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Internet Startups Face a Change of Plan

Internet firms are looking down the barrel, in terms of the financial crisis. Yahoo Inc. (Nasdaq: YHOO), for instance, faces a 64 percent drop in net profits, as 1,500 employees are scheduled to lose jobs and the stock price touches $12. (Some investors think Jerry Yang’s decision to turn down Microsoft for $33 was a huge mistake.) Even Google (Nasdaq: GOOG) stock has fallen (in spite of strong financial performance) from a 52-week high of $747 to a recent new low of $310.

As the overall bailout and new stimulus packages from the U.S. Fed take effect, the scene will get tighter for Silicon Valley firms of all sizes, including startups, as VCs revise their investment plans.

So, how does the situation affect the lifecycle of an Internet startup?

Up to now, the philosophy for new companies has been: Get an idea, bootstrap a company, show that your model works, get seed funding, show some scaling in terms of traffic, and then get proper VC funding to build the traffic. Revenue will come once the traffic is there (the Google way). Funding is based largely on revenue “potential.”

This philosophy will be tested in the worldwide severe economic downturn. “R.I.P. Good Times” is Sequoia Capital 's response to the current situation, in a leaked presentation that is proof -- if any were needed -- that startups should expect a lifecyle plan more like: Get an idea, bootstrap a company, show that your model works, make some money in a short amount of time, demonstrate your viability, then seek VC funding with some running cashflow at decent burn rates.

It hasn’t helped that a lot of funding for the Web 2.0 bandwagon has been quite unworthy. There are tons of social networks and video publishing sites that have been funded in arenas where even leading lights don't have revenue plans. Example: Twitter is still undecided on revenue channels. Bijan Sabet, board member of Twitter, says: “Stay tuned, they are working on it.”

Startups interested in making it in the present environment could benefit from the following tips:

• Get costs down. Burn rates must get lower in order to justify startup expenses, period. “Time is money," after all.
• Get cashflows higher. Don’t expect to get funding unless you can generate revenue.
• “Get Real or Go Home.” This admonition from the Sequoia Capital presentation tells it like it is -- and will be -- for those seeking VC funds. Companies without a demonstrable product or service with a robust revenue model can’t expect much in the way of financial assistance.
• Expect high expectations. In today’s startup market, VCs will focus on better apples in the portfolio and quickly drop the rotten ones. A viable exit is the way VCs and angels make money, and in these tough times, it’s going to be difficult. Startups will need solid key metrics to keep themselves saleable.

There is some good news: Since this isn’t the first economic crisis Internet startups have faced, some firms are better prepared this time with lessons from the dotcom bust eight years back. Also, Internet penetration is far higher than it was in the year 2000. Web sites today have solid traffic with high user involvement -- giving TV viewership a run for advertising dollars. The SME segment and other ROI advertisers are getting more direct purchases from the Internet than from any other medium. Vertical startups have strong niche traffic, which is useful in targeted advertising.

Still, most funding will dry up for the next two or three quarters -- during which time robust business models will be promoted, while frivolous copycats will meet their demise.

Written by Sandeep Amar

Silicon Valley Legends Tackle Internet Switching

Entrepreneurs and venture capitalists in Silicon Valley may be pressed by the economic climate, but at least one Valley legend has made his reputation -- and a sizeable fortune -- by zigging when everyone else is zagging. And it looks as though he is doing it again.

Andy Bechtolsheim, a co-founder of Sun Microsystems Inc. (Nasdaq: JAVA) and an early investor in Google (Nasdaq: GOOG), is once again putting his large brain to work on the hardware that makes the Web run.

Bechtolsheim has just announced that he is leaving Sun -- where he has been chief systems architect ever since the company bought his last startup in 2004 -- to focus on an Ethernet hardware maker known as Arista Networks Inc. The company's main product is a 10-Gigabit switch, which puts it in direct competition with networking-equipment giant Cisco Systems Inc. (Nasdaq: CSCO), as well as a couple of smaller players.

If you're going to go up against a company like Cisco, it helps to have someone who knows the opponent on your side. Arista has just that: The company's new CEO is Jayshree Ullal, the former head of Cisco's corporate data center unit and an engineer with a background in highspeed Ethernet switches. (She wrote about her new job here.)

The company's new chief scientist is Stanford University computer-science professor David Cheriton, who has been involved in two previous startups with Bechtolsheim and was also an early backer of Google.

According to a report in The New York Times, Cheriton and Bechtolsheim are financing the company themselves -- which probably isn't surprising, considering each has a net worth that is estimated in the billions.

Cheriton, a Canadian, helped to connect Google founders Larry Page and Sergey Brin with the venture capitalists at Kleiner Perkins Caufield & Byers , while Bechtolsheim provided the very first $100,000 angel investment to Google, at a time when the company was still based in a garage and hadn't even been legally incorporated.

Bechtolsheim and Cheriton co-founded two other networking equipment companies that were later acquired: Gigabit Ethernet company Granite Systems was bought by Cisco for $220 million in 1996, and Kealia was acquired by Sun in 2004 for an undisclosed sum.

Although Arista is a hardware maker, Bechtolsheim has said the company has an edge over other high-speed networking equipment providers in the software that runs the switch. The Sun co-founder says too many switches use what amounts to slow, outdated software routines that don't take advantage of the speeds available within a network. He says they also don't allow for rapid prototyping and customization the way most Web-programming software does.

Arista touts its systems as more easily updatable, and the firm says it will even offer users a form of open API that will allow them to add their own features. Arista is also reportedly aiming to price its wares lower than its competitors.

As venture capitalists and investors of all kinds question the benefits of pure Web 2.0 services -- the ones that have managed to survive until now despite a lack of a revenue model, based on the "build it and they will come" philosophy -- it's likely that many of them will turn toward solutions that are rooted in hardware, as Arista's is. The benefits of a faster switch are not only more tangible, but more immediately obvious for companies that spend millions on their networks.

As usual, Andy Bechtolsheim is ahead of the curve.

Written by Mathew Ingram