Investors Look to Fund Capital-Light Businesses Low startup costs and cheap customer acquisition make web-based startups an attractive investment.

More and more, entrepreneurs are turning to the web to start new businesses because of low startup costs--often less than $1 million. Investors are helping drive the trend, in part because they have less money to invest. The average venture fund has shrunk from $166 million in 2007 to just over $120 million at the end of last year, according to data from the National Venture Capital Association and SVB Capital. Smaller funds tend to gravitate toward smaller funding rounds.

But it wasn't always this way. In 2005, when Jim Andelman and Brian Kelly co-founded Rincon Venture Partners to fund web-based businesses, VC were flush and funding the likes of Facebook.

Andelman and Kelly zigged as bigger firms zagged, reasoning that partners at mainstream firms wouldn't be interested in the small, capital-light startups they were pursuing. With hundreds of millions to invest, bigger funds would be "compelled to write bigger checks," Andelman says, leaving more opportunities for his firm.

Today, five years after Rincon's creation, capital-light startups are en vogue. "From an investor's perspective, it's ideal if I can invest $1 million to accrue $100 million," says Wright Steenrod, principal with Louisville, Ky.-based Chrysalis Ventures.

The message to entrepreneurs: Do more with less capital. Here are three things VCs are looking for from the next generation of web-based businesses.

1. Cheap Customer Acquisition
   The problem with the capital-light business model, Andelman says, is that it's available to everyone. "What used to cost you $10 million in 1999, you can now get for $100,000 or less," he says.
   
   But cheap servers and software offer no guarantees of success. Cheap startup costs can also mean bad ideas are easier to pursue. An investment-worthy business allocates startup capital carefully and acquires customers cheaply.
   
   Take oneforty , an iTunes-like store for Twitter software that was created last March. Founder Laura Fitton says she needed just $140,000 to get the initial version of the store ready, and most of that was to cover the cost of outsourcing. "With my own developers, we really could have gotten the initial alpha version of the site done for $40,000 to $100,000," Fitton says.
   
   Marketing was even cheaper. Fitton needed only her 60,000 Twitter followers and a pair of blogs to engage buyers and sellers. Venture capitalist Brad Feld liked the economics enough that he invited oneforty to participate in last spring's TechStars startup mentoring program in Boston.
   
   Oneforty has since attracted $1.9 million more in a funding round led by Flybridge Capital Partners. And today, less than two years into its existence, the company does business with some 1,300 software creators.
   
2. A Clear and Inexpensive Growth Strategy
   Capital-light business models such as oneforty's aren't without risks, and listening to Andelman talk, you get the sense he fears as much as loves them.
   
   "You could take advantage of that dynamic [of cheap servers and software] and build a business that has lots of users and no revenue model, but I wouldn't necessarily call that capital-efficient," Andelman says. "All you're doing is buying yourself time, not a path to profitability."
   
   A veteran entrepreneur, Scott Abel knew he'd need a system for profitable hypergrowth when co-founding Spiceworks in 2006. He and his partners chose social networking.
   
   Spiceworks' ad-supported software for managing corporate networks includes tools for connecting with other IT managers. Each new IT manager in the network increases the value of the overall system to advertisers, just as Google gains value with every completed search.
   
   The trick for Abel would be to scale up the network cheaply. His approach? Make developers more productive by choosing friendly coding environments, such as Ruby on Rails. "We figured, why chase low-cost developers in India or the Ukraine? Instead, we had a small number of developers--10 up until January of this year--do the work of 20 or 30," Abel says.
   
   Today, backed by $13 million in total funding, Spiceworks has more than 1 million IT managers connected via its network, which has been translated into 22 languages. Abel says 1,500 new IT managers join the network daily.
   
3. A Clear Differentiator
   Spiceworks' model is attractive because IT managers keep going back to the network, fueling repeatable growth. Everlater is pursuing the same dynamic, and is getting traction despite taking just $362,000 in funding, including $12,000 from Feld's TechStars. Why? Because Everlater is different.
   
   It might not seem like it at first. Going by its website, Everlater looks like a simple travel blogging service. Scrapbooks are what set the company apart. Vacationers who use Everlater have the option to memorialize their journeys in a hardbound journal.
   
   Tourism operators have taken to the idea, co-founder Nate Abbott says. A handful of them now use Everlater to produce scrapbooks for their clients.
   
   "We realized that, in this day and age, folks are just posting their photos from their safari in Africa on Flickr and giving no attribution to the tour operator. What we've done is created a way to insert the tour operator's brand back into the conversation," Abbott says.

A Better Bottom Line
In the end, Andelman says VCs are pursuing more capital-light investments because businesses are being acquired for less now than a few years ago. "$50 million exits are not unusual these days, whereas $500 million exits are almost unheard of," he says.

That's a problem for venture capitalists who live off bets that return 10 times or more their initial investments. Why? The math doesn't work when you're writing big checks. Only the investor that bets $5 million (or less) in exchange for a 40 percent stake gets a 10x return on a $50 million buyout.

By focusing on lean web-based businesses, Andelman says he's put his fund in a position to earn big profits on small exits. "What we found is that anyone can write a business plan that looks capital-efficient. The odds that it actually will be capital-efficient are much higher in the web domain," he says.

In one instance, Rincon would earn 10 times its money on a portfolio company sold for less than $25 million. Entrepreneurs can benefit from this same dynamic. Capital-light businesses are more likely to be bought, Andelman says.

"I don't think anyone gets into this business targeting $50 million exits," he says. "But it's nice to know that if the businesses in which we invest ended up there, it would still be considered a great outcome for everyone."