It's Still Expensive to Build a Great Product

It has become commonplace to claim that the cost of starting a company has declined by an order of magnitude; just this morning Dave McClure took this claim as the starting point for his dazzling essay, Moneyball for Startups.

I think the claim is partially true, but overstated. And I wish we had data, not rhetoric, to settle the dispute. The costs that are supposed to have declined radically are usually for hardware and sales. But that is nothing new. Since I have been involved with startups, hardware has  been essentially free compared to the cost of software development. In fact, Jeff Bezos coined the phrase “hardware is free” in 1997, not 2007.

And the idea that a sales-force is expensive is ridiculous. It may be inefficient or a pain in the neck, and it may slow revenue growth, but a sales-force isn’t expensive. Since sales-people have existed, the terms of their existence have been that they pay for themselves, often within a few months of starting. And the idea that sales-people have disappeared is a myth: Google, Yelp, LinkedIn are filled with sales-people, cleverly hidden in corners of the campus that nobody visits.

What’s really changed is that software development has gotten easier and faster, due to agile development frameworks like Ruby on Rails. This is a genuine difference but it is incremental not disruptive: it still takes time and talent to build a stand-out web application.

Another genuine difference is that marketing costs have declined, though this too is overstated. We all deplore the 1999 dot.com that spent $10 million in venture capital on SuperBowl ads. But the reason we all noticed startups buying SuperBowl ads is that they were anomalies, not the norm. Nobody building the first railroad had to spend much on advertising to persuade people that it was a better way to travel across the country than a covered wagon. Disruptive technologies have always sold themselves.

And we’ve always known that. For ten years at least, the advice on Sequoia Capital’s website has been: “a huge market with customers yearning for a product developed by great engineers requires very little firepower.” For a hundred years, people have said that if you build a better mousetrap, the world will beat a path to your door.

So I still think the hard part of a startup is engineering a great product — – Picnik’s co-founder Jonathan Sposato once told me that a startup’s prime directive is to “build something hard” – and that the primary cost of doing that has always been great hiring great engineers.

Great software engineers, engineers who could easily get a job at Google, Facebook or Twitter, are worth hundreds of thousands of dollars on the open market. They will accept less if they are major equity holders in a great company, but not much less, at least not for very long. A team of five or ten engineers costs one or two million dollars a year.

To Google, a full team is worth much more than that; as soon as the company forms its value is more than the sum of its parts, creating an arbitrage opportunity for early-stage investors. Unsurprisingly, many companies don’t so much build great products as build great teams, hoping that Google will buy the company for the talent, even if it sets aside the product.

This is less a startup than it is a union. Since I’ve long believed engineers should reap the rewards of their work, a union may be a good trend, as long as your goal all along was a job at Google –and a huge signing bonus.

But if you don’t get bought, you have to build a product that is self-evidently better than any of its competitors, so that it can generate millions in revenue. And I still think that takes at least a year or two. Maybe it shouldn’t, but a true pioneer often screws up along the way, and you always encounter knotty problems you hadn’t anticipated.

What that means to me is that startup costs have declined, but not by the orders of magnitude claimed by angel investors. And I still wonder whether one reason startups are spending less money is that at least some are tackling less ambitious projects.

I am not judging that choice, in part because I am not even sure it is a choice. The path that Redfin has taken has not been any more deliberate than our own idea of fun, and it has been driven for years by our realization that no one will buy Redfin if we fail.

This is cold comfort for an investor. Dave McClure would say thanks but no thanks to a Redfin investment, because he is a seed investor who wants to stake only a little money and get a lot back in a very short time-frame. I like his approach, but I don’t think it’s the only approach. When he argues that his type of investing is the best type of investing, and that the alternative will go the way of the dinosaurs, I just want some data, or even a single example.

His article has no examples, even though we can easily think of counter-examples. Ask any casual technology observer to name a great investment and he might say Twitter or AdMob, both VC-funded deals. Maybe this is the wrong question to ask, since people inevitably focus only on the latest valuation, and not on the time and capital it took to get that valuation in the first place. The best way to phrase this question may be: what are the top 20 deals since 2005, as measured by internal rate of return? It seems silly to argue over what strategy makes the most money, when money can always be measured.

If anyone knows the answer to this question, I’d love to hear it.

Discussion

  • http://www.Kens411.com Ken Brand

    Interesting stuff. Thanks.

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  • http://twitter.com/evanjacobs Evan Jacobs

    There seem to be two separate issues here:

    1. Companies require less investment to get started because of the trend to find product/market fit sooner. I don't think that even Dave McClure would argue that the cost of building the next Twitter or Facebook has dramatically decreased. I think his point is that we shouldn't have to wait 5 years (or even 2 years) to see if a company is going to be that successful.

    2. Companies that are on their way to finding product/market fit are increasingly the target of larger companies which can make very compelling acquisition offers. It takes a special personality to refuse the offer of an immediate substantial payoff in exchange for the chance of something much more compelling down the road.

    • http://blog.redfin.com GlennKelman

      I agree with your first point more than your second Evan. I think you can figure out if you've got demand for your product more quickly when it's a web service, a trend that has been true since the dot.coms of the '90's, though iterative development has increased our willingness to experiment.

  • Dan

    Great article and I would like to offer my own perspective based upon my startup experience. I think in today's world of crowdsourcing, the cost of building a great product has actually reduced significantly. I have used crowdsourcing platforms such as 99designs, Squadhelp.com, voices.com to get to a much better user experience and product for my customers – something that would have cost me a multiple of atleast 10x if I had used a professional agency or built my own team from ground up. I used Squadhelp to run a contest to find a name for my business ($50). Within 2 days I had received more than 200 awesome name suggestions. Then I used 99designs to create logo as well as design for my site ($500). Then I used Odesk to create my initial platform using open source technologies ($3000). Then I used Squadhelp again to host contests for viral videos for my platform ($250). Then I used Voices.com to create a nice voiceover for my site introduction video ($250). Then I used Squadhelp again to run a contest for testing my website ($200). I was up and running with a very cool product for around $5000. My personal experience from the past has been that I would have to invest about $50,000 to get to the same level of capabilities if I used a dedicated agency to do all this work.

    Now, one would argue that the value of crowdsourcing is not as good as having your own dedicated team. I, on the other hand, strongly believe that these crowdsourcing platforms help create an amazing experience because you have an army of freelancers competing to create the best product.

    However, these are just my thoughts based upon my personal experience. They may not be consistent with the experience of others.

    • http://blog.redfin.com GlennKelman

      I am going to explore your idea more Dan. I oscillate between being iterative and crowd-source, versus being or wanting to be driven by a personal vision.

    • Varun

      Dan, your comment is VERY useful – kudos. You haven't just spoken in generalities but linked to specific sites and stated what you paid. I'm off to voices.com now to get good voiceovers for the how-to demos on our site. Thanks.

      - Varun Arora
      Co-founder, GotoCamera

  • http://www.umb.edu/vdc/ William Brah

    It indeed seems that one reason startups are spending less money is that at least some are tackling less ambitious problems. I think of those startups as next generation of mom and pop stores along main street.

  • http://www.facebook.com/people/Mike-Simonsen/527691553 Mike Simonsen

    Glenn – it's clear that the *startup* costs have indeed fallen by orders of magnitude for certain types (many? most?) of tech companies. I live that example every day. In our case it's quite obvious we would have needed 100x more capital ten years prior – just to get the underlying infrastructure (servers and database software) on which to build the hard stuff.

    Great product is, in my experience, usually the output of a very few rockstars. One vision + a handful of powerful developers. Great product is only “expensive” if the founding team isn't those people.

    What's also clear to me is that *scaling* costs are *not* cheaper. Scaling requires people and people cost money. I live this every day too. Live by the sword, die by the sword. Dave generalizes this as “sales” but it's an entire organization of people.

    All the great product companies are the output of just one or two amazing individuals. The investment capital has been to scale.

    But that's why McClure and the super angel model is so compelling. Investors build a broad portfolio of would-be-stars, entrepreneurs get more power in the deal.

    Rock on.

    • http://blog.redfin.com GlennKelman

      This is one of my favorite comments, and the best arguments that a great company can be built with only a few folks. I agree that a small number of rock-stars make great software, not an army of folks there to fill out the numbers. The best example of that to my mind is Urbanspoon.

  • Jgreenough

    Love the counter arguments and agree that certain investors are going to pass on “wins” if they don't look right for them. Any time that you are getting into a partnership both sides should be talking about and looking at the same thing.

    If your vision is to have 5 programmers in a garage who can grab 10 Million customers in 6 months using a new mobile/social app then you don't need the extra rounds of funding. If you are doing something that requires a longer sales cycle or research then you are going to test/iterate and grow when you have the right formula.

    Redfin has taken the time to test and iterate the model and still grow aggressively. I applaud the ability to manage and sustain through an unforeseen time in your particular industry. This is a credit to good growth and steady investors/leaders.

    The Angel / Seed investors have built a strong place in the ecosystem and has helped shift the market to be more open & competitive which serves the entrepreneur well. My hypothesis is that it we will hit a nice balance in a few years with less total VCs who are more capital efficient. I am unsure whether we will have more or less angels but we will probably find out relatively quickly.

    • http://blog.redfin.com GlennKelman

      I agree it's a question of balance, and that the market shift towards angelas is more balanced. But i think anyone, a VC or an angel, would love to invest in a company that gets 10 million customers in six months. Did even Twitter get 10 million users in its first six months?

      • Jgreenough

        Fair point, maybe I should have said 1 million or 100K to prevent hyperbole.

  • gaganbiyani

    Hey – wonderful post and I'm totally split on the issue. Personally, I don't have the experience to know whether the shotgun approach is better or worse than the laser approach. Regardless, you asked for data and I think there's one good source: the folks at RightSide Capital have done some significant work on the matter. Here's the post: http://emergentfool.com/2010/05/11/simulating-a

    Would love to see what you think!

    • http://blog.redfin.com GlennKelman

      That is a great analysis, but isn't it still based on an abstract model rather than actual returns?

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  • http://twitter.com/hgadhia Hemang Gadhia

    Great post Glenn, I think you are 100% on the mark. No doubt that it's far cheaper (in relative terms) to build a business nowadays than it was 30 years ago. But I think the discussion is now being driven by a lot of “lean startup” hyperbole more so than facts and figures. It may be cheaper to build a startup that aspires to generate $5-20MM in annual revenue, but if you are thinking more ambitiously there are significant capital costs associated with it. Those that are arguing that you're not a “real” entrepreneur if you can't build a company with $20k are missing some key nuances (and yes, perhaps I'm exaggerating a little bit as well). You can't always build something great with 4 developers who are paid close to nothing who eat raman noodles all day. Sometimes you need a more senior level team to execute on bigger ideas <gasp! 30 or 40-somethings!!>. I for one would like a more fact-based discussion on this topic as you are suggesting. Sure foursquare might've been able to do the two guys bootstrapping in the basement model, but not every startup can. And while the “fat” startup model isn't necessarily the right one either, it feels like this debate has gotten to a stage where there's no room for a middle ground or differing opinions.

  • Jgreenough

    Fair point, maybe I should have said 1 million or 100K to prevent hyperbole.

  • peteR

    Well stated, and while Dave McClure's post does resonate for those looking at the Zyngas and Twitters of the world, there are still sectors for Venture investment out there that take more to start IMHO. I agree with Dave about the shorter runway for Web 2.0 companies, but there are other areas that still require more capital.

    Take the biotech space, or the medical device space, both ripe areas for innovation. If you are going to scale up fuel production, you've got to build out physical plants to prove your manufacturing techniques. Same goes for getting FDA approval of a device.

    Then there is enterprise software. Is there any room for someone to build a company that competes with Oracle, Microsoft or SAP? Certainly Google is out there trying, and they were brand new not that long ago. Enterprise software companies like Guidewire might have a chance, but they require larger amounts to capitol to get to a size where they can avoid being swallowed by one of the existing behemoths.

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  • http://www.tricontowers.com/en/ Real Estate Hanoi

    That was a very interesting article. Today, we don't really think that in order to build your own business, you have to have lots of money, but besides that you have to know for your self what are the products or the services you will share to them. It is not like you are going to ask someone to do it for you, but you will have to try it yourself first with lots of effort and passion.

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  • http://anuragmjain.com anuragmjain

    Great post, and I totally understand what you are saying. I failed at my startup, primarily because I think we didn't tackle the hard problem, but instead always focused to keep the problem small. Sometimes, they are just not that small, and it does require guts to just solve the harder one instead. I mean, after all, isn't that why we leave cushy jobs and jump into the startup-space anyway? I think Dave's model of investing really doesn't want to do anything disruptive, but rather encourages finding arbitrage opportunities in smaller addressable markets that exist, so that small teams can jump in, innovate a little and make use of that opportunity. But solving a hard problem means that those arbitrage opportunities don't really exist, and thus requires a lot more effort and smarts. My $0.02.

  • João Morossini

    Lack of reliable data on the subject is a huge concern of mine. I myself have started a new B2B web business (ww.eurekaclick.com) with a couple of friends and, since then, we've been reading a lot about lean startups, case studies, web businesses and so on… Although there's a lot of quality material available, there's also a lot of divergence and that makes it harder for us to come to a conclusion, specially when it comes to raising capital in order to start and grow a business. Most people say it's best if you find a profitable business model before going for venture capital (wich makes sense to me), but reaching that stage may be difficult (if not impossible) for a low budget startup. You might end up risking the whole thing trying to make the most out of an immature product.
    Personally, I like the way Sean Ellis approaches the matter by advising companies to try and reach Product x Market Fit and then using VC.

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