Tech, Startups, Capital, Ideas.

With so many Internet-enabled companies being started, one of the biggest challenges is filtering the massive amount of deal-flow in the space. Here’s one way to think about the opportunities across a range of funding stages.

Pre-Traction There are a lot of these startups, perhaps thousands or even tens of thousands of them (probably an order of magnitude less on the business side than the consumer side). This applies to both Internet-enabled business to business (B2B) and business to consumer (B2C) companies. The reason so many companies are being started is that broadband is, at long last, widespread, there are lots of technology building blocks, and capital is available.

On the consumer side, that makes these companies really hard to invest in, because it is practically impossible to predict consumer behavior, that is, what the result of the actions of millions of different individuals will be.

Just as Supreme Court Justice Potter Stewart once said about pornography, the answer to the question, “if you had to do it over again, how would you replicate viral growth?” is typically, “I couldn’t, but I know it when I see it.”

The value of domain expertise A lot of experimentation goes on during this stage, until some traction is achieved. Successful progress is often made when entrepreneurs focus on something in which they have domain expertise. A lot of people think that only applies to business focused companies, but domain expertise applies equally in the case of consumer entrepreneurs as well, typically in the form of: themselves! (Recall, Time‘s 2006 Person of The Year: You.) That is, entrepreneurs who are solving their own problem or working on a problem near and dear to their hearts.

A variety of vehicles have emerged to fund entrepreneurs at this stage, from angel investors to smaller funds; some larger funds also have programs targeted at this stage. The smaller funds and angels can do a significantly larger number of seed deals, because even if the seed deals exit for “relatively” small amounts of money, say in the $5M – $50M range, that is still a great outcome for these investors relative to the amount of money they are working with.

Larger funds, of course, need to return larger amounts of money, and so a limited number of seed deals make sense, combined with working very closely with the network to find companies that are a bit later in the process, namely

Early traction, with un-scaled monetization model These startups have early traction, but only a view toward how they will monetize it. This traction may be the indicator of something great to come, or it may be the indicator of an impending local maximum. It’s hard to tell.

Early traction means different things to different people; what’s important is that it’s a very helpful negative filter: there’s almost no good reason not to be in market today for an Internet-based startup.

For these companies, there is a possible path to revenue in the form of advertising, the sale of virtual goods, or premium up-sell (freemium / subscription model), which is especially common for Internet-based B2B offerings.

The reason to invest here is two-fold:

1) A startup could be in a break-out category. This is a sort of option value in the market with the aspiration that one or more of the companies ends up in a tornado of a market. The phrase, “a rising tide lifts all boats” is highly applicable here ” if you end up in a great market, you can go a long way. The trick here is either to recognize a tornado market before it happens, or to have sufficient bets at this stage that one or more of them ends up in a tornado market.

As one venture capitalist told me, the other implication of this is that it’s often not the case that repeat entrepreneurs have the level of success that they had the first time around, because even though they’re great entrepreneurs, they may have been in a great market the first time, but not the second or third. As venture partner Donna Novitsky put it,

“A great market and a bad product is better than a bad market and a great product.”

For an Internet-enabled company at this stage, growth is more important than revenue.

2) The opportunity for 10X to 100X returns. The later an investment is made, the less opportunity there is for hugely out-size returns.

Capital efficiency remains highly important, because in terms of Mark Leslie’s Sales Learning Curve (SLC), the company has still not proven scale. Spend too much capital too fast before figuring out how to achieve user or customer adoption, and you’ll need more money too soon.

The easiest way to raise money in the current market is to prove more traction. More traction means a higher valuation. Fail to gain traction and it’s hard to raise money, which is bad news for the entrepreneur and investors. A lot of experimentation still needs to happen.

Late traction, un-scaled monetization model The next stage is “late” (for venture capital – I’m not talking about buyouts here), in which the company has traction, but an un-scaled monetization model. Some companies at this stage still have no revenue, nor a vision of how they will ever get any.

In that case, it’s all about growth and timing. They are spending significant amounts of money (because it’s expensive to run at large scale), yet they don’t have revenue and so can’t become stand-alone businesses (unless they can answer the revenue question).

Some of these companies are highly dependent on other companies for their users. This is a dangerous place to be in, whether it’s on the B2B side with users coming from, say, a large CRM platform, or on the B2C side, with users coming from one of the large social networks (without a long-term business relationship in place). Having this dependency is much like having a mobile play that gets traction but goes around the wireless carriers: eventually they’ll want a piece of the pie.

I’d rather have a company that defines the ecosystem and owns the customer (or user) than a company that is part of the ecosystem. That’s not to say that lots of great and valuable companies that are part of an ecosystem won’t be built. I’d just rather be in pole position.

The struggle with these companies is that one has to be both careful and skeptical about investing in them but also aware that they have the potential to deliver significant returns. They’re momentum plays that are about continuing to scale and then finding a buyer who wants to monetize them or get into the game, before the company runs out of cash. These companies (you know the ones) can, however, produce huge returns.

Late traction, scaled monetization. This last category of companies has scale and revenue and is looking to scale further or more rapidly, using capital. The returns do not have as high beta at this stage and investors may not own as much, but the opportunities are incredibly interesting because the companies are already at scale and have meaningful revenue.

Of course, something could happen to the companies at this stage, so there’s still some real risk. A competitor could move in, a source of revenue could dry up, a company could fail to execute, or something might not be what it appeared to be prior to the investment.

Investments come in a variety of forms at this stage, from buying equity, to buying founder equity or providing liquidity for some of the early investors (such as small funds who have more than reached their goal and promise to their limited partners by this stage and would welcome liquidity, even if they don’t achieve maximum return as the company continues to grow).

Conclusion It’s a crazy world out there, with sky-rocketing valuations and dozens of new Internet companies being started every day. The availability of widespread broadband to the home, lots of ways to accelerate initial user and customer adoption, technology building blocks, and early stage capital means that it’s a great time to be in IT. With all these investment stages, it’s easy to get caught up trying to define a great company in a tornado of a market, but like Justice Stewart once said, “I know it when I see it.”