Who Needs the Tech IPO?

Open source and Facebook have completely changed the economics of Web startups.

Kevin Rose of Digg

For weeks, Silicon Valley’s tech entrepreneurs slavered over the rumors that Google was in the final negotiations to buy Digg, the social networking and news aggregation site, for a remarkable $200 million. The deal would give them a desperately needed morale boost; if Digg’s founders could slap together a Web site with $11 million in venture capital and a few strings of open-source software, and then sell it for almost 20 times what they put into it, maybe there was hope for all the startups. So when Google suddenly backed out on July 25, you could hear the groans up and down Sand Hill Road. The money train, it seemed, was still derailed.

Indeed, there hasn’t been a high-tech dry spell like this in decades. According to officials with the National Venture Capital Association, not a single technology initial public offering was made in the second quarter—the first time this happened since 1978. At the height of the bubble in 1999, some 90 IPOs were issued per quarter, and the number had hovered around 25 or 30 as little as a year ago. Now, it seems, no one thinks the public will bite on any tech offering, no matter how cool. “A lot of companies that were vested right around the bubble, they’re maturing,” says NVCA spokesman John Taylor. “But the IPO market is so inhospitable, these companies aren’t even trying to go public. … The public money isn’t coming, and the VCs have to write another check.”

For startups watching their reserves dwindle, a deal like the one Digg was contemplating is their best hope. If public investors don’t have the cash to gamble on an online dating service, the only buyers left are big media companies like Google or Microsoft—and Google announced this week that it will create a venture capital arm—or an old-media firm like Viacom. Yahoo’s chaos has taken one of the biggest buyers out of the mergers and acquisitions market, and that leaves only one or two companies with the cash and the will to put it to work changing the face of the Web. This may well be the worst time for tech startups to cash out in history.

But strangely, no one’s panicking. Despite the doldrums, despite the fact that tech may not get out of this slump for several quarters, startups and venture capital executives are barely breaking a sweat. Here’s why: In the last 18 months, new developments in open-source software and cloud computing have made it cheaper to run a Web company than anyone thought possible. Just a few years ago, startups had to build their own IT services and administrative software, and the costs would soar into the millions. Today, tech leaders can just rent prepackaged software from Microsoft. Operating costs have plunged so low that companies vested with just a few million bucks can easily afford to wait until the good times roll around once more. “It’s simply a matter of economics,” says Bob Ackerman, a managing director at Allegis Capital. “What would it cost to build a house if you also had to create all the nails?”

Sharon Wienbar *, a managing director at Scale Venture Partners, is flabbergasted at how little it costs to run a digital media company these days. “I have one company, Merchant Circle, that provides advertising businesses,” she says. “They have only 15 employees, and they have 5,000 paying customers. I was meeting with a few entrepreneurs from [social gaming site] Playfish who told me they don’t own a single server. Everything is on a cloud. E-mail, accounting, file-sharing is hosted on a cloud. And they’re serving millions of game players a day. … If you’re burning $1 million a month, it’s a really expensive experiment to fail. But if your burn rate is $100,000 a month, you can go a long way with just a little bit of angel financing and see if you can tweak your product just right. So you can afford to wait.”

According to Maha Ibrahim of the venture firm Canaan Partners, it’s not just infrastructure costs that have plummeted. Thanks to Facebook’s willingness to let other applications piggy-back on its Web site, advertising and promotions costs for digital media firms have plunged as well. “Before Facebook, in order for a dot-com or an app to woo users to their site and get them go come back 10 or 15 times a week, you had to spend a lot of money with Google and others promoting your wares. With Facebook, an app doesn’t have to spend their money on customer acquisition.” The same phenomenon will only grow with mobile Web use, as Apple’s App Store lets users troll a bazaar of third-party mobile applications.

But there’s a downside to all this innovation. Because it’s so easy, cheap, and fast to throw together a new digital media company, the window of opportunity in which startups can think of a neat new trick, generate buzz, and cash out has become smaller than ever. Consumer media firms have sunk their costs lower than ever, but now they have an entirely new challenge: how to remain the coolest thing going long enough for the public or one of the big media companies to buy you out.

“The more unique your company, the greater the value of your company,” says Ackerman. “If you’re one of 20 companies doing the same thing, there’s not a lot of differentiation. And if a large company wants to buy one, they have 20 to choose from. The lower the barriers to entry, the noisier the marketplace.”

And that means that the companies with the most buzz this month are in a terrible position. Getting hot and popular in a few months is one thing; staying that hot until the investment market recovers is another, particularly when the metric of cool is so viral and intangible.

According to Wienbar, even Facebook has suffered from the vagaries of the digital consumer market. “Facebook could have sold the whole thing for $15 billion, but they won’t be able to get that in a year,” she says. “Even now, they can’t get it. So there was a feeding frenzy six months ago. Maybe they should have taken the money and run.”

Which is why the Digg deal’s flameout was so telling. At first glance, it seemed like the ideal model for the new digital media. Kevin Rose started the firm in 2004 with a handful of cash; soon, he was on the cover of Business Week, and he barely had to spend a cent. But without a clear plan to monetize the buzz, Rose had no choice but to wait for a bigger company to buy him out. Now that Google’s taken a pass, he’ll have to wait a little longer, while rival social news sites like Yahoo Buzz are already challenging Digg for supremacy. Rose had no problem dealing with the cost of doing business. Staying cool until the money comes back … well, that’s a different kind of animal.

Correction, Aug. 1, 2008: Sharon Wienbar’s name was originally misspelled as “Weinbar.” (Return  to the corrected sentence.)