Investing small, making it big

By Inc.com

As venture-capital deals go, it doesn't seem like much -- just $6,000. But that was all Sam Altman needed to get his business, a cell-phone-software maker called Loopt, off the ground.

And if the investment seems rinky-dink, the investor certainly isn't. The money came from Y Combinator, a Cambridge, Mass., venture firm founded by heavy-hitting Internet entrepreneur Paul Graham.

What's Graham, who created the seminal Web application that eventually became Yahoo's (YHOO, news, msgs) Yahoo Store, doing playing with such trifling sums? "It's gotten to the point now where the most important things you need to found a tech startup are food and rent," he says.

Graham is not the only one who feels that way. A small but growing number of venture firms now provide seed-level funding -- thousands rather than millions -- to promising young startups.

The approach differs from the usual venture-capital model, in which investors take equity at the outset and demand board seats and input in day-to-day operations. But these smaller deals make particular sense in today's marketplace, the investors say. After all, tech firms now can be launched for peanuts.

Cheap investments soar

Thanks to declining costs for servers, more-powerful coding languages and the prevalence of free, open-source software tools, new startups can attract sizable audiences for next to nothing. And with the market awash in private equity, competition among investors for promising companies and concepts is more heated than ever. As a result, the number of seed-level deals increased almost 50% in 2006, according to PricewaterhouseCoopers, the National Venture Capital Association and Thomson Financial (TOC, news, msgs).

"The days of throwing huge sums of money at an entrepreneur are gone," says Mark Heesen, the president of the venture-capital association.

Y Combinator is a good example of the trend. Launched in 2005, the venture firm now dishes out between $10,000 and $20,000 per company to fund a three-month stay in Cambridge, where entrepreneurs spend their time perfecting their technology, meeting with mentors and swapping ideas with peers.

In exchange for the cash, Y Combinator takes a small stake in the companies it funds, usually about 6%. So far, three of its companies have been acquired, including Reddit, a news-aggregating site recently bought for an undisclosed sum by Condé Nast. Y Combinator is banking on a similar outcome for Sam Altman and Loopt.

Altman, now 22, founded the business in 2005 while he was a sophomore at Stanford University. He was looking for a way to keep in touch with his friends on campus and got the idea to write software that would allow all of his friends with Global Positioning System-equipped cell phones to find one another. Altman heard about Y Combinator's newly launched program from a classmate and got in touch.

Later that year, he got $6,000 from Y Combinator and left school. He spent the summer in Cambridge developing his product, listening to guest speakers and learning the nuts and bolts of running a business. In return, he gave his investors an undisclosed amount of common stock in his company.

The deal pays off

For Altman, the trade has been more than worth it. Last September, Loopt launched its cell-phone software with Boost Mobile, a subsidiary of Sprint Nextel (S, news, msgs) with 3.8 million subscribers. Boost has since invested several million dollars in a TV advertising campaign to support the launch.

In July, Loopt announced that its service would be available on select phones throughout the vast Sprint network, and Loopt plans to add other carriers in the coming months.The company is adding staff and recently raised $5 million in Series A financing from powerhouse venture-capital firms such as Sequoia Capital, which helped launch Google (GOOG, news, msgs), Yahoo and PayPal, now owned by eBay (EBAY, news, msgs).

"We have five people on our team, none of whom is over 23, and none of whom has any business experience," says Altman."Y Combinator really understands what a company needs in its first three months."

TechStars, a Boulder, Colo., venture-capital firm, launched a similar program last year, offering startups as much as $15,000 and a three-month stay in Boulder, in exchange for 5% equity. Charles River Ventures, one of the nation's oldest venture-capital firms, has also created a seed-level program, albeit with a slightly different approach. Charles River's QuickStart program, launched in 2006, provides tech startups with low-interest loans of an average of $250,000 in convertible notes. Should a borrower go on to raise venture capital, the loan can be converted into equity at a discounted rate (a maximum of 25% off). The deal also gives Charles River the option to participate in the Series A round.

"What we've noticed is that there is often an inverse relationship between the amount of money entrepreneurs raise and the quality of their companies," says George Zachary, a partner at Charles River.

Continued: There's a downside

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