I recently came across several very similar situations with software start-ups located in the Bay Area.

Venture capitalists seldom invest in software start-ups nowadays, especially if their product relates to WEB 2.0, social networks, or other online businesses. They first want to see (i) an initial product financed by the founders and (ii) some market traction. Market traction clearly means revenue; a sizable number of free users/subscribers is not recognized as market traction anymore.

It might not be that bad after all. We are back to a more traditional business model where entrepreneurs have to contribute their own savings, and turn to business angels, incubators or friends and family to complete their initial round of funding.

Budgeting and raising the proper amount of money required to get a product to market is critical, and entrepreneurs cannot afford any mistake, as these first dollars are likely to determine the fate of their new venture. The equation is simple: the initial funding has to take them to a point where their venture becomes either sustainable, or at least shows a demonstrable revenue model. If this goal is reached, then raising more money should not be an issue; if not, it would be highly challenging to get any extra funding.

And just because delays seem to be an intrinsic part of the software industry, entrepreneurs should always spend wisely and even keep a cash reserve when possible.

Some unnecessary expenses that were the hallmark of VC-funded start-ups have disappeared already, and that is very good: high-end offices stuffed with expensive furniture, company’s catered parties, oversize administrative team, etc.

There is still one area though where entrepreneurs tend to spend too much money, and that is on their development effort.

I can think of 2 major mistakes there, one happening when there is solid funding and the other when there is not enough funding. Let’s illustrate the point with these 2 sentences we all have heard too often:

1 – “We want the best developers, and we will pay whatever it takes to assemble the dream team.”

First, and unless the entrepreneur is the most wired person in the Valley, chances are he/she won’t be able to attract the shining stars. And that is not even the real question; if the very best developers are required to get the ball rolling, then the concept might not be as good as it sounds. The founder’s role is to over motivate his/her team, not to find and hire shining stars; shining stars who by the way are very unlikely to join any start-up, especially during these hard economic times.

2 – “We have very limited funding (=not enough), so our team works mostly, if not entirely, for equity.”

In this case, the developers will become rapidly impatient, or will not give their undivided attention to the project. Bottom line is that precious cash (and precious equity) will be burned away for little result. Remember, getting only 80% of the first version of an application is getting nothing! In most cases, it will be easier to rewrite the code entirely, as opposed to trying to understand the existing stack. How many entrepreneurs have the cash to afford the rewrite of their initial version?

I meet at least 4 to 5 times a month with entrepreneurs who have spent their funding with no results and are turning to established outsourcing companies, offering them to finish the work for equity! Hello??

Remember, the first dollars are essential. If you were unable to deliver, why should anyone take the risk to commit their resources for an equity that is already worthless?

I do not mean to be rude, but I witness these situations too often. If you are an entrepreneur, spend wisely with your developers. My observation is that in most cases, the technical challenges are not as big as many entrepreneurs think they are. Technical problems tend to grow with the success of the company. Trying to anticipate too much at the beginning is just counter-productive.

And remember, turning to an outsourcing company that will work for a fixed price is often the best way to spend less, limit your risks and prepare for the next steps. And finally do not worry, if your business does take off, you will be snowed under by resumes of the Bay Area’s “best” developers.

Remi Vespa
Venus Software International

Posted by Remi on Monday, July 6th, 2009 at 7:43 AM.