Product investing and ‘because of’ rather than ‘with’

By November 14, 2006Venture Capital, Web2.0

This is a follow up to yesterday’s post where I was arguing that investing in inspiration – i.e. products – is the easiest way to make money. 

In On VCs and Products and Services JP commented on this, wondering if VCs are missing the point somehow as we move into a ‘Because Of rather than With world’.

I want to pick up on two things JP said.  Firstly he wrote:

We’re moving into the Because Of Rather than With World, so eloquently described by Doc. Where infrastructure is often built on a Nobody Owns It Everyone Can Use It Anyone Can Improve It world. Where the creativity and innovation of the knowledge worker teams operate on the edge of the core infrastructure. A core infrastructure that used to be a rich vein of gold, but is now a humble spade.
And maybe. just maybe, VCs aren’t prepared for this. Product-based business plans are all about With. You make money With the product. Knowledge-based business plans will all be about Because Of. You make money Because Of the product.

This notion of ‘because of’ is complicated.  JP explains it at more length in this post – but I think there are two things going on here – firstly there is a transition from product to commodity.  At that point the model switches from making money by selling (i.e. with) a product to making money by using a product to do something else (i.e. because of it).  To repeat from the excerpt above “A core infrastructure that used to be a rich vein of gold, but is now a humble spade.”.  This is product commoditisation which is something VCs understand well – the plan is always to exit before it happens.

The second thing going on is an emerging view that there is a need to create products that go straight to the ‘because of’ stage without being premium ‘with’ products first.  Linux and blogging are oft cited examples.  We do stuff (have fun, do business, make money) because of these technologies rather than with them.  This blog helps me to make good investiments, it doesn’t make any money itself.  If Linus Torvalds had not open sourced Linux and Dave Winer had not opened up RSS we wouldn’t be where we are today (and you quite literally couldn’t be reading this blog which sits on a Linux server and you probably access via RSS).

VCs have not been behind these innovations, it is true.  Thankfully there are fantastic innovators like Torvalds and Winer and many other open source gurus whose lives are about contributing to the greater good.  I get that.  Venture capital is different though, it is about making money, and we do that by supporting people with great ideas who are similarly motivated. 

It is true that most VC investments have been in products of the ‘make money with’ kind, but we have played a part in many ‘because of’ developments as well.  E.g. MySpace, YouTube, JBoss and MySql are (or were) all venture backed.

I concede that these types of company are more difficult for us to fund, but they do happen.  The difficulty is in building cash flow and the exit strategy usually has to be that someone (NewsCorp, Google, Oracle) will pay a strategic premium for your business.  (The definition of strategic by the way is ‘can’t explain it now’.)  A lot of what I have been wrestling with on this blog over the summer relates to this issue.

The second thing JP said that I wanted to pick up on was:

This is all about perception, the perception that Web 2.0 companies are free-riding on someone else’s infrastructure investment.  And the VC community may well believe that as well, I need to think about it.

I may be missing something here, but I haven’t viewed the low cost of starting web2.0 companies as any kind of free riding.  They pay hosting and bandwidth costs at market rates.  The reason they are cheap is that in the early days there isn’t much traffic.  As I said yesterday, once the traffic picks up there is often a need for VC.

These thoughts are all forming rather than formed and rather complex.  I think I need to go and have a cup of tea.