Penny-pinching entrepreneurs changing world of venture capital

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Once upon a time on the Web, there was a lot of talk about “burn rate” – a phrase describing the way start-ups like Webvan and Pets.com went through venture capital like a blowtorch. Many flamed out.

Today, the operative phrase is “bootstrapping.” In “Web 2.0,” a term reflecting the medium’s maturation into a dynamic, cost-effective business platform, penny-pinching entrepreneurs simply don’t need venture funding as much as they used to.

The landscape of the brave new Web has changed radically, with start-ups sprouting daily and clout shifting from VCs to entrepreneurs. The cost of launching a business has plummeted, driven down by the advances in the “open source” software movement, outsourcing and the potency of Web-based marketing. Further complicating life for VCs is the acquisitive appetite of deep-pocket firms like Google, Yahoo, Microsoft and eBay, all shopping for companies.

VCs have reacted by becoming more creative, often acting as seed investors in exchange for equity. “There’s a lot of money chasing a lot of deals,” said Venrock’s David Siminoff.

They also can play a valuable role in the growth phase.

“The concept now is that you build your company, hope it takes off,” said Guy Kawasaki of the venture firm Garage Technology Partners. “If it does, then you go see the pain-in-the-ass VCs, but with more power on your side.”

Consider the story of Box.net, an online data storage business that was launched in February 2005 by college sophomores Aaron Levie and Dylan Smith, seeded by $11,000 from Smith’s Internet poker winnings.

Today, Levie, 22, and Smith, 21, have put textbooks aside to run a Palo Alto-based company that claims more than 1 million registered users – both individuals and businesses – and 12 full-time employees, with three openings to fill. For the past year, Box.net‘s growth has been supported by a modest $1.5 million in venture funding from Draper Fisher Jurvetson in exchange for about one-third percent of the company.

Data storage is, as Box’s founders acknowledge, a rather bland commodity amid the flash and cash of such Web 2.0 phenomena as YouTube, the video-sharing site that Google bought for $1.6 billion, and Facebook, the ascendant social-networking site.

In tech circles, Mark Zuckerberg, Facebook’s 23-year-old founder, is likened to a rock star, as are the founders of YouTube and Google. Storage, suggests Levie, “is like the rock star’s best friend.”

Is Box profitable? “I can’t discuss profits,” said Levie, Box’s chief executive. Then he smiled: “But I can say we have a lot of users paying us. We’ve proven out our model, so now we’re scaling up.”

A similar business model, circa 2001, might have needed 10 times as much venture funding, said Josh Stein, the DFJ managing director leading the Box investment. And it might have failed anyway, because the market simply wasn’t ripe.

The beauty of Web 2.0, Stein said, is more than the success stories. Just as important, the new economics have “lowered the cost of failing,” he said. “Five years ago it would have taken $10 or $15 million to determine if you had a business. Most start-ups are ultimately unsuccessful. By lowering the cost of failure, now a team can tell for $2 or $3 million whether or not it’s pointed in the right direction.”

So now, VCs say, entrepreneurs are better able to shrug off a setback and move on to the next thing. There is a faster pace and more experimentation.

Costs creeping down

Reasons for lower costs are well understood. The continuing progress of Moore’s Law – the predictable doubling of computer power every few years – keeps driving down the costs of hardware and computing. At the same time, the “open source” software movement has dramatically upgraded tools while pushing costs down further.

Ten years ago, six or seven programmers would have been needed to achieve the results of one programmer today, valley veterans say. Also, entrepreneurs now have the option of outsourcing programming chores overseas.

“One of the good things of the last boom is that we overbuilt bandwidth capacity and laid all this fiber,” said serial entrepreneur Kevin Hartz. An early investor in PayPal, Hartz founded the overseas money transfer site Xoom and is also a limited partner in Sequoia Capital and Founders Fund. Today’s entrepreneurs, he said, are reaping the benefits of the infrastructure.

Entrepreneurs and VCs alike, Hartz said, are impressed by how the “mash up” features of Web 2.0 – the ability for users to manipulate sites and embed applications – have enabled start-ups like Box to build on each other’s success.

Facebook’s decision in May to open its site to outside developers is credited with driving traffic for Facebook and those who jumped on its bandwagon. For example, Facebook users can embed their sites with a window linking to Box, where they may store photos or graphics.

Two new venture capital firms – Founders Fund and First Round Capital, both founded by young Internet tycoons – are specializing in the Web 2.0 opportunities. And in the past 18 months, several established firms, such as Charles River Ventures and Venrock, have added principals to focus on the Web.

Also stirring the pot are powerful Web companies – Google, Yahoo, eBay, Microsoft and others – that aggressively gobble up start-ups, sometimes elbowing out VCs who might prefer to take start-ups public in hope of greater success.

With Big Web dangling big checks and attractive jobs, “entrepreneurs are faced with a structural question they really never faced before,” Siminoff said. “They think, `Why would I take VC funding when I can just sell and make a small bundle of money and have a risk-free step up in my life?’ I don’t blame some of these guys.”

Box.net’s story

Few companies illustrate the Web’s new dynamics better than Box.net.

When the first wave of Web commerce was peaking in 2000, Levie and Smith were 15-year-olds at Mercer Island High School near Seattle who teamed up on class projects and later made a film for fun. Graduation set them on separate paths – Levie south to the University of Southern California with vague Hollywood ambitions, and Smith across the country to Duke University, trying pre-med before switching majors to business.

For a business class assignment, Levie researched the online data storage market. He learned that some online storage businesses failed in the dot-com bust because the price was too high. But now the cost of storage had fallen precipitously and consumers were becoming more comfortable with the Web.

Timing was “hugely important,” Levie said. “Now people are willing to pull out their credit cards for things they consider valuable.”

He contacted Smith, who became interested enough to commit his poker winnings. Smith’s parents, both attorneys, provided legal advice.

To augment Levie’s technical skills, they subcontracted work to a Russian firm through the Web-based job clearinghouse Elance, further controlling their costs.

The prime competitors, Levie said, were Streamload, now known as MediaMax, and Xdrive, which has since been acquired by AOL. To distinguish itself, Box offered “a little less space for a lot less money,” Levie said. Box’s initial price for 1 gigabyte of storage was $2.99 a month. A year later, the company’s usage soared when it offered the first gigabyte free in hopes that customers would sign up for more. As Levie acknowledges, this time-tested “gateway” marketing technique is used by, among others, drug dealers.

Levie and Smith juggled business with school work. Levie found himself answering his BlackBerry in accounting class to take technical support calls.

Back home on summer vacation, the 20-year-olds made their first attempt at raising capital. They hand-delivered a business plan to the home of Mercer Island resident Paul Allen, the Microsoft co-founder. The effort went nowhere. They were rebuffed elsewhere before venture capitalist Kent Johnson, representing a small syndicate, provided $80,000 in seed money for an equity stake.

Levie and Smith went back to school. Then in September 2005, they sent a press release about a new Box.net. feature to billionaire tech blogger Mark Cuban, an Internet radio entrepreneur now better known as the owner of the Dallas Mavericks pro basketball team. Levie said they were just hoping for publicity. But Cuban was intrigued, and after an exchange of e-mail, he provided $350,000 in angel funding.

After the first semester of their junior years, Levie and Smith suspended their studies to concentrate on Box. Their first hires were two friends from Mercer Island High, Jeffrey Queisser and Sam Ghods. To contain costs, the four initially lived and worked together in a Berkeley rental owned by Levie’s uncle.

When DFJ invested in Box in July 2006, the deal bought out Cuban’s interest. The Box team moved to the live-work loft on El Camino Real. The office, with its door typically locked to the outside world, operates from 9 a.m. to 2 a.m., with some employees able to stay overnight if needed.

The question is, how big can Box be?

Levie sees enormous potential as the Web becomes more popular and more integrated into daily life. “People aren’t putting a lot of data online. That represents a lot of growth for us.”

And what is Box’s destiny? Is it headed for an acquisition or an initial public offering? What if Google comes a-courting?

“I try not to think about it much,” Levie said. “I try to take it as it comes, just build as large a business as we can, and see what comes out of that.”