While Entrepreneurs Scale On The Cloud The Angels Get Supersized

Cloud computing is disrupting the venture capital industry in a big way. One of the obvious changes we all have observed is the reduced up-front capital expenditure to start a new venture. Things that used to require an array of expensive servers and an army of people to maintain them have essentially been replaced by a bunch of EC2 instances and a few smart developers. The tools and the technology stack for today’s applications are designed for cheaper and faster experimentation allowing the entrepreneurs to follow the lean methodology and pivot as fast as they can. I agree that some investors underestimate the people cost and overestimate the capabilities of the cloud but regardless this has caused a major shift in how the companies are funded.

The rise of an emergent category of super angel is all about leveraging the cloud computing. Fred Wilson closed a $30 million fund and Aydin Senkut closed a $40 million fund. These funds will invest into dozens of companies that can be bootstrapped with low up-front cost. More and more entrepreneurs prefer to raise as little money as possible in the beginning. This phenomenon has a few effects:

Raise AS you scale and not raise TO scale:

Founders have been able to raise money at good valuation without giving up large equity. This has been an uneasy situation for many venture capitalists and has crated strange problems while raising money. When Foursquare raised money the founders sold part of their equity to the VCs so that the VCs can earn money on a successful exit. The founders also decided not to sell out to Yahoo. Raising money as the company scales follows the cloud motto of scale-as-you-need and pay-as-you-go.

Build a product that you want and not what a VC wants:

The super angels typically stay on the sidelines and definitely don’t serve on the board. This means a lot more freedom to entrepreneurs to define and shape their product. This also allows the companies to take up-front risk, venture into new areas, and experiment where conventional wisdom would otherwise have prevented them. Fail fast and fail cheap is now a reality from a venture as well as technology perspective.

Prominent network effects in the start-up community:

I strongly believe that the cloud is the best participatory platform to create network effects of all kinds. I have seen similar kind of network effects occur in the new angel industry, especially in an incubator such as Y Combinator. The Silicon Valley start-ups have enjoyed the network effects for long time. These effects are even more profound when some of these start-ups are in an incubator setting. Such environments have a natural advantage for the entrepreneurs to leverage cross-pollination. Cloudkick is such an example of a YC company that was started by three entrepreneurs to build a solution to manage the Amazon EC2 instances that all other YC companies used at that time.

Competition in the portfolio companies could be a good thing:

The VCs do not prefer to have competing start-ups in single portfolio to avoid conflict of interest. As rational as it sounds this is simply not feasible when an angel or a super angel funds tens and hundreds of companies. I believe that it’s a good thing. At macro level the angels can see the patterns and advise the companies and at the micro level the companies can hone in their competitive differentiation before raising more money. This might also change how the founders pick and choose the angels. If the founders pick an angel who has similar companies in their portfolio they can expect better connections and mentoring from the angels despite of having the competing companies funded by the same set of investors.

It’s not that the entire VC industry has changed. The series A and B investors are as important as angels and super angels but the way the VCs operate and the expectations that the limited partners have would certainly change. I also believe that the VCs who are not stage agnostic will revisit their seed-funding strategy. The performance of the traditional VC funds that were raised in the last ten years is far worse than what an investor would expect from an alternate class assets, which is what the VC investments are. Time will tell whether doing more deals with same money will yield better return on the portfolio but, at least for now, the VC climate change is imminent.

Software Is The New Hardware

Today Intel announced that it is buying McAfee for $7.7 billion. This acquisition made people scratch their heads. Why McAfee?

The obvious arguments are that Intel has hit the growth wall and organic growth is not good enough to satisfy the shareholders. But this argument quickly falls apart from margin perspective. Why dilute their current nice gross margin even if McAfee has steady revenue stream? [Read my update at the end of the post]

I believe there are two reasons. The first is that the companies need a balanced product and revenue mix regardless of different margins. Oracle bought Sun and HP bought EDS. Big companies do this all the time. The second, not so obvious, reason is a recognition that software is new hardware. The processors are processors – they are a commodity any which way you look at them. It is not news to anyone that the computing has become commodity which is the basis of utility style cloud computing. Software, embedded or otherwise, has significant potential to sell value-added computing. The security solutions could fit in nicely on a piece of chip. When you drive a few miles from Intel’s headquarters to meet folks at nVidia you will be amazed to see what kind of value a software tool kit can derive from the processors.

I don’t know how Intel will execute the merger considering the fact that this is their largest acquisition ever. But, I am even more convinced that software is the new hardware. Cloud computing, data center automation, virtualization, network security, and a range of other technologies can leverage software in a chip that is optimized for a set of specialized tasks. Time to move from commodity to specialized computing until specialized computing becomes commodity. Interesting times!

Update: Romit sent me a message commenting that how McAfee will dilute Intel’s margin since McAfee’s gross margin is more than Intel. I should clarify. The assumption on the street is that the cost of capital for this purchase is about 4% and Intel expects 8% return on the investment even after paying 60% premium for the purchase. The tricky part is that how long Intel can maintain the close to 75% software margin of a software company operating inside a hardware company. When I say diluting the margin I mean diluting the overall combined margin post-purchase. The analysts are skeptical about the success of the merger and so am I. Intel has no track record of integrating large software companies such as McAfee especially after paying significantly higher than average premium. Hypothetically if Intel were to buy a company with more synergies that can leverage existing channels and can fit into their culture they could have increased the gross margin and hence the return to their shareholders.