Friday, June 20, 2008

Software startups face funding gap

By Stephen DeSantis, Special to Mass High Tech

Take a novel idea, a talented team of tech savvy entrepreneurs and a few thousand — highly caffeinated — man hours, and stir rigorously. It’s the recipe for many software startups taking their very first steps toward creating a feasible company. That is an over-simplification, of course. However, the barriers to entry for many online companies and software as a service (SaaS) technology firms are fairly low.

“Do the analysis of what it took in the mid-’90s to start an enterprise software company, built from scratch, to reach $1 million in revenue. Did it take $10 million? Today it would probably take half of that investment,” stated William Rurode, executive vice president at SaaS Capital Inc., an Ohio company with its East Coast headquarters in Westwood.

The initial funding to bring to life the next great social network, CitySearch site or salesforce.com-like SaaS business can be relatively short money. That fact alone allows for a constant flow of exciting innovation, more opportunity and a fast start on the steep road to success. The atmospheric conditions are ripe for grassroot startups and the word is out. That’s a good thing, right?

It turns out that for a lot of software venture hopefuls, those conditions can have a downside too. Finding that first infusion of funding to get a fledging company off the ground, may just be getting a little trickier.

“There seems to be a new gap in the capital markets for companies that are under a certain threshold, looking for less than, say, $4 million in capital. We often get these questions from young companies who are just looking for a little bit of money, perhaps $500,000, to get their company to the next level. And, we have no place to send them right now. The overhead and work involved with doing a very small investment is just not worth the potential returns on it,” said Bas van der Brugge, a principal at Burlington-based Mirus Capital Advisors.

Funding levels between angel groups and venture capitalists fluctuate along the current economic and industry landscapes. When the gap widens, it is typically the entrepreneur who gets caught in the middle. Today, it seems the rapidly changing nature of the software sector is the culprit. Subscription- or advertising-based business models take time to build. For a capital investor, it can be a long wait and take a lot of expensive marketing for the hope of just a modest return.

“Because of the nature of this software- as-a-service approach, with each new customer you don’t get the upfront hits of a perpetual license, so you have to try and grow incrementally to maintain your cash flow. It’s very challenging unless you have the good fortune of getting funding from an outside source,” said Jeff Kaplan, founder of THINKstrategies, a strategic IT consulting firm based in Wellesley.

Competition is also tough. Hundreds of Web 2.0 or SaaS ventures are popping up, looking for funding. “Now we see a whole set of tools like Amazon’s E2C (Elastic Compute Cloud) and others that are taking a whole chunk of the costs out of launching and running a 2.0 company. That said, it’s really not a confrontational comment to say that the business models, and how these communities are getting monetized, is still very much a moving target and I think that is why the enthusiasm for funding them may have tempered,” said Peter Alternative, a partner and head of the software practice at Mirus.

It is true, venture capital firms are indeed in the business of spending money to make money. Unfortunately, for some players, they like to make big bets with higher returns.

“Despite the operating efficiencies, multi-tenant architectures, predictability and all the things associated with SaaS, some of the luster has come off the rose. The simple truth is, as long as you are maintaining a 30 to 50 percent growth rate, you’ll have folks who are willing to postpone saying ‘show me the money.’ If you can’t, they become a lot more discerning,” Alternative explained.

For-profit incubator groups can offer an entrepreneur a whole host of invaluable resources, solid business guidance and even cheap office space. However, companies still need to be able to pay rent and fees. That leaves looking to family and friends, applying for grants, maxing out credit cards — and then there are the angels.

Typically a former entrepreneur or a group of like-minded backers, angel investors have the financial patience and the appropriate business models to bridge the apparent funding gap in the capital markets. Think Google Inc. Before any venture capitalist would touch them, the quintessential rags-to-riches Internet startup began with a $100,000 check written by an angel investor. “You can have teams of young, enthusiastic, creative entrepreneurs with a lot of energy, but they are never going to get a product to market without at least some amount of money. The engine that drives small technology companies is clearly angels,” said George McQuilken of eCoast Angels (see story this page).

But ironically, McQuilken sees some value in trying to finance your dream yourself, without the help of outside capital. His premise is simple. If you don’t need a lot of money to build a business, then you don’t need to make as much profit because it all stays with you.
 

Angels for the big and small

The eCoast Angel Network often provides the first money into a deal, typically investing $250,000 to $500,000 per round.

Two of eCoast Angels’ budding investments are CitySquares and My Punchbowl, both of which received seed money and follow-on financing “at the higher end of the range,” according to eCoast Angels. Framingham-based My Punchbowl, which bills itself as the ultimate party planning and online invitations website, is based on web application software developed by founders Matt Douglas and Sean Conta. Their business model goes above and beyond revenue from advertising and includes revenue sharing on supplies, merchandise and event booking partners.

Known for its socially minded philosophy, Boston-based CitySquares is a popular advertising and community events site that focuses on locally owned, neighborhood businesses.

“Our philosophy is that you enhance local neighborhoods and communities by strengthening the locally owned businesses. Local businesses are what make our neighborhoods unique. Citysquares.com gives those businesses a voice through an online presence that they can afford,” the company website states.

And eCoast Angels has helped some seriously cutting-edge software companies as well. Portsmouth, N.H.-based VKernel Corp., a maker of appliances for managing virtual server environments, was originally funded in 2007 by eCoast Angels and fellow angel group the Breakfast Club of New Hampshire for just a few hundred thousand dollars. In February, the company raised $4.6 million in its first round of venture capital funding from Hummer Winblad Venture Partners and Polaris Venture Partners.

 

Stephen DeSantis is a freelance writer in Boston.