Wallen's

Innovation: more or less?

There has been some discussions lately on whether the crisis will increase or decrease innovation (see for example Mark Evans or Jason Kolb). By innovation, I mean a new product/service addressing successfully an unmet need in a new manner (not a perfect definition but it should be sufficient for now). I've been changing my mind on this topic several times. Here is my latest attempt to answer the question.

 The different arguments go the following way:

• Less innovation: there is less funding available for ideas hence there will be less new products hence less innovation
• Same innovation: though there is less funding available, (all) good ideas will still get funded
• More innovation: me-too is not sufficient to build a business anymore. At the same time there are plenty of talented people with more time to find ideas. Hence innovation should increase.

The implicit assumption in the first two arguments is that investors are good judges of what is or is not innovative. Nothing proves this assumption. The third argument implies that they are constant economies of scale in innovation. The reality is that there are diminishing economies of scale when it comes to innovation. Big corporation with their massive R&D budgets tend to be less innovative than start-ups be it in the web or healthcare sectors. However, one characteristic of the process of innovation is serendipity so the more people do "stuff", the more people find innovative "stuff".

Taking the above ingredients and mixing those leads me to my current "work-in-progress conclusion": there will be much more innovation in relative terms but a bit less in absolute terms.

Don Dodge on starting a company during a recession

You've got to love this post from Don Dodge "Start a company in a recession? Absolutely". That's enthusiasm!

I agree with Don on the conclusion but for different reasons. IMHO, the main reasons are that it will be more difficult for competitors to copy you as everybody is focusing on their core activity and VC funding is (a bit?) tougher for new start-ups.

While Don's reasons are valid too, there is however a big "if". He argues that VCs are loaded with cash these days based on discussions with some of them. As I had mentioned in a previous post, US VC fundraising and investment was indeed more or less flat in the first half of 2008 by the credit crunch. However, the "treasury coffer" of US VCs was around USD 7bn end of 2007 vs. USD 21bn end of 2001. Hence, Don's conclusion is correct if institutional investors like pension funds continue to invest in VC funds. It will be interesting to see the figures for Q3 and Q4.

Freemium can be a viable revenue model... sometimes

Mark Evans wrote a post two days ago claiming that freemium is not a business model. Peter Christensen followed with another post on the topic saying that it is not a business model but just a marketing strategy. IMHO freemium can be a viable revenue model... under certain conditions:

• A "free" service with real value (either directly or through network effects) to build a user base
• A good balance between "free" features and "paid" features, i.e. "paid" features really need to add value to the "free" service. Not all web products can cater with this segmentation
• Well-thought price points that match the willingness-to-pay of certain segment of the user base... and that is very difficult to get right, especially when there is no market benchmarks
• Good marketing tactics to encourage conversation from "free" to "paid"

There might be other conditions but the point is that not all web products are candidates to freemium due to their inherent characteristics. Nor is it easy to implement. It's an iterative process with trial and errors. But if a product builds successfully a freemium model, it can be an elegant substitute to an advertising revenue model, especially if the product doesn't fit with an ad model. Think about it, if 5-10% of the user base pays USD 2-4 per month, it could generate as much revenue as advertising from the entire user base. A value added service is bound to find people willing to pay the price of a coffee.

A good example is Xing (a European publicly quoted competitor of LinkedIn). Xing has 8% of it's entire user base or 26% of its unique visitors with a paying subscription. They pay an average of EUR ~55 (USD ~75) representing EUR ~15 per unique visitors vs. EUR 3.4 in advertising and job listing. Of course users have a higher willingness-to-pay for their career than for other typical web services. But still it makes the point that freemium can be a viable and lucrative revnue model and at the same time not hinder the user experience.

Valuation and the power of framing

There are some discussions going on about the valuation of web start-up funding rounds. Most people predict that it will go down. But should it really be the case?

A web start-up investment has a particular cash flow profile for investors: very negative today and 4-7 years down the road very positive (hopefully). With this particularity in mind, the current crisis should in theory lead at worst to a small decrease in web start-up valuation levels (for a comprehensive site  on valuation go here):

• DCF tells us that there should be only a small decrease in valuation levels today: the cost of capital for the next few years cash flows is increasing but the remaining elements are not affected (e.g., LT cost of capital)

• Multiple approach, if correctly used, should marginally affect today's valuation levels. (however it is not - during a bubble investors overestimate valuation and during a downturn they underestimate it because they use the current market multiples)

• Option valuation implies that today's valuation levels should increase because volatility has gone through the roof (mind you while it is the best methodology in theory to value start-ups, it's nearly impossible to apply in practice)

But what about reality?

VC funding is a market in which each player (VCs and entrepreneurs) has a framing at any particular point in time. In the past few weeks, a majority of VCs have changed dramatically their framing. They are afraid of having difficulties to raise their next fund. This fear is even stronger for poor perfomers. This leads today to an effective decrease in supply of VC capital and of valuations expectations. Let's call this the "fear framing". I am not saying that it is an organized process by VCs ; it's rather an "unconscious" process for the vast majority of them.

While in theory "fair" valuation levels should not be dramatically affected for web start-ups, I am afraid that some entrepreneurs will get caught in this "fear framing" and accept "unjustified" valuations. Others (if they have enough cash to survive) will only accept "fair" valuations.

Panic at TechCrunch?

The problem of being a journalist is that you need to find stories. I usually appreciate Michael Arrington's post but here is a story that is totally beside the point.

How can one relate directly a financial crisis to a media usage pattern??? Yes, some start-up will go bankrupt, i.e supply goes down. But it does not mean that the entire media usage pattern of the past 10 years will suddenly change, i.e demand is still here.

If one defines web 2.0 (and I'm not fan of lingo) as harvesting collective intelligence, claiming that it is dead is just absurd. Did train usage stop because of 1929 crisis? No. Did TV stop because of 1973 crisis? No. So why would the demand side of the Web "democratization" stop because of an upcoming recession? "Democratization" of all sort of products have been a common pattern over the past century across all industries. A new one has recently emerged in the media industry via the Web. CDOs and CDSs won't stop the demand for this! User generated content will survive this financial crisis.

While I am not sitting in the Silicon Valley, it seems from reading blogs in the past few days that there is a real state of panic currently in the Web industry because of Wall Street events. As I mentioned in a previous post, yes, we will go through rough times. But demands rarely changes dramatically, it usually waits for supply to come... Web 2.0 is alive and is here to stay!