Investing in iPhone Startups (Part 2): The VC Way

We’ve looked at the stats and prospects of iPhone, iPod Touch, and App Store in Investing in iPhone Startups (Part 1): The Prospects. The numbers are encouraging and the downloads are downright inspiring (3 billion and growing with no end in sight).

BUT, barriers to entry is low and there are heaps of other issues to consider. With all ‘em challenges and all ‘em developers itching to try their luck, how do you identify startups that have good potential?

Let’s take a look at the kind of startups VCs are backing and the things they said about the space. This will at least give you some clues as to what criteria should be met, which could save you some time in the screening process should you decide to back an iPhone startup.

I. Target

The key is to look for iPhone startups whose goal is to build scalable businesses, not individual developers who are just hoping to hit the jackpot.

II. Exit

Investors typically make money upon exits (e.g. M&A, IPO). They expect the startups to have an exit within 10 years.

For KPCB, it invests in companies that have the potential to become standalone, public companies. Successful investors aim big and look for homeruns.

III. Focus

KPCB has its hearts for location based services, social networking, mCommerce (including advertising and payments), communication, and entertainment.

For aggregate data, ChubbyBrain offered a breakdown of companies per industry that have received angel and VC funding. Industries that appear relatively hot within the iPhone ecosystem include: social network, gaming & entertainment, diversified application development, information provider, and monitoring & security.

IV. Multi-Platform

iFund manager Matt Murphy told mocoNews that they’re not betting solely on the iPhone platform. “Over time, most companies [in the fund] will eventually diversify to other platforms.” This is important as portfolio companies can leverage the popularity of other platforms like Android.

Case in point: Most recently iFund-backed GOGII has released its textPlus app for Android.

V. Business model

How do the companies make money? “Majority of apps right now are moving towards, or are pursuing a free ad-subsidized model, or a model using virtual goods with some apps being a paid download or monthly recurring charge,” said Murphy. “90 percent will be monetized by advertising, virtual goods, or some form of affiliate fees or commerce.”

A word about micro-payments: With the golden price point being US$0.99, your investee will need to sell a whole lot to ensure you get the great ROI. Is the market for the app there and is it big enough?

And take note of the freemium model. Mobile knowledge portal MSearchGroove (MSG) cited studies from Pinch Media which showed that iPhone app usage drops significantly after 90 days as novelty wears off. The iPhone startups you’re evaluating must be quick and meticulous in releasing apps. Fredrick and Rainey note that a clear and compelling upgrade path is a must.

While [the freemium model] works in some sectors, overall, the gap between free and paying customers is widening. This is happening because buyers can be very fickle. As their attention spans shorten, their brand loyalty diminishes as well.

In the mobile space, for instance, a game or app that’s hot today can easily be forgotten tomorrow. Users have little or no incentive to upgrade, so they just move on to the next trendy, free offering. Providers must innovate at an incredibly rapid pace in order to keep pace with market demand. But they can’t be careless – offerings must be thoroughly tested before they go public, since most people won’t give something a second chance if they’re unhappy the first time. And these providers must have a clear and compelling upgrade path to entice a larger percentage of paying customers.

Of course, you’d want to do your due diligence and look at other factors like the startup team, the company’s competitive edge, piracy concerns and go-to-market issues before opening the checkbook. But now that you’ve gained a clearer picture of what a fundable iPhone startup looks like, it’ll help you filter out a good chunk that obviously don’t fit the bill and give you an easier time to find that special company that hasn’t reached the VC stage. You might come across it in 3 to 5 days or 3 to 5 months, or you might never find one that steals your heart.

Just to give it some context, iPhone startups received between US$15,000 and US$15.5 million from VCs and angels as of June 2009, according to ChubbyBrain’s aggregate statistics. For the initiated, there’s plenty of room for individual angels and angel groups to play.