How Amazon changed start-up funding requirements
Start-ups gobble capital. In the tech space a lot of the funding requirements used to be for server infrastructure, which had to be bought. Given how hard it is to predict demand or the actual time it takes to build an online business, this meant that most businesses either over-or underinvested in tech, and a lot of capital was wasted through over-capacity and depreciation.
When Amazon.com launched Amazon Web Services in 2006, it changed the amount of f unding required for tech start-ups because it could now lease infrastructure by the hour. The result is that start-ups are far cheaper than they used to be and far more ideas can be tested in the market for a lot less capital at risk. Funding requirements have come down as a result, and a smaller fund can now have as much impact as a much larger fund used to.
THE DARK BUT OPTIMISTIC AGES OF TECH START-UPS:
In 1999/2000 I worked as a venture capitalist in London, investing in early -stage Internet deals. Aside from the normal challenges of identifying which ideas could be turned by the teams that came with them into billion- dollar businesses, the tech space at the time was also characterised by real problems in terms of the assets required to actually run an online business, and the capital required to fund these.
You see, back in the dark ages, if you wanted to run a website you needed to own the physical infrastructure. This meant that you needed your own webservers, load-balancers, air-conditioned
server rooms, RAID storage and connection to the main Internet l ines. Everything was ordered, paid for, delivered, installed, tested and usable.
The crucial and complex nature of the infrastructure meant that the startups often had their best developers setting up and testing servers. A single server could take six weeks to arrive and t wo days just to get up and running. It also meant that the working capital needs of the business were far greater than they would be for the equivalent business today, and so much harder to predict.
AS UNPREDICTABLE AS EVER
As anyone who has ever tried to build an app, e-commerce site, or run a big tech project will tell you, it’s very hard to predict how long it will take to build. Interdependencies in connected systems always throw up unexpected glitches and these delay production. Similarly, as anyone who’s ever launched a new product will tell you, it’s very hard to reliably predict how long it will take to launch the product and how quickly customer demand will ramp up.
So when your ser vers need to be ordered and paid for, then delivered and tested, you have a lot of working capital locked up in infrastructure. This is not terrible news if the product is delivered on time and things take off. However, when it takes longer than expected to go live and longer than expected for customers to start buying your product, you now have expensive servers sitting idle, gobbling up capital that demands returns of ±40% while the assets it bought are depreciating at 33% a year. You don’t need to do the maths to understand the ugliness of this picture from a capital perspective.
In the age of optimism (as the 1999/ 2000 period was) it seemed like everything would be online in a few months and a massive land grab occurred as start-ups and investors fought for f irst-mover advantage. So along comes a start-up that wants to sell high fashion online. Although we chose not to invest, they had a very clever system which included a virtual avatar that would guide you through the process of buying, just as an in-store assistant would in the real world. Mind-blowing stuff 15 years ago. Investors swooned and the entrepreneurs raised £ 125m ( yes, over R2bn) – for a pre-revenue start-up. An estimated $70m of this was for technical infrastructure.
HIGH FASHION, HIGH RISK
High fashion comes with other problems though: lead times on the clothing it sel f. Clothing designs must be chosen, ordered, paid for and delivered in a process that takes months before items are ready for sale. Fashionable items, by def i nition, are perishable – miss the market by a few months and you’re selling what was fashionable, not what is fashionable. Or rather, you’re not selling.
So add together technical delays, inevitable launch problems, and a system that was designed for more bandwidth than most users had at the time, plus a very poor user interface and you end up with one of the biggest dot-com busts of all time. Boo.com launched late, couldn’t sell its no-longer-fashionable clothing and ultimately died within 18 months. On liquidation, $70m of hardware and software got sold for $250 000.
This wouldn’t happen today, largely thanks to Amazon.com.
AMAZON CHANGED THE WORLD OF TECH START-UPS BY REMOVING THE NEED TO SPEND PRECIOUS CAPITAL ON INFRASTRUCTURE.
AMAZON SAVES THE DECADE
Amazon obviously uses huge amounts of computer processing power, bandwidth and storage to drive its e-commerce business. The company knows how fast the costs come down, have scale in purchasing these services, and also have excess capacity in their networks. It figured out that it could lease this excess capacity to the market, which in turn would give the online retailer more scale and allow it to bring down prices.
So it launched Amazon Web Services (AWS) in 2006. On AWS, you can lease a server by the hour, storage by the gigabyte per month, and bandwidth is supercheap. This simple concept changed the start-up landscape forever. Whereas Boo.com spent $70m on infrastructure, modern start-ups spend about $1 000 to $5 000 a month (and this at scale – you can run a lot – my usage of the system rarely tops $300 a month). There is no working capital requirement – you can simply f ire up a server (installed from an existing disk image, so no testing required), give it some t ra f f ic , and shut it down as t ra f f ic d ies down. Things can run idly if you like or you can lease large amounts of capacity if you’re running some computer simulations, for example. Scientific experiments that took months running on a few machines now take days running on hundreds. Amazon changed the world of tech start-ups by removing the need to spend precious capital on infrastructure. You simply lease it now. At huge scale it still makes sense to build and buy your own, but there are very few businesses that will ever reach these levels.
NOW YOU CAN DO MORE WITH LESS
The end result is ref lected in the funding needs of today’s start-ups. Seed capital of $100 000 will achieve as much as $2m did 15 years ago. Add that to very cheap marketing and customer acquisition potential thanks to Google AdWords, and you have the ability to build an application, build demand, and provide a business model for under R1m.
If things are working and you need to scale up then you have all the numbers to convince investors, who should still have enough capital to assist.