The Rise of the Lean VC – Consumer Internet Gets Its Own Investors

Consumer Internet investing seems to have split off from traditional Venture Capital, and is creating a new category of VC’s: Lean VC’s.  I think you can blame Customer and Agile Development for a small part of it.

Here’s why.

Electron-based Venture Capital
When I first came to Silicon Valley the world of Venture Capital looked pretty simple. VC’s invested in things that ran on electrons: hardware, software and silicon.  While individual VC’s inside venture firms specialized in particular domains (PC’s, peripherals, semiconductors, test equipment, operating systems, applications, etc.,) their investments had roughly the same time horizon and were focused around things that used electrons – primarily computing and computing infrastructure.

The VC business took off with the rapid growth of the semiconductor business. Fairchild Semiconductor became the progenitor of a flood of Silicon Valley chip companies and at the same time the adoption of the limited partnership as the model for Venture Firms gave VC’s their own profitable business model. The personal computer business was built on top of the semiconductor business about the same time that the last of the pieces of Venture Capital were falling into place – the 1979 change in the EISRA “prudent man” rule allowing pension funds to pour billions into Venture Funds.

Here’s what the start of Valley chip business looked like on a genealogy map, tracing most all of its DNA back to the first Silicon Valley chip company, Schockley Semiconductor.

Cell-based Venture Capital – The Birth of Biotech Venture Capital
In 1980 Genentech became the first IPO of a venture funded biotech company. The fact that serious money could be made in companies investing in life sciences wasn’t lost on the venture community.  But the knowledge that VC’s had built investing in electron-based companies didn’t translate to expertise in cell-based or cell-proximate companies.  The technologies were different, the time horizons were different, (2 to 5x longer to take a drug through FDA trials ~14 years,) and the regulatory environment was different (barely any in traditional VC investments compared to FDA trials for drugs and 510K approvals needed for medical devices.) Finally the amount of capital needed to take a drug to FDA trials could be enormously expensive, at least 10x more than startup costs at an electron-based company.

The two watershed events for biotech startups were the Bayh-Dole Act of 1980 and the Orphan Drug Act of 1983. Bayh-Dole allowed for private ownership of government funded intellectual property developed in universities while the Orphan Drug Act created incentives for developing drugs for disorders afflicting fewer than 200,000 Americans.

After a while, the only thing Biotech VC’s had in common with their compatriots who invested in electrons was that they both invest.  (In some Venture Capital firms they may share the same roof and overhead, but no one is confused, they’re in very different businesses.)

The Rise of the “Lean VC’s” – Consumer Internet Gets Funded
For a few reasons, I’ve been struggling to make sense of all the noise happening in what others have called the Super Angel arena. First, my students are confused about who to talk to and how to think about funding their consumer internet startups.  Second, and full disclosure, I’ve invested in a few of these funds; and third my teaching partner Ann Miura-Ko is a partner in one of these funds.

My take is that we are watching an entirely new category of Venture Capital firms emerge.  It is as an important a split as when the biotech guys hung out their shingles.

Consumer Internet startup investors are now their own category.  I call them “Lean VC’s” to emphasize why they’re different.

(In his indomitable way, Dave McClure describes this shift best, but I have to screen-scrape his posts, paste them into Word and clear the formatting to read them.)

One could argue that there’s nothing new here, as Internet distibution models started in 1995. But in reality they only became mainstream ~5-7 years ago. Most of the social and mobile channels (YouTube, Facebook, Twitter, iPhone, Android) have emerged in just the past 3-5 years. But these VC’s aren’t Lean because they fund startups with web-based distribution models. It’s because the startups are doing something very new that make them “Lean” :

  • These startups embrace customer and agile development that Eric Ries has been evangelizing.
  • They build a minimum feature set.
  • Quickly iterate the product in front of customers.
  • Drive for a repeatable and scalable business model (revenue in Dave McClure’s investment thesis, “network of scale” in Union Square’s.)
  • Their capital needs are low at the front end. The advantage of commodity software stacks drops initial startup costs for Internet Commerce companies. (But scaling customer acquisition may take the same amount of dollars as a traditional software startup.)

Lean VC’s are Different
The skills needed to succeed as a “Lean VC” are different from those needed for traditional software investing. Previous experience of investing in software companies that hire direct sales organizations and take years to build the product using waterfall development doesn’t translate to expertise in Consumer Internet startups. The technologies are different, the speed of execution, iteration and pivots are different and the time horizons for exits are different, (2 to 5x shorter for a consumer Internet company.)

Finally, the “death of the IPO” and the emergence of the “small market M&A” changes Consumer Internet economics. One of the interesting characteristics of these new “Lean VC” funds is that they can be smaller than the traditional multi hundred million dollar VC fund. The small investments necessary to get a consumer internet startup going enables Lean VC’s to make lots of early bets and double-down when early results appear. (And the results do appear years earlier then in a traditional startup.)

(BTW, just like the Biotech VC’s who may share a building with Electron-based VC’s, you may find a Lean Venture Capitalist sitting under the same roof as a traditional VC. Just make sure they get and embrace the Lean VC principles. The test is, ask them how they differ in their investing philosophy from the rest of their firm.)

Lean Angels
Along with Lean VC’s a new class of angel investors has emerged. YCombinator, Techstars, et al, have been described as incubators but in reality they are the new “Lean Angels.”  These angels “get” the sea change happening in Internet Commerce. The difference is that unlike Lean VC’s, these angels help their startups rapidly develop the product, but typically don’t add much help in developing the market/customers. And while they provide the initial investment they rarely follow-on with the Series A dollars needed for scale. They’re a great feeder system for the new class of Lean VC’s.

Lessons Learned

  • Entrepreneurs in the consumer Internet space should look for funding from Lean Angels or Lean VC’s
  • Lean VC’s are expert in on-line distribution, Agile and Customer Development
  • They drive for early results inexpensively, and invest heavily when they see results
  • Their strategies for their startups differ – some focus on revenue, others build large networks of users

24 Responses

  1. Great piece. Looking back, you could consider that AOL (the original company name was Control Video Corp) was Lean as it pivoted to try to find market fit back in the 80s. Yes in the 90s there were many companies with great ideas, many of which were similar or the same ideas that are taking off today, but there are two key differences: 1. The size of the market is dramatically different (100s of millions instead of 10s of millions) and 2. The cost of starting these businesses is approaching zero today whereas just to get started in the 90s you needed 100,000s of dollars. Like the Bayh-Dole Act and the Orphan Drug Act of the 80s changed the landscape for Bio Tech, these two factors have changed the landscape for Lean Startups.

  2. This makes sense, although unless i’m misunderstanding, you’re implying that lean principles and non-consumer internet startups (i.e. B2B) are somehow mutually exclusive. In other words: would a lean VC be interested in a B2B internet company with a direct sales force or direct sales component (ex: hubspot), so long as the company embraced a lean approach to product development?

  3. Appreciate the breakdown. From a founders perspective the breakdown become how much money versus how much revenue/traction.

    Actually if and when to seek external funding has become an important concern.

    Based on market size lean VCs can provide a smoother vehicle to a small exit. I’m curious about why entrepreneurs would choose lean Angels (20k for 8%) unless they needed help landing 500-750k for 20-35%

  4. I’ve heard from a number of VCs and super angels these days that they think they’re an “angel bubble” en route (if not here already).

    Do you think this is a justified concern? Or perhaps just fear of losing deal flow to new, “amateur” money?

    Cheers,
    Tristan

  5. Steve
    Good post. Rise of super angel and lean VC adds much to the entrepreneurship. Seraph is working to add to this community additional Network Effect. Stay tuned.
    Tuff

  6. A cool element of this evolution is that other parts of the ecosystem are having to rapidly iterate as well. Law firms tend to be the last to innovate and among the least nimble institutions out there, but we’re also being dragged along by the wave.

    Similar to traditional VC, the startup lawyers are having to get on board with social media, public facing personas and other aspects of getting deal flow from consumer internet entrepreneurs who don’t want their father’s law firm and don’t give a shit who played golf with who on Sand Hill in 1999.

    And, of course, we need to find more creative ways to run our businesses so that legal expenses can stay in step with some of the other dramatic cost reductions that in many ways are driving this movement. I think more and more we’ll see “start up packages” and other fixed fee type arrangements for qualified startups (ie, clean formations without a bunch of hair – no “my uncle set us up as a Florida LLC and I may have started working on my cool search startup while still at Google” startups).

    Similarly, while it’s happening in fits and starts, simple form docs that everyone can largely pre agree upon are gaining momentum and market acceptance and while they will never be perfect, I think they will increasingly become a part of this segment of VC/early stage investing.

    No question it’s an exciting time.

  7. Steve, I couldn’t help commenting on and chuckling at:
    “In his indomitable way, Dave McClure describes this shift best, but I have to screen-scrape his posts, paste them into Word and clear the formatting to read them.”

    I can imagine how annoying that must be. Have you heard of the Readability bookmarklet? If not, you should give it a try as it does exactly what you do but in one click:

    http://lab.arc90.com/experiments/readability/

  8. Wow. Ivan, my fingers were literally starting to type the same comment you just made in response to Steve’s outstanding post. I founded a new law firm earlier this year on just that premise. Coming straight out of a decade in the consumer Internet industry (eHarmony, MySpace — and going back a decade, Excite@Home), it’s been an exciting time to hang out a shingle aimed directly at this market. If you go to my website you’ll see the tagline “Lean Startup Lawyers for Emerging Growth Companies.”

    Targeting my pitch to early-stage startups and entrepreneurs in the consumer Web space, I’ve found them incredibly receptive to the model that I put forth of “lean lawyering” — bringing to bear the expertise of a real Valley firm that “gets it”, but with a leaner cost structure that results in dramatically lower billing rates and overall legal expense, commensurate with the Lean Startup approach. It’s crazy to spend $75K in legal fees to raise a $500K seed round.

    Almost every entrepreneur I meet with is looking for less than $1MM capital, eschewing VCs in favor of angels, and — while certainly ambitious — would be perfectly happy with a nice M&A exit at a valuation in the tens of millions. A dramatic contrast to the founders of a decade ago whose idea of success was raising $5MM Series A from Kleiner Perkins, hiring 500 employees and going public with a billion-dollar valuation (but minimal revenue and no profits). The swing-for-the-fence approach of traditional VC’s seems out of sync with this new reality.

  9. Great post! Why do you think incubators / lean angels “typically don’t add much help in developing the market/customers?”

  10. Are the Lean VCs truly “Consumer Internet” or just Internet? IOW, I suspect that if not yet, then soon, B2B SaaS will also be funded by Lean VCs.

  11. The Readability bookmarklet (http://lab.arc90.com/experiments/readability/) is the perfect companion to Dave McClure’s blog… :-)

  12. 1. There are more categories of investors: Angels, Lean Angels/Incubators, Super-Angels, Lean VC and Traditional VC. The reason I actually differentiate between Super-Angels and Lean VC is that the fundamental expectation for exits is very different. Super-Angels typically have <$20M funds and are very happy with $25M exit. I'm not. For me, that was a deal that "didn't suck". The reason it's important to get these investors categorized is that something very amazing has happened over the last few years – Entrepreneurs now have the ability to match exactly – the dollars they raise, the dilution hit they want to take, the expectations for exits, the involvement from their investor – to the needs that they have. Entrepreneurs no longer have to be subjected to a "one size fits all" mentality and I think that's a beautiful thing.

    That said, entrepreneurs need to know exactly who they are approaching when they come to someone for money. Dave McClure doesn't like the same kinds of deals I do. I don't have the same taste in deals that Jon Callahan has in deals. This creates tremendous confusion in the market

    2. The concept of Lean VC goes much broader than Consumer Internet. Half of our portfolio is in business software and services. I also believe that it will impact other sectors as well if there are commoditized technologies that you can bring to bear within the business.

    3. I think the very best Traditional VC firms will encourage their companies to continue to pivot far beyond product market fit. I think it's a mistake to assume that a) product market fit is a definitive moment within the lifecycle of a company and b) product market fit enables you to entirely stop customer development. I believe that markets continue to shift and evolve and customer demands also shift dramatically. Companies that stop this iterative development ultimately become irrelevant. Traditional VC firms need to figure out how to dump money into a company and ensure that you're scaling the things that are working and continue measuring to make sure that what you're scaling is scaling while keeping money out of areas that require more experimentation.

    4. I actually think that the revenue vs. traction debate is not universal to all startupsCertain companies are built to create network effects and become a top 10 internet site. We have one set of metrics for these types of companies. The other kind is ones in which revenues matter – (basically anything not trying to become a top 10 destination site). In this case we have a different set of metrics.

  13. Interesting observation Steve, though I don’t see Lean VC as a person, or a type of firm. Most lean deals end up being able to put bigger $$ to use to scale once they find their path (Twitter, Facebook ,etc) and traditional funds are doing more seed work as well. Thus, I see it as more a type of deal that can be lean, and the longer term implications is that hopefully the entire industry of VCs (small, medium, large) will lose less on the dogs that don’t make it improving the overall returns. Big exits and IPOs will still be had for the big new ideas that execute well, but there will be a lot of small deals that simply couldn’t get to a $100m/yr type of run rate that get taken our or just live off of cash flow.

  14. early stage requires a specific set of skils to deal with p/m fit. a corollary imo is that you cannot outsource this to anyone whether junior people or consultants or whatever. it’s a labour of love that can only be done by principals. hence whether angel or vc or entrepreneur, lean is the only way to be. fluid strategy and execution requires it.

    growth is a different animal. post p/m fit (by no means a binary event btw) the game changes. different skills required, different funding.

    i think vc’s have to figure out their natural habitat. i could not do growth to save my life.

  15. Hi Steve,

    Great post. I love your work, and we give your book The Four Steps to the Epiphany to all True Founders when they join the True family.

    We follow your principles every day, and not just for our portfolio but for our own business. We started True with the belief that our customer is the Founding entrepreneur. Everything we do stems from this belief. We build products, and they happen to be called deals. We work with our customers to consistently innovate and make our products better.

    Today, we build 3 products for entrepreneurs: super-seed deals of $250k, seed deals of $500k to $1 million, and “real” deals of $1 million to $2.5 million. Each product has different attributes designed for entrepreneurs at that stage (eg legal costs, terms, etc). These products were inspired, designed, and honed by the interaction we have with our Founders and other entrepreneurs over time. We’re about to launch a 4th product in response to our customers needs. Stay tuned.

    Your thinking about the Lean VC is spot on. Small initial rounds designed to demonstrate initial product traction are the right approach to funding in today’s capital efficient market. True’s first few deals of Automattic, Meebo, Sphere were tiny amount of capital that succeed in creating very large and successful products and customer ecosystems. Our portfolio is now 67 companies strong executing on this belief.

    Though we initially thought that this worked well only in consumer segments, over the past few years our thinking has evolved. Our portfolio companies like Socialcast, Assistly, and Syncplicity have shown us that these lean funding models apply to a new generation of web-centric enterprise software companies. Same goes for the web infrastructure related software providers, as shown by Puppet and Loggly. A few years ago we developed a thesis that devices were becoming more capital efficient, so we funded Fitbit, Sifteo, Valencell and another one yet-to-be announced startup.

    The bottom line for Founders is that now is an incredible time to start a company across a wide range of industries. Capital efficiency, newer methods and approaches to product development, and new, effective, robust global distribution channels enable Founders to minimize downside but still maximize the chance to build a product that can change the world. The good news is that the venture market is responding, and more options for capital exist now than ever.

    It is good to be a lean VC.

    P.S. Ann, I love your deals :) – McClure’s too.

  16. [...] brings me to another point about the ShinyArt model. Apparently, small start-ups with low costs and a vision for small incremental scaling are a sign of the new Jerusalem here in Silicon Valley. If you are [...]

  17. [...] is a guest post by Steve Blank who has graciously allowed Founders Block to repost his article, originally published on August 5th, [...]

  18. The VCs are STILL not looking at reality. Instead, they have their eyes closed and are like the blind men looking at an elephant. There they look for ‘patterns’. Problem is, they way they are looking for patterns has next to nothing to do with reality, still less to do with actual causes, and little promise of anything useful.

    E.g., take (1) “agile development” versus (2) “waterfall development”. BS, 99 44/100% BS. Neither (1) nor
    (2) is very meaningful. When a programmer starts
    typing in software, he is fully free to ignore both. Basically he is just doing his work, and his work doesn’t have to fit either (1) or (2). Next, trying to find a ‘pattern’ for the software development is brain-dead: Look, guys, clearly, in simple terms, what matters for the software is does it run, does it do good things, is it nicely free of bugs, is it well enough structured so that it can be changed reasonably easily for likely changes, is it documented, will it scale, is it novel enough to be difficult to duplicate or equal, etc. These are some totally obvious, important points about software, not (1) or (2). Come ON guys; let’s get this thinking way, way up past, say second grade. I mean, just where do people get the really strong funny stuff they’ve been smoking to think that (1) versus (2) is important?

    And, it’s not just the ‘software development'; instead, it’s the whole list of criteria.

    Instead, we need to do what we have long known we need to do but, for various reasons, are reluctant to do: We need to look at projects one at a time. Maybe some nervous LPs want to see ‘patterns’. Hmm …: If want something new, powerful, valuable, ‘disruptive’, ‘ground breaking’, in conflict with ‘conventional wisdom’, …, then just what smoky funny stuff says to look at simplistic, obviously nearly meaningless patterns?

    Uh, there really are some ways of knowing with some really good examples in the rear view mirror, but, sorry, VCs, you can’t do that work, or, to be more clear, maybe some of the biotech VCs could but not the ‘information technology’ VCs.

    Maybe it’s all the fault of the LPs. I’ll settle on that conjecture for now.

  19. You are correct that the model has shifted for consumer internet companies. The costs for designing and building enterprise solutions has also dropped dramatically, however:

    Until the mid 80′s most solutions were proprietary and very expensive to design, engineer, develop, sell and support. There were therefore relatively few choices and few methods to disseminate information about them (trade shows, trade rags, sales forces, etc.) This began to change with the introduction and use of open standards (SUN/Unix). So prior to then it was relatively difficult to build a product but relatively easy to market it.

    The advent of the web and the proliferation of open standards and openware in the late 90′s, brought different challenges to creating a successful company. With the web, there are now countless ways to get information about a solution or offering. The challenge to an emerging company is identifying the audience they need to reach, finding the correct messaging and then efficiently and cost-effectively reaching them. As there are exponentially more solutions available now than there were 20 years ago, prospective buyers are bombarded with messaging from literally hundreds, if not thousands of vendors. It is challenging for any company to get through all of the noise. Further, buyers are a lot more informed and sophisticated now than they were prior to the web. If your messaging isn’t personalized it won’t be believed. Many great products/services/solutions die on the vine because they can’t get through the noise and to their audience.

    The result is that the capital investment it takes to create a successful enterprise has shifted from engineering and development to sales and marketing. The challenge here is that while this may be conceptually true it has not occurred in fact. Most B2B companies underfund and do an extremely poor job of marketing.

    Why?

    1) Generally speaking, the best marketing people go to B2C companies where there are huge budgets and lots of ‘interesting’ things to do. B2B companies tend to scrimp on marketing budgets – what really good marketer wants to work with that?

    2) Typical career paths for VPs of Marketing in B2B companies are System Engineer-to-Product Manager-to-Product Marketing Manager-to-VP of Marketing. Often the people performing marketing in B2B companies know little about customer buying processes and have little customer empathy. Regardless, they are not funded sufficiently to successfully accomplish their missions. You want a good B2B marketing person? Find one that came up through the ranks in sales.

    3) Many technical entrepreneurs still have a “build it and they will come” mentality and have to go through a painful learning process to discover that this is not true. It is almost a rite of passage that they move from CEO to CTO and then leave “to pursue other interests.”

    A fundamental shift in how capital is allocated to build a company is required. It needs to shift from development (which is now relatively easy) to marketing and sales (which is now relatively complex).

    thruthenoise@gmail.com
    twitter.com/ThruTheNoise

  20. Steve – this is a great post.

    We are clearly seeing a shift in the venture industry that offers tremendous return potential. Your term Lean VC is exactly the strategy that we prefer to invest with, but I’m not sure it applies only to the consumer internet or extremely small micro funds.

    In September 2009 my partner Roland Reynolds and I co-authored a paper outlining our view that only small funds (less than $250mm) are right-sized for the venture opportunity. You can download the full paper here: http://bit.ly/a5ZeYS. This does not presuppose that just by being small in size can a VC generate the returns we’ve come to hope for from the asset class. It’s not enough that an individual company exit be successful for a VC – he/she must generate returns across a whole FUND.

    We believe a small fund should have a strategy of investing in capital efficient businesses to allow for diversification and protect against later round dilution, while also driving significant returns back to the fund at a $100mm exit and a $1B company can return a multiple on the whole fund. I’d argue that many angel, or micro funds do not behave like a small fund should, but instead have the same return dynamic as large funds – where small exits don’t move the needle and they require many $1B companies in order to generate returns (a $1B fund needs to own 20% of TEN $1B companies in order to return 2x gross). It is extremely rare to have even one of these blockbuster companies in a portfolio. If a fund has one and is able to exit, that investment should return the entire fund or even a multiple on the entire fund.

    As such I’d be careful to classify an investor a Lean VC simply on the qualification that they have a small fund and/or invest in the consumer internet, because these lean characteristics can describe a number of firms outside this micro fund / consumer internet ecosystem.

    As the venture industry undergoes a rightsizing process – fundraising back to the levels of the mid 90s – less capital will be available to finance the best companies of tomorrow. Companies will need to be capital efficient and cannot require as much investment as we’ve seen in recent years. Further the exit markets have shifted from one dominated by IPO in the 80s (96% IPO) to one in which M&A is now the chosen path (85% in the 2000s). Valuations for venture backed M&A exits are not astronomical at $112mm but exits are hard to come by and this should be a profitable event for an investor and its LPs. If a $100mm outcome is a positive one – how can a FUND make money in that dynamic. Lean VC firms have a strategy that profits from these types of exits in a material way and will drive significant returns to investors. Since a firm must do right by both entrepreneurs and LPs to succeed as a business net fund returns are a vital component to equation.

    There may not be a “right” answer to this riddle, but as we evaluate the characteristics of micro funds we are attracted to the return dynamics of certain strategies – especially those consisting of a portfolio concentrated in a reasonable number of companies that can drive significant returns at average exit valuations as a group, with each able to return the entire fund should it be outrageously successful.

    Twitter: @kcw3rd

  21. [...] The Lean VC [Founder Insight] Steve Blank runs through a brief history of the VC industry and describes what he considers a “lean VC.” This new category of Super Angels is what Blank refers to as lean VCs with smaller investments, flexible exit options, and 2 to 5x shorter time horizons, Super Angels have a different investment philosophy. – Steve Blank [...]

  22. Hi Steve,

    I am a fan of your blog since a while now.

    I am trying to find investors for my project named http://www.blipsport.com a Mobile & Internet social network for sports related activities and health monitoring.

    As I am heading to San Francisco for a few weeks from the 25th of august until the 19th of September I was wondering if we could meet and share a coffee some day?

    I am French with a material science PH D background and 10 years in the wireless network industry. I come to discover the Silicon Valley its entrepreneurs and investors.

    Here is my email: lucdurand@hotmail.com

    Hope to have the chance to meet you!

    Regards

    Luc

  23. [...] some best practices for Lean Venture Capital?With Lean VC as definded by:(a) Steve Blank (Stanford):http://steveblank.com/2010/08/05…(b) Dave McClure (500 Startups):http://www.slideshare.net/dmc500….Is there any best practice [...]

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