SurePayroll Inc., an online payroll service provider for small businesses, was founded in 1999, at the height of the tech bubble. Co-founder Troy Henikoff remembers going out to raise the company’s first round of venture capital in the first week of April, 2000, when the tech-heavy NASDAQ stock index was tumbling hundreds of points daily.
“On Monday we had meetings with big VCs, but by Tuesday they were a little distracted,” he said. By Friday, they were canceling meetings, scrambling to salvage their existing investments.
Despite the discouraging climate, Henikoff said he and his partners pushed through, conserving cash and finally closing on their first round of financing in January 2001, after the bubble burst. Terms were not as favorable, but the company raised $8 million.
“We ended up with the appropriately frugal culture,” he said. “We treated every penny as though it was our last.”
Last year, SurePayroll was acquired by competitor Paychex Inc. for $115 million.
Though today’s sky-high valuations of companies like Facebook and Groupon, along with the more than $350 million collected by LinkedIn in its highly anticipated IPO, have investors fearing another tech bubble, experts say the tech industry’s climate is inherently different these days and better positioned to produce real revenue and investor returns.
The dot-com bubble was characterized by overvalued IPOs of companies that were not producing revenue and “irrationally exuberant” investors. Pets.com, an online pet supply store, famously spent $11.8 million on advertising while earning only $619,000 in 1999, its first fiscal year.
“The joke was, yea, you know they’re losing money on every transaction, but they’ll make it up in volume,” Henikoff laughed.
Pets.com entered bankruptcy a year later.
“People were investing hopefully, with perhaps too much aspiration and not enough confidence in where this opportunity might lead,” said James Gerard Conley, professor at the Kellogg Center for Research in Technology and Innovation. “That led to a breakdown in the discipline of investing and drove up prices for things that never should have been invested in.”
There’s a growing worry, based on LinkedIn’s oversubscribed IPO, 173 percent post-offering rally and talk of a $15 to $20 billion valuation for Groupon when it goes public, that investors are losing their heads again.
Though Groupon has proven revenue, bringing in $713 million in 2010, it posted a net loss of $389.6 million for the same period. It now faces a host of competitors and is preparing to follow Linkedin’s lead into IPO mania.
But Robert Jordan, serial entrepreneur and author of How They Did It, said the marketplace might not be as fond of Groupon’s daily deals in a year.
“We don’t have to look any further than this past recession to see that there isn’t necessarily a rational basis for these valuations being as high as they are,” he said.
Conley isn’t as worried. He says the industry has a “pretty strong hangover” from the dot-com bubble and sees today’s startups being pushed to grow organically, or based on revenues they can earn rather than money they can get from the investment community.
This rationale is evident in the U.S. IPO market, which shrank from 271 venture-backed IPOs in 1999 to just 72 in 2010, according to the National Venture Capital Association Yearbook 2011.
Henikoff said a more common next step for startups now is to be acquired by a larger company like Google or Facebook, who view startups as their “outsourced R&D.” Rather than putting money behind 10 ideas when nine will fail, it makes more sense for Google to listen to the market and see what is going to be successful, then pay a big premium for that one idea, he said.
Also, startups have the benefit of lower financial barriers to entry and a hungry community of angel investors.
Jordan said, “The cost of pursuing a good idea is infinitesimally small compared to what it used to be.”
He cites cloud computing and applications on smart phones and Facebook as important assets to startups looking to get off the ground cheaply. Based on profitable Facebook apps like Farmville, a farming social networking game, Zynga reached a $9.3 billion valuation in February. The social network game developer has estimated annual revenue of between $500 million and $1 billion from user credit card payments and advertising partnerships.
Maura O’Hara, executive director of the Illinois Venture Capital Association, said she doesn’t see indicators of a tech bubble in the Midwest, valuations or not.
“It’s definitely true that Chicago firms or funds don’t have the peaks that the coasts have, but we also don’t go into the depths that the coasts have,” she said.
Henikoff sees a vibrant, local angel investor market that did not exist a decade ago, providing funding for early stage companies and those looking to scale their business nationally.
Angel investors are focused on capital efficiency, or “exactly how much capital needs to be invested in the infrastructure of a company before it starts to show revenues and profits,” O’Hara said.
Though Chicago lacks the critical mass of tech companies that exist in the Bay Area, the community is “tuned in to what the possibilities are” and is trying to help innovators successfully bring their products to market, Conley said.
With a mix of bright young Andrew Masons (Groupon founder and CEO) and a growing incubator and investment scene, Midwest startups’ only worry is taxes, he said. Earlier this year, the Illinois legislature passed a corporate income-tax increase of 45 percent.
O’Hara sees today’s investors searching for solid companies and sticking with them, rather than making more plays with less investment per play. Last year $720 million of VC funding went into Chicago area startups; this year, O’Hara has already tracked $200 million of investment in the first quarter alone.
“Chicago has been ripe for this for a while,” said Henikoff, also citing the city’s high-profile universities, large metropolitan area, and heavy presence of Fortune 500 companies and big advertising agencies.
Henikoff’s own Excelerate Labs, a local incubator and investor, seeks to “shine a really bright spotlight on 10 companies a year,” he said.
Excelerate provides seed funding, office space, pro bono legal services and mentoring in the form of a 90-day boot camp, all in exchange for 6 percent ownership in the company. Afterwards, participating startups take the stage at the House of Blues in front of 250 investors. According to Henikoff, last year’s class raised $7.2 million and he thinks they have encouraged other innovators to take the leap.
Henikoff does worry that as valuations soar beyond what seems reasonable, it will be problematic for companies to prove their value when they seek second- and third-stage financing.
But even if valuations continue to zoom higher, he says that won’t change the fact that today’s successful startups have real revenue models and proven positive cash flow.
He promotes “agile development” in his mentoring, in which companies execute quickly and inexpensively, then respond to customer feedback and iterate through many versions of their product. That’s 180 degrees different from the 1990’s-era dot-com company model of presenting a perfected business, mainly through slick marketing, but failing to attract customers and revenues.
“You haven’t got a business unless you've got customers, that rule has been around since the Venetians,” Conley said. “You need people paying as market evidence of the value of your offering.
Joe Matthews co-founded Poggled in 2009, a deal site for drink specials. After raising $500,000 in Series A venture funding from Lightbank and $5.6 million in Series B funding from New Enterprise Associates, the company now employs 35 people and is about to branch out of the Chicago market.
“The big thing that everybody’s looking for in startups is that you can prove an economic model,” he said. “You can start small, but you’re trying to [eventually] be playing in an industry that’s big.”
Matthews said the mobile, social and couponing trends are game changers, and they have all reached an apex.
“Whenever you see such a big opportunity, you see a run-up of people wanting to put money into it,” he said.
Poggled will be launching in New York City, Washington D.C., Milwaukee and Denver in the next couple of weeks.