Aside from Last.fm, we've been well behind the 2.0 startup curve here in the UK and I suspect that a significant part of that has been the lack of interest from funders. It seems that that may be beginning to change though. Simon Murdoch and Rikki Tahta of Episode 1 have started a new Web2.0 targeted investment fund.

The structure of the fund is such that they will back a good prototype idea with both cash (sub £50k) and advisors. You pitch the idea to them by submitting a URL to their signup page, they give it the once-over and invite you back for more if they like it. If I've understood things correctly then the founders will hand over 8% to Episode 1 and 2% to their advisors.

It’s good to see this sort of fund open up. There are currently very few startups in London and I know of no other 2.0 investment funds so this is a good thing. That said, I think the fund will still find it hard to attract good candidates. I think this for a number of reasons but the main one is purely financial.

The career option

Startups attract young people. Shielded in a Batfink-like cloak of ignorance and enthusiasm we're arrogant enough to think we can change the world and not yet jaded enough to understand the odds against us doing so. Successful startups correspond to smart, successful people and one of the most lucrative alternatives for those in the UK is the City.

In their first year in the city a graduate can easily pull down £40k in consulting and anything up to £80k in banking. Year by year the figures go up and after five or six years of banking, the best entrants could make vice president and gross £200-500k including bonus.

The startup dream

Now let's look at the startup option and take one of the most successful 2.0 trailblazers, Flickr. Flickr is a photo sharing website. It was launched proper in February '04 and acquired by Yahoo for what was rumoured to be $15m in March '05.

I've no idea how equity was split in Flickr or how many founders there were but let's map their best-case-exit onto a cookie-cutter startup. Let's say that the startup has three founders, an angel investor who puts in $100k for 33% of the company and that the four of them cash out within two years for $15M.

With $5M, the Angel gets a great return on his £100k and vicariously enjoys the thrill of being on the winning team. Each of the founders gross $3.3m and buys themselves a nice flat, a new car and an expensive skiing trip to Europe. $3.3M equates to about £1.9M so in this best-case scenario, the lucky founders have each made eleven times the £180k they might have expected in an investment bank. Definitely a good result.

The startup reality

A good potential result but is it a good anticipated result? If this represents the maximum return, what is your expected return? What are the chances that you will actually be bought? Your expected return is more like £1.9M divided by (1 + number of startups who will fail in the same space).

If you're daft enough to choose something like tagging then you can expect the denominator to be of the order of 20 so now all of a sudden your expected payout is now half what you would have made in banking. Not only that but you've also acquired the added cachet of telling people that you were behind a failed internet startup which just isn't as cool as it was.

So what's the conclusion of all this, after all, I've got a startup and I'm in exactly the same game as all the others, why have I done it? Well I guess there are two conclusions, one on seed funding and on myself..

On seed funding

Most VC funds have one single objective and that is to maximise their return. To do that, they need entrepreneurs who are aligned with that objective and seeking to maximise their own return. If the expected return for the startup does not better the expected return for an equivalent job, the VC’s will automatically lose those candidates.

One way of improving the deal for the entrepreneur would be for the VC to improve the upside and take less equity. Given that a 2.0 startup requires very little cash but still offers serious revenue potential, this seems like a smart thing to do. It takes about £60k to fund a two person team for a year and with potential earnings in the millions a lower equity stake is not an unreasonable.

Paul Graham's Y-Combinator invests at an initial valuation of ~$350k whilst Simon and Rikki's fund is going in at a more generous £500k.For something that is no further than a barebones proof of concept, I would accept these as good valuations and both Paul and Simon & Rikki bring a lot of experience and connections to the table.

The risks

As much as heavy equity hits present issues, I doubt they're the real throttle on entrepreneurship. We entrepreneurs are notoriously optimistic and will always make it great enough that 0.7 x upside = what we want.

The biggest danger in committing one or more years of your life to a startup is not that you won’t be as rich as you could be, but that if things go wrong you will have to re-enter the employment market with no observable career progression and the stigma of a failed business behind you.

You know what you went through, your family know, your customers know and your friends know. The problem is that when the next in line for that job interview is a two year graduate of McKinsey it’s very difficult for your potential employer to know.

In the UK there just aren’t the Googles, Microsofts and Apples around to appreciate what you’ve done and to welcome your experience. If you fail at a 2.0 startup in the UK, you can only really capitalise on your experience in somewhere like San Francisco and that's a big move to make.

A false economy

So my conclusion for seed funders is that they need to decide who they want to recruit. Money is seldom what distinguishes fantastically successful businesses from merely mediocre ones, people do. Economising on people in a startup makes as much sense as building a beautiful restaurant and cheffing it with cooks from a school canteen.

Money isn't enough to create better entrepreneurs but the lack of it can turn would be entrepreneurs elsewhere. It's no coincidence that each year Stanford has so many startups it puts on a fair and that, as far as I know, Oxford hasn't managed to produce any serious student successes since Freshminds, five years ago.

If funders want to create successful startups, they're going to have to get behind successful people and they need to know that the competition for those people is offering £50k/year salary, travel, status and dramatic career and salary progression.

Offering £50k to run the business (not salary) and a 10% loss in equity on a venture with no obvious exit and which will require confinement, hard work and, statistically, failure, is not a great alternative.

On me

Having left a PhD in order to do what I’m doing I’m excruciatingly aware of the downside. Although I’ve only been working on Deeptag for nine months I’ve been working to reach this position for five years. Half my twenties and almost a hundred thousand pounds is now staked on the code I write. Why am I doing it when the expected payout is so low?

The main reason I’m doing it is because I want to solve a problem. There are huge pains in the world of data and software and I believe that I can solve one of them. I would be stupid not to consider how to maximise the revenue from that solution but it is the solution, not the money that inspires both me and those who back me.

On the financial side of things I think that a $30M flip is a dumb target. In this space I actually think that flipping is a pretty silly target. There's a time and a place to sell but as a end in itself I find it rather uninteresting. If it's creating solutions to problems that you're interested in, why give away the team, the brand and the revenue stream you've worked so hard to build?

Maximising customer value

Building a business should never be about creating wealth it should be about creating value, customer value. Create value for customers and both wealth and shareholder value will follow. Any idiot can charge for something or slap advertising on a webpage, it's creating something that people want to look at in the first place that takes skill.

I've worked for a long time to learn enough to be able to create something of real value. Only time will tell whether it's as useful to others as it is to me but as much as I'd love to be rich, it's fixing pains that drives me.

And the fear of failure? Like every other entrepreneur I know, building a business is in our blood. It's not something we choose to do, it's who we are. The fear of failure may keep me awake at night and sometimes makes that blood run cold but it's nothing compared to the failure of never having had the guts to be myself and try.

Update:
Since writing this article it's been pointed out to me that Flickr was actually sold for about $35M, not $15M as I previously thought.