even more friends in. And as in all dynamic systems, there’s no way to optimize a sub-part without sub-optimizing the whole. If you’re focused on viral loops without measuring the effect of your changes on other parts of your business (of which engagement is just one), you’re at risk of missing the truly big opportunities.

  Todd Stephens, Viral Expansion Loop.

  Tony Wright, Value or Viral?
  

  It’s easier to build a great business on top of an existing viral engine than it is to build virality into an existing business”
  At the time, I found myself nodding. … It turns out that viral loops are HARD.

  But, as I think about it, I can name something that’s a LOT harder, and that’s building a product that people really want.

  Andrew Chen: Freemium business model case study: AdultFriendFinder ARPU, churn, and conversion rates:
  

  * Visitors -> Members: 6-15%
  * Members -> Subs: 10-22%
  * Subs -> Renewing Sub: ~80%
  * Revenue per member: $0.48-$0.95

And most recently, the latest from Andrew Chen on Freemium models, How to create a profitable Freemium startup (spreadsheet model included!). Worth a deep look…

Learning how to design organizations that reduce (or even eliminate) the “deadweight loss” of the social capital transactions within and between companies may be the greatest opportunity for a 21st century capitalist.

Let’s start with an example: Social Venture Commons.

Michael Lewkowitz (@igniter on Twitter) is right now leading the development of a Social Venture Commons (SVC) to create an open-sourced micro-messaging based collaboration platform to help people “discover and make meaningful contributions to purposeful projects”.

Why is SVC important?

We’re in a world where more people can independently create organizations to create value, and while the technological and cultural trends are pointing toward a more distributed model of value creation, we’re lacking the infrastructural tools / platforms necessary to create the structures we need.

It’s a model that creates the transparency and kind of interactions necessary to help people trade their personal social capital near par value for corporate use.

And it’s not just about social entrepreneurship or creating better interaction methods for non-profits; the SVC community is also testing the potential of peer-producing a for-profit startup using the SVC platform and organizational model.

Our organizational structures need to adapt to the new reality of constant disruption, and SVC is one path, one of many potential business model designs that are based on change, adaptation and flexibility.

SVC is hardly the only effort in the area: I can’t hope to mention all of them, so please chime in with examples and links to other efforts in the comments below.

What is being created?

• A “broadly accessible” collaboration platform: easy (web-based), distributed (available in any site) and portable (sms compatible).

  The beauty of using micro-messaging to power the collaboration? To quote Michael:

  My experience with Twitter and the emerging projects have been that they allow really fluid entry and exit without having to ‘join’ something. Follow v. join (or friend) is a very important difference in this. Similarly this is not about destinations – rather it needs to show up where people and ventures are/do/happen.

  This fluidity nurtures interest and discovery which I think also will nurture the best, authentic, passionate and productive contributions.

• An “action-oriented” collaboration structure: every interaction is a contribution, every contribution builds relationships.

  How can an organization optimize for micro-interactions? Me:

  The SVC model is based on a different culture: contribute and stay in or get out, but contribute.

  Imagine how the organization model would be different if all interactions were contributions, if every interaction created value rather than allocated value. Is it possible to reduce the need / ability to dilute contributions with politicking, bureaucracy, et. al.?

• A self-organizing, “interest driven” organizational structure: the platform is the organization, empowering people to fluidly find, follow, and do things that *are* interesting at every moment

  This is not simply crowdsourcing using Twitter; whereas most crowdsourcing models transfer value from participants / creators to buyers, SVC is about empowering creators and allowing some of that value to transfer back to the contributors themselves in the form of social and / or financial capital.

  Developing new tools is a necessary start, but the real value is in creating new rules for interaction and value creation. Interestingly, SVC is testing these new rules in its own development, questioning and developing its own organizational structure and interaction systems along the way.

How can for-profit endeavours apply the SVC organizational and economic model?

How can for-profit ventures own the intellectual property? How can these new ventures capture customers and revenue? How will contributors get paid?

How do we create an equity structure to allocate future distributions of wealth to fairly compensate past, present and future contributors?

Creating value on the edge is hard; creating new societal conventions and organizational structures based on still-emerging methods for interaction and communication is even harder. Can our current corporate legal structures adapt to allow the kind of innovation in compensation and ownership rights necessary for new organizational possibilities like SVC?

I’ll return to this shortly…

—

Want to learn more or get involved?

• Track the #SVC hashtag to follow the progress, thoughts and people on Twitter
• Contact Michael via the web or twitter via @igniter
• Contact the current core contributors building SVC: Joe Dee, Matt Nish-Lapidus, Dan Williams and Peter Flaschner. Expect more to join…

Recent declines in venture fundraising…

Shouldn’t we be worried about the recent decline in venture fundraising?

Venture capital funds raised only $3.4 billion in the last three months of 2008, according to new data from Thomson Reuters and the National Venture Capital Association. Unsurprisingly, this is a big drop (about 70.9 percent) from the same period in 2007, when venture firms raised $11.7 billion, and also a substantial decline from the $8.4 billion raised in Q3 of 2008.

Was the amount of capital raised in Q4 2007 or Q3 2008 a meaningful base for comparison? Is a measure of venture fundraising over a short period of time meaningful? Is this a signal or just noise?

Wouldn’t we expect some venture capital funds to fail, struggle and close up shop in an economic downturn? Isn’t that part of a healthy cycle of creative destruction?

In any case, less venture capital isn’t necessarily a bad thing; more money doesn’t necessarily lead to better startups and innovation.

David Hornik, Innovation doesn’t take a vacation in an economic downturn:

So why am I optimistic about investing in 2009? Because entrepreneurship is an addiction, it isn’t a choice. Great entrepreneurs aren’t driven to create companies because it is easy, or because capital is plentiful, or because the public markets are swallowing anything the venture community will throw at them. Great entrepreneurs start companies because they can’t help themselves. They see a problem or a solution or white space or an opportunity and they have to do something about it.

Innovation doesn’t take a vacation during an economic downturn. Innovation is a constant. While the resources an entrepreneur may be able to bring to bear on a problem may vary with the economic climate, the desire — the need — to innovate never goes away. And Venture Capital is the fuel of that innovation.

… combined with a shift in investment strategy…

A more meaningful trend, however, may be the increasing deployment of “risk capital” to fund follow-on investments, even as seed-stage valuations are decreasing.

Based on everything I’ve heard, venture investors are using funds to keep their current bets alive rather than making new bets. It’s a reasonable strategy given the structural math behind venture investing, the Darwinian nature of startups and the resulting need to give possible successes the chance to be “moonshots”.

… is helping create a gap between funding for “testing ideas” and “building businesses”.

A wide range of business, cultural and technological trends created the need for new models to support early-stage ventures, and the resulting rise of seed-stage and venture-launch funds investing in the $5K – $25K range have created many new opportunities and paths for entrepreneurs to test ideas.

But what comes after the ideas have been tested and “proven”? From what I have heard, entrepreneurs are finding it difficult to raise funding in the next level of investment, the more traditional seed-stage $100K to $500K range. If I’m wrong, please correct me.

Why?

Is this funding gap a sign of economic conditions or a deeper structural problem in venture investing?

As usual, the answer is not either / or but both. In the last decade (especially the last five years) the M&A market has been a popular exit strategy for startups looking for funds in this range, but current economic conditions have forced many strategic investors to the sidelines. Traditional Series A institutional capital will find it difficult to make the math “work” for deploying smaller amounts of capital. And even though the recent shift has been towards focusing on follow-on investments, the new early seed-stage funds really do not have the capital or the investment focus to make the follow-on investments to take their “proven ideas” into businesses.

Which leads me to ask: what is a bigger problem for the venture community: not being able to find funding to test an idea, or not being able to find funding to take a promising idea forward?

Bemoaning the structural gap between venture capital math and the new operational and economic realities behind new ventures is pointless.

What’s the path forward?

If it’s a structural problem, venture investors will figure out an operational and investment model that works. The recent rise of the early seed / test / launch phase investors is one of the newer evolutions in venture investing but hardly the last. I would be surprised if investors do not figure out how to bridge this seed-stage gap. Perhaps we’ll see tighter angel networks, strategic shifts from institutional Series A-stage investors, follow-on funds run by the early-seed funds or even new entrants with new investment models.

If it’s part of the broader economic downturn, then we’ll see good investors succeed and less-successful investors fail until the next run-up in venture fundraising and investment creates new opportunities. It’s not the death of the industry.

And on the other side of the coin, entrepreneurs will figure out how to build new businesses regardless of the funding climate. All new ventures have to have a business model “built-in” from the start; it’s the entrepreneur’s choice when to turn it on. [1] Right now is the time for entrepreneurs to focus less on raising nonexistent capital and focus more on turning on their “built-in” business models.

Need help figuring it out?

—

[1] I think I read that line somewhere, but I can’t seem to remember where…

What is the right price to put on your work? Often, the right price is zero.
Michelle Goodman in the New York Times, When to work for nothing:

When you agree to work free, you reinforce people’s misguided ideas that the self-employed are independently wealthy hobbyists. Don’t degrade your profession by letting a cheap client take advantage of you.

While it’s important to get a fair price for your time, it’s entirely up to you to determine your own fair price. In many situations free may be the fair price for you, and don’t let anyone attempt to convince you otherwise.

Whenever we talk about free services or pro-bono work, it’s valuable to revist the idea of the “freemium” business model. Lately I’ve realized I operate my life on the freemium model, and I love it. But can the freemium model work for products and services with high marginal costs? Can it really work for me?

Freemium is not the same as free

Freemium is a business model which works by offering basic services for free, while charging a premium for advanced or special features.
(Wikipedia)

The freemium model flips the normal equation: instead of selling the vast majority of what you produce (and giving away a small amount to promote and incent sales), the idea is to give away the vast majority of what you produce and instead make a profit by selling a much smaller amount.

Let’s be clear: freemium is not the same as free. The cost to deliver the free versions of the product can be thought of as business development or marketing expenses; spending on customer experience supplements (or replaces) advertising.

While there is an active debate about whether the freemium model works, the fact is that the freemium model is not new; what has changed is that the range of products and services that can be delivered at zero marginal cost has increased drastically.

A Freemium Life: How do we balance giving away our time with making a living?

Simple: giving away our time is a way to make a living.

What I do has a high marginal cost; dedication, time, passion and intellectual energy all carry a high marginal cost. And especially in today’s world of early-stage startups, time is more valuable than money.

But even if I do not directly trade my time for money, I earn a lot in return for giving away my time. If you’re spending your time on doing things that make you better, work no longer consumes you; it creates you. We owe it to ourselves to spend our time on our passions, but more importantly we owe it to everyone we care about: only by fully engaging ourselves can we truly give back to others.

Would you rather:

• Spend 100% of your time chasing and working on many projects for marginal compensation on each, or
• Earn the same amount of compensation and spend 100% of your time on projects you really care about, but give away 90% of your time and only charge for 10% of your time (for an obviously higher per-paying project compensation)?

“Social capital” might be the key next-gen asset.

Moreso, giving away my time and connecting with people still creates something real: relationships and reputation have values. We all implicitly know this, but we’re reaching a point where we might be able to explicitly value our relationships… for better or worse.

Umair Haque, How To Be a 21st Century Capitalist

Next-generation businesses are built on next-generation assets. Yesterday’s businesses were built on cash, factories, and IP – financial, physical, and intellectual capital. Next-generation businesses are built, instead, on human, social, natural, and cultural capital – to name just a few.

… Here’s one of the commandments of next-generation business: capitalize something.

What happens if you “capitalize” your relationship and reputation networks? Can you become a “Pareto node”? John Hagel, Pareto Power and Leveraged Growth:

Effectively engaging with Pareto nodes requires a form of collaboration marketing. Collaboration marketing emphasizes the need to attract others, creating a motivation for them to seek you out wherever you are, rather than trying to reach out, intercept them and get their attention. Of course, in order to do that you need to develop a deep understanding and appreciation for what motivates the other party. It forces you to get out of the “what’s in it for me?” mindset.

The best way to attract others is by offering assistance to them, by being more helpful to them than anyone else. Once again, this requires a deep understanding of the unmet needs of the other party.

“Capitalizing social relationships” is an ideal with very practical applications

How can this apply to venture capital and entrepreneurship? In response to my post What is the next platform for new businesses?, Ethan Bauley outlines how the “the network is the platform” for Y Combinator:

So what do we do with this knowledge? A quick and obvious example of a node that exploits these trends is Y Combinator. YC is 1) launching a large volume of new companies; every new company brings along relationships that other YC companies can access 2) emphasizing collaboration among their portfolio companies, so that their social capital is exposed to other people that can use it, and 3) exposing their principal’s network to portfolio companies (of course all financiers do this, but because of the sheer volume of companies YC is dealing with, Paul Graham et al drive even more value for their pre-existing network).

Social capital has always been an important part of business, but what’s changing is our ability to monitor, measure and value relationships and the varied degrees of value they create.

What happens when we start trying to measure, value and “sell” social capital?

But what does “social capital” really mean? Better yet, what happens when we try to practically apply the concept to our lives and our businesses?

• What happens when we develop an “accounting system for social capital”? How does our social structure change? How does explicit measuring and valuation change our behavior?
• Similarly, what happens when we create a social communication system based on asymmetric intimacy? What happens when we create systems to publicly display our status?
  

  By creating systems that allow us to publicly display, measure and compare some facet of ourselves, we implicitly create societal competition over that artifact.

  How will we compete over “social capital”? Will we realize it is not a zero-sum game?

• What happens when our methods, standards and codes of conduct for business development, promotion and selling change?
• How will the “shadow system” of social and business relationships change as our social ties become increasingly transparent? Are the days of back room deals coming to a close?

Our current online social networks are just a start, a limited application of our maze of relationships and connections. The real cultural and business impacts are still to come.

And only by participating now will you play a role in setting and leveraging those trends. Start now.

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[1] There has been a pretty active debate lately among professional photographers about “working for free”. John Harrington and Chase Jarvis have provided two of the more interesting viewpoints on this pretty hot issue in the photography industry…

But even in wildly uncertain markets and consumer sentiment, change creates opportunities, especially in a cultural climate that is crying out for significant political, social and economic change.

Why is now a good time to start a business and what opportunities will emerge?

• Change.

  Change was obviously an overriding message throughout the current election season and it rode Obama and numerous other politicians into office. But what other political themes emerged and what opportunities will be created?

  How will the outcry over the excesses of capitalism impact large and small companies? What new standards of information transparency will we want? How can private enterprise create the standards, analysis tools, platforms and devices to deliver more powerful business and public government oversight and management?

  The web has fundamentally changed the power of individuals and small teams to create companies. How will the same forces creating the democratization of the tools of production and distribution have an impact on political organizations and government?

  We’ve all read endless articles analyzing what Obama did to magnetize and mobilize an army of “ground troops” to win the election. Now what will everyone do? How will the focus of the troops shift from winning an election to governing a country? How will consumer change? How will companies adapt?

• Stabilizing the economy is going to fall to government intervention and investment.

  What will the government invest in? What themes did we see in the campaigns? Off the top of my head: Iraq, energy independence, infrastructure investment and revitalization, economic and financial stabilization. Obama has already declared his intention to create jobs by investing in transportation and energy infrastructure projects. While these may not sounds like obvious areas for startups, they are probably more meaningful than another desktop or mobile Twitter client or a new way to share photos.

• Consumer spending is down, but it’s looking for options.

  Yes, consumer spending is down: but it’s also shifting as people re-evaluate where and how much they spend. Anytime a consumer decides to change their spending behaviour, that’s an opportunity for a competitor to offer a better solution more tailored to their current economic situation.

  How will a desire to save money and spend less manifest itself in the consumer marketplace? What can companies help people do?

  • A fundamental shift towards value for money: luxury consumption, organic foods, expensive personal grooming or styling, etc.
  • A broader shift away from spending money and instead spending time.
  • Comparison shopping: prices, value, quality, production origination (“Made in USA”?).
  • Increased bartering for services, more second-hand selling, more of a need for online and offline marketplaces for goods and services, better vendor management and reputation services.
  • Decreased use of credit, less purchasing on credit and more use of rental agreements and shared use across groups of people (including known or unknown people).
  • Decreased desire to enter into long-term contracts (especially in deflationary conditions). How can companies help people get out of long-term contracts, especially for discretionary purchases such as cell phones, gym memberships, etc.?
  • “Insourcing”: shift away from outsourcing the home. As people re-take the responsibility for laundry, cleaning and cooking services back from outsourced providers, what do people need to learn, what do people need to buy, what goods are homeowners, renters, singles and families going to invest in to save money?
  • Continued pressure to reduce transaction costs, decreased use of middlemen.
  • Continued or increased push for inferior goods or counter-cyclical assets.

  The broad cry against over-consumption and the excesses of capitalism will be wide, deep and far-reaching.

• Market uncertainty forces businesses to freeze up, under-invest and under-innovate.

  As companies pause and cancel testing and growing new business opportunities to focus on their existing business lines, now is your time to innovate and catch a company off-guard. Find and hire good people (cheaper than before). Test new working relationships with employees and new partnership and outsourcing arrangements. Negotiate prices and long-term contracts and create new risk-sharing agreements with buyers and suppliers.

  Companies with leveraged excess capacity will be looking for ways to keep their sales and production pipelines full, and now is your time to get them to take a chance on you.

• Less venture capital can be a good thing.

  Less venture capital creates less competition, less overfunded competitors, less focus on finding outside funding and more focus on delivering immediate, tangible value.

  More capital will be diverted from potential new investments to support existing investments to keep them alive. Let venture capitalists throw good money after bad. Given the current costs to launch startups, you may not need significant external funding anyway.

• A slowdown in online advertising will force startups to deliver tangible value from day one.

  A plateau in online advertising will force companies to create better ads. Obviously, it will be harder to create businesses based on indirectly monetizing large audiences through delivering advertising, but similar to the decreased capital argument, the constraint will force entrepreneurs to give up on the misplaced dream of advertising revenue to refocus on demonstrating tangible value from the beginning. That’s a good thing.

  But I’m not declaring the death of web services such as Twitter, Backtype, Disqus, Facebook et. al. These businesses create tangible value solving human problems and desires, but the eventual business models will not be based on advertising. Attempting to monetize communication services by applying the tired model of interstitial, interruptive corporate spam is short-sighted: the nature of the intentions underlying communication and content consumption are very different and require very different business models.

• Available talent and time.

  Unemployment goes up (seemingly) by the day right now. What will everyone do? How will private enterprise re-train and educate the unemployed? How will private enterprises learn to deploy and use the new market of freelancers?

  Even the employed can create the opportunity to create time. Whether that’s the right strategic approach or not, in trying economic conditions most larger companies will focus on reaffirming their core business. It will be difficult to most entrepreneurial and change-oriented employees in larger companies to convince managers and executives to attack new business opportunities. Millenial (Generation Y) employees will be particularly hamstrung; Millenials are ready to dive in and create change but are not yet trusted by the generation of business leaders holding the purse strings.

  Instead of waiting for companies to say yes to your ideas, say yes to yourself. Keep your day job and use your spare time to work on your skills, to build networks and to create and launch business ideas. The opportunity to test your ideas is brighter now than ever; just set your goals accordingly.

How can companies take advantage of broad deflationary conditions, declining consumer spending, massive deleveraging, a loss in trust in big companies and a cry against overconsumption and the excesses of American capitalism?

What trends can entrepreneurs leverage to create new businesses?

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This post was inspired by a notes from Bryan Landers on Twitter about microstartups and by Brooks Jordan on Friendfeed about the opportunities in deflationary conditions. Since I didn’t specifically address either topic here, I’m looking forward to future explorations on those topics…