Innovation 2.0: Why Web 2.0 companies might have to flip to avoid being flopped

The question of "What is Web 2.0" has been debated at length in the blogosphere and in the alleys of the eponymous conference a week ago (and I am not sure that we have come to any agreement yet).

The question of "What is Web 2.0" has been debated at length in the blogosphere and in the alleys of the eponymous conference a week ago (and I am not sure that we have come to any agreement yet). For a quick review of related opinions, start with Tim O'Reilly's essay on the topic, and follow the links of this Memeorandum thread. I offered my own point of view, pointing out to the low cost of bootstrapping and the expected exit profiles of Web 2.0 companies, including the (in)famous short term flip. Peter Rip recently added an interesting perspective on the Web 2.0 entrepreneur bubble.

The industry commentaries have already stated that "build to flip" was a very risky endeavor, especially as the number of "feature startups" increases exponentially in a number of clusters (bookmarking, media sharing, mashups of all sorts). However, there are cases where a short term exit might not be such a bad thing. Here is why.

It is now clear that successful Web 2.0 companies will be the ones managing to reach "escape velocity", which basically means attracting millions of users, with a big zero cost of acquisition, at a rate of tens of thousands new users signing on per day. These "must join" networks (MySpace, Skype, potentially the Facebook) have risen to levels of usage and popularity that created strongholds very difficult to duplicate. Interestingly, technology had nothing to do with the differentiation at all, and sort of proves Ross Mayfield's statement that Wed 2.0 is made of people (or the network thereof) - at least as a valuation metric. However, a majority of community-based services will take a long time to reach escape velocity on their own, which means that they will need a real business model and/or benefit from someone else's user base through distribution deals--relying therefore on larger networks.

Who are these networks, and what are they doing? GYM (a shortcut for Google, Yahoo and Microsoft/MSN) are not sitting still, and over the past 12 months have delivered to the market a number of new products at an unprecedented pace: MSN Spaces, Yahoo 360, Google Maps, MSN Visual Earth, Google BlogSearch, Yahoo Podcasts, blah...

So far the technology ecosystem has lived under the principles of the innovator's dilemma; large companies can only deploy large scale initiatives, small companies out innovate them, develop a market presence and eventually become a large company through organic growth, acquisitions or being scooped up. Not in the Web 2.0 world.

Innovation 2.0 is a context in which large companies take on ideas and develop new products and services using the same tools as fledgling start-ups (LAMP, Ajax and stuff...), and release them within six to twelve months of the first mover. Look no further than Odeo vs Apple vs Yahoo in the podcasting directory space for a good example. Big companies don't always release great implementations of a given concept-- at least in the early days (Yahoo Blog Search, Google Reader, the initial revision of MSN Spaces,...). Early adopters (that's us boys and girls) will most likely not switch to these in the short term, but how about the early majority that does not jump on each and every new tool after reading a review on TechCrunch? GYM has such a level of distribution that they can get away with us not being too enthusiastic.

Google, with its 20 percent of free time for personal research, is a poster child of Innovation 2.0. Let's say that they have 3,000 people on staff who can develop "things"-- the 20 percent represents the equivalent of an army of 600 people, working in 3/4 person teams on their pet projects-- on top of the Google infrastructure. Don't be surprised to see them release cool new things at a breakneck pace. Yahoo is the same, with their "Friday Fun," which sees engineers work on their own ideas. Both have a concept of "Founders awards" that rewards the best teams with "no shabby" bonuses in the millions of dollars, creating a sort of internal startup mentality. And if it is not already in place, one can expect Microsoft to put a similar concept in place, or else...

Another driver bringing Web 2.0 start-ups closer to GYM is that they often rely on advertisers to pay for the services delivered to their users. The value brought by traditional advertising networks is challenged when you get into the hundred of millions of ad impressions per months, because the interesting inventory is exhausted pretty quickly, and AdSense/YPN have both the inventory and the sales force to provide interesting yields. The alternative is, of course, to build a proprietary advertising network, and put ad sales people on the street. Only a subset of companies will reach a scale that makes this economically viable.

Back to the flip, or actually the flips: The seed stage and the early stage. The seed stage flip was embodied by Google's acquisition of DodgeBall, and Yahoo's of (and others), where companies of a handful of guys were acquired for "$20 and a latte" (read that as a nice sign-on bonus for these teams, who then get to work in an environment with a lot of resources).

The early stage flip takes place after one or two years of running the company and a bit of financing has been raising ($1M to $2M). A $25M to $30M exit provides a 3X to 5X return to early stage investors and a nice chunk of change to founders who will then spend a couple of years working for the acquirer, contributing elements of their DNA to a number of projects (e.g., Flickr/tags/MyWeb), take a year off (recommended), and start again. Nothing wrong with that in my book, and by the way, nothing saying that $25 to $30M is the expected exit range for these companies.

So how will founders decide to go one way (the flip) or the other (VC funding)? Essentially by engaging both sides, and deciding what they want to do for themselves and their stakeholders, based on their chance of reaching this famous "escape velocity." In some cases, the time (and hype) value will maximize their personal returns in the short term. In others, it will make sense to "suffer" a VC dilution in order to bring in the resources to get to the next stage, betting on the fact that the opportunity they are aiming for is big enough to satisfy the return expectations of their VCs, and then some.

Thanks to Niall Kennedy for commenting on an early version of this piece. We were on the same plane en route to New York for BlogOn 2005.

Jeff Clavier is the Managing Partner of SoftTech Venture Consulting, a firm advising seed and early stage Internet startups. He will occasionally post his thoughts here on start ups, Web 2.0 and social media. Jeff also blogs on Software Only, generally about venture capital, early stage startups, and consumer Internet, and co-chairs the Search Special Interest Group of the SDForum.