The Venture Capital Squeeze

In the next few years, venture capital funds will find themselves squeezed from four directions. They're already stuck with a seller's market, because of the huge amounts they raised at the end of the Bubble and still haven't invested. This by itself is not the end of the world. In fact, it's just a more extreme version of the [norm](http://www.archub.org/dilbertvc.gif) in the VC business: too much money chasing too few deals.

Unfortunately, those few deals now want less and less money, because it's getting so cheap to start a startup. The four causes: open source, which makes software free; Moore's law, which makes hardware geometrically closer to free; the Web, which makes promotion free if you're good; and better languages, which make development a lot cheaper.

When we started our startup in 1995, the first three were our biggest expenses. We had to pay $5000 for the Netscape Commerce Server, the only software that then supported secure http connections. We paid $3000 for a server with a 90 MHz processor and 32 meg of memory. And we paid a PR firm about $30,000 to promote our launch.

Now you could get all three for nothing. You can get the software for free; people throw away computers more powerful than our first server; and if you make something good you can generate ten times as much traffic by word of mouth online than our first PR firm got through the print media.

And of course another big change for the average startup is that programming languages have improved-- or rather, the [median language](avg.html) has. At most startups ten years ago, software development meant ten programmers writing code in C++. Now the same work might be done by one or two using Python or Ruby.

During the Bubble, a lot of people predicted that startups would outsource their development to India. I think a better model for the future is David Heinemeier Hansson, who outsourced his development to a more powerful language instead. A lot of well-known applications are now, like BaseCamp, written by just one programmer. And one guy is more than 10x cheaper than ten, because (a) he won't waste any time in meetings, and (b) since he's probably a founder, he can pay himself nothing.

Because starting a startup is so cheap, venture capitalists now often want to give startups more money than the startups want to take. VCs like to invest several million at a time. But as one VC told me after a startup he funded would only take about half a million, "I don't know what we're going to do. Maybe we'll just have to give some of it back." Meaning give some of the fund back to the institutional investors who supplied it, because it wasn't going to be possible to invest it all.

Into this already bad situation comes the third problem: Sarbanes-Oxley. Sarbanes-Oxley is a law, passed after the Bubble, that drastically increases the regulatory burden on public companies. And in addition to the cost of compliance, which is at least two million dollars a year, the law introduces frightening legal exposure for corporate officers. An experienced CFO I know said flatly: "I would not want to be CFO of a public company now."

You might think that responsible corporate governance is an area where you can't go too far. But you can go too far in any law, and this remark convinced me that Sarbanes-Oxley must have. This CFO is both the smartest and the most upstanding money guy I know. If Sarbanes-Oxley deters people like him from being CFOs of public companies, that's proof enough that it's broken.

Largely because of Sarbanes-Oxley, few startups go public now. For all practical purposes, succeeding now equals getting bought. Which means VCs are now in the business of finding promising little 2-3 man startups and pumping them up into companies that cost $100 million to acquire. They didn't mean to be in this business; it's just what their business has evolved into.

Hence the fourth problem: the acquirers have begun to realize they can buy wholesale. Why should they wait for VCs to make the startups they want more expensive? Most of what the VCs add, acquirers don't want anyway. The acquirers already have brand recognition and HR departments. What they really want is the software and the developers, and that's what the startup is in the early phase: concentrated software and developers.

Google, typically, seems to have been the first to figure this out. "Bring us your startups early," said Google's speaker at the [Startup School](http://startupschool.org). They're quite explicit about it: they like to acquire startups at just the point where they would do a Series A round. (The Series A round is