Make-or-Break Time For The Net Newbies

As shakeout fears rise, startups are spending furiously to break from the pack

It's a formula that has fired up Internet entrepreneurs from Palo Alto to Paris: Start with free software, add falling prices for computing and data storage, toss in ever-cheaper distribution costs, and you can launch an online service for practically nothing. But now that many so-called Web 2.0 outfits have a couple of years under their belts, it's sinking in that it takes real money to turn those ideas into real businesses--to reach a broad audience, scale up operations, and, you know, turn a profit. "It's true that you can do a science experiment more efficiently than you could five years ago," says Rob Shurtleff, managing director at Divergent Ventures, a venture capital firm. "But don't confuse doing the science experiment with building a large enterprise."

For many Web companies, 2007 will be the year that difference becomes painfully obvious. They may have started out with dreams of getting snapped up by the likes of Yahoo! Inc. (YHOO ) and Google Inc. (GOOG ). But out of scores or even hundreds of startups in any given category, whether it's video sharing or photo slideshows, only a handful will be bought in their first rush of success. The phenomenal triumph of MySpace (NWS ) and YouTube Inc. (GOOG ) is the exception, not the rule. To complicate matters, basic expenses such as salaries, marketing, and real estate are on the rise, driven up by the very fact that so many companies were started on a shoestring.

That means raising significant money to spend on nuts and bolts. Web services may cost mere hundreds of thousands of dollars to set up. But turning them into profitable companies could cost $15 million to $25million, much of which must be spent on distribution, engineering, and infrastructure, says Brad Feld, a managing director at Mobius Venture Capital Inc. Some outfits are raising even more. Brightcove Inc., a video-distribution company, has raised $82 million, and home-appraisal site Zillow has $57 million.

They're getting room to run because venture investment in consumer Web projects is on the rise, more than doubling in 2006, to $943 million. And the amount that VCs are investing in each financing round is growing. Compared with the fourth quarter a year ago, the average amount per deal in a later-stage round has nearly doubled, to $9.2 million. But this rapid rise in funding sets up an 'inevitable day of reckoning.


If they can't prove their business models or break from the pack, Web companies risk becoming part of a shakeup that observers expect to really get going in 2008. "We're still a year or two away from the bigger market segments like social networking, user-generated video, and vertical search showing real Darwinism," says Todd Dagres, general partner at VC firm Spark Capital. Some winnowing has already begun.

One of the biggest costs of scaling up is adding employees. After launching a startup with two or three friends, founders soon realize that, no matter how much they work, they can't answer all the e-mail or put out all the features they want. So they hire customer service reps and engineers. That's the case at 4INFO, a mobile search service that has raised $16 million to dish up weather updates, sports stats, and local restaurant listings to cell phones. Last year, CEO Zaw Thet added 17 employees, for a total of 31. Now he spends just under $500,000 each month, about 60% more than last year.

Infrastructure can get pricey fast, too. Companies may start with Inc.'s (AMZN ) cheap data storage service, but as they become more popular, they must invest in their own data facilities. FeedBurner Inc., which helps publishers distribute and make money from blogs, has spent nearly 20% of its $10 million in funding on upgrading data centers.

Even a search-engine marketing campaign--the most basic means of getting attention--is becoming prohibitive. Ellen Siminoff, CEO of marketing firm Efficient Frontier Inc., estimates that it would cost a startup $20,000 a month now to run a worthwhile campaign, up from $5,000 two years ago. As vets of the dot-com bust might say, welcome to the real world.

By Heather Green

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