December 2008(I originally wrote this at the request of a company producinga report about entrepreneurship. Unfortunately after reading itthey decided it was too controversial to include.)VC funding will probably dry up somewhat during the present recession,like it usually does in bad times. But this time the result maybe different. This time the number of new startups may not decrease.And that could be dangerous for VCs.When VC funding dried up after the Internet Bubble, startups driedup too. There were not a lot of new startups being founded in2003. But startups aren't tied to VC the way they were 10 yearsago. It's now possible for VCs and startups to diverge. And ifthey do, they may not reconverge once the economy gets better.The reason startups no longer depend so much on VCs is one thateveryone in the startup business knows by now: it has gotten muchcheaper to start a startup. There are four main reasons: Moore'slaw has made hardware cheap; open source has made software free;the web has made marketing and distribution free; and more powerfulprogramming languages mean development teams can be smaller. Thesechanges have pushed the cost of starting a startup down into thenoise. In a lot of startups—probaby most startups funded byY Combinator—the biggest expense is simply the founders'living expenses. We've had startups that were profitable on revenuesof $3000 a month.$3000 is insignificant as revenues go. Why should anyone care abouta startup making $3000 a month? Because, although insignificantas revenue, this amount of money can change a startup'sfunding situation completely.Someone running a startup is always calculating in the back of theirmind how much "runway" they have—how long they have till themoney in the bank runs out and they either have to be profitable,raise more money, or go out of business. Once you cross the thresholdof profitability, however low, your runway becomes infinite. It'sa qualitative change, like the stars turning into lines anddisappearing when the Enterprise accelerates to warp speed. Onceyou're profitable you don't need investors' money. And becauseInternet startups have become so cheap to run, the threshold ofprofitability can be trivially low. Which means many Internetstartups don't need VC-scale investments anymore. For many startups,VC funding has, in the language of VCs, gone from a must-have to anice-to-have.This change happened while no one was looking, and its effects havebeen largely masked so far. It was during the trough after theInternet Bubble that it became trivially cheap to start a startup,but few realized it because startups were so out of fashion. Whenstartups came back into fashion, around 2005, investors were startingto write checks again. And while founders may not have needed VCmoney the way they used to, they were willing to take it ifoffered—partly because there was a tradition of startupstaking VC money, and partly because startups, like dogs, tend toeat when given the opportunity. As long as VCs were writing checks,founders were never forced to explore the limits of how little theyneeded them. There were a few startups who hit these limitsaccidentally because of their unusual circumstances—mostfamously 37signals, which hit the limit because they crossed intostartup land from the other direction: they started as a consultingfirm, so they had revenue before they had a product.VCs and founders are like two components that used to be boltedtogether. Around 2000 the bolt was removed. Because the componentshave so far been subjected to the same forces, they still seem tobe joined together, but really one is just resting on the other.A sharp impact would make them fly apart. And the present recessioncould be that impact.Because of Y Combinator's position at the extreme end of the spectrum,we'd be the first to see signs of a separation between founders andinvestors, and we are in fact seeing it. For example, though thestock market crash does seem to have made investors more cautious,it doesn't seem to have had any effect on the number of people whowant to start startups. We take applications for funding every 6months. Applications for the current funding cycle closed on October17, well after the markets tanked, and even so we got a recordnumber, up 40% from the same cycle a year before.Maybe things will be different a year from now, if the economycontinues to get worse, but so far there is zero slackening ofinterest among potential founders. That's different from the waythings felt in 2001. Then there was a widespread feeling amongpotential founders that startups were over, and that one shouldjust go to grad school. That isn't happening this time, and partof the reason is that even in a bad economy it's not that hard tobuild something that makes $3000 a month. If investors stop writingchecks, who cares?We also see signs of a divergence between founders and investorsin the attitudes of existing startups we've funded. I was talkingto one recently that had a round fall through at the last minuteover the sort of trifle that breaks deals when investors feel theyhave the upper hand—over an uncertainty about whether thefounders had correctly filed their 83(b) forms, if you can believethat. And yet this startup is obviously going to succeed: theirtraffic and revenue graphs look like a jet taking off. So I askedthem if they wanted me to introduce them to more investors. To mysurprise, they said no—that they'd just spent four monthsdealing with investors, and they were actually a lot happier nowthat they didn't have to. There was a friend they wanted to hirewith the investor money, and now they'd have to postpone that. Butotherwise they felt they had enough in the bank to make it toprofitability. To make sure, they were moving to a cheaper apartment.And in this economy I bet they got a good deal on it.I've detected this "investors aren't worth the trouble" vibe fromseveral YC founders I've talked to recently. At least one startupfrom the most recent (summer) cycle may not even raise angel money,let alone VC. Ticketstumblermade it to profitability on Y Combinator's $15,000 investment andthey hope not to need more. This surprised even us. Although YCis based on the idea of it being cheap to start a startup, we neveranticipated that founders would grow successful startups on nothingmore than YC funding.If founders decide VCs aren't worth the trouble, that could be badfor VCs. When the economy bounces back in a few years and they'reready to write checks again, they may find that founders have movedon.There is a founder community just as there's a VC community. Theyall know one another, and techniques spread rapidly between them.If one tries a new programming language or a new hosting providerand gets good results, 6 months later half of them are using it.And the same is true for funding. The current generation of founderswant to raise money from VCs, and Sequoia specifically, becauseLarry and Sergey took money from VCs, and Sequoia specifically.Imagine what it would do to the VC business if the next hot companydidn't take VC at all.VCs think they're playing a zero sum game. In fact, it's not eventhat. If you lose a deal to Benchmark, you lose that deal, but VCas an industry still wins. If you lose a deal to None, all VCslose.This recession may be different from the one after the InternetBubble. This time founders may keep starting startups. And ifthey do, VCs will have to keep writing checks, or they could becomeirrelevant.Thanks to Sam Altman, Trevor Blackwell, David Hornik, JessicaLivingston, Robert Morris, and Fred Wilson for reading drafts ofthis.
