Coursera

Is there an ed-tech investment bubble?

February 19, 2014: 4:56 PM ET

Amid the recent flood of venture money, startups have learned that schools make complicated customers.

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FORTUNE -- The promise of a digital-first education system has driven venture capital dollars into the fast-growing category of education technology startups. There are countless software portals aiming to create efficiencies in school systems and even more digital tools for streamlining the classroom. There are tutoring startups and MOOCs, or massive open online courses, that have attracted massive venture funding. And there are algebra games. Oh yes. Many, many, algebra games.

The explosion of ed-tech startups in the last five years has led many to speculate we're approaching peak ed-tech. The word "bubble" has been thrown around. Venture firms invested around $600 million into ed-tech startups in 2012, which is approximately four times as much as they did in 2002.

Meanwhile, industry observers aren't terribly excited about the most latest ed-tech innovations.

"I don't need another algebra app," said Peter Cohen, president, McGraw-Hill School Education, speaking at the recent DeSilva & Phillips Dealmakers conference in New York. "I don't need another one. Everyone in Silicon Valley thinks they've created the first algebra app ever. That's not actually the biggest problem, although algebra is a problem," he said.

Brian Napack, a senior advisor to buyout firm Providence Equity Partners, said many ed-tech companies are aiming too low. "Do they have a product that's actually a solution for someone's needs, and will the decision makers recognize that it's a problem?" he asked. "There are lots of gradebooks out there. Don't tell me you've got the first digital gradebook, and also nobody is viewing that as a problem."

The "small problem" problem isn't unique to ed-tech. Look no further than the sea of derivative photo-sharing and music apps to see how many startups' offerings start to blend together. Venture investors Mark Suster of Upfront Ventures and Chris Fralic of First Round Capital popularized the term "FNAC" to describe startups whose idea is a "feature, not a company."

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Regardless, companies based around small features are particularly tempting in the education sector, which has been dominated by longstanding relationships with textbook giants, and tech stalwarts like STI Education Data Management Solutions, or Renaissance Learning, a 29-year-old company which Google's (GOOG) new private equity arm, Google Capital, just invested $40 million into. Schools are slow to adopt new technology because they have to be: Their procurement processes are inflexible and complicated, involving contracts, RFPs, lawyers, review cycles, approvals, and compliances. This makes it difficult for small startups to sell their products into schools. The procurement cycle alone lasts long enough for a startup to run out of money.

Napack said not understanding the market they're selling to is the most common mistake for ed-tech startups. Schools make complicated customers because they're not financially motivated -- their goal is to educate students, not make money.

The second-most common mistake is with a startup's go-to-market strategy. "Is their problem actually attached to a pocket of money?" Napack asked. "Occasionally [a deal] happens by Federal caveat, and then that changes, and then the companies don't have a source of revenue anymore."

Napack predicted a shakeout to the venture investment flooding education startups, but said things are different this time around. "There's a Darwinian thing that happens in ed-tech. It's survival of the fittest," he said. "But this isn't going to be like the last ed-tech bubble. We're actually going to get some real companies out of this one."

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It's unclear if "real companies" will be the ones which have raised the most money. Last fall, the shortcomings of some well-funded startups had industry observers asking whether the bubble has already popped: Kno, which had raised almost $100 million from Andreessen Horowitz, First Round Capital, Floodgate, and others, sold to Intel (INTC) for just $15 million, reported Om Malik. Then Altius Education, which had raised $26.6 million, sold in an acqui-hire deal to a marketing company. And Grockit, backed by $44.7 million from Benchmark and GSV Capital, pivoted away from its initial strategy, selling its core assets to Kaplan. Tutoring startup Tutorspree also shut down last year.

Others are only beginning to figure out monetization while offering their main product for free, the so-called freemium business model. Coursera, which raised $85 million in venture backing, has experimented with selling certifications to students who complete free courses on the platform. Udacity, backed by $20 million from Andreessen Horowitz, is experimenting with sponsored courses and matching students with employers. Knewton, backed by $54 million from Founders Fund, Pearson (PSO), Accel Partners, Bessemer Venture Partners, and FirstMark Capital, is also going freemium, earning revenue with licensing fees and a premium platform for universities. Edmodo, backed by $40 million from NEA, Union Square Ventures, Greylock Partners, and Benchmark, doesn't charge teachers to use its platform, but instead sells them apps.

These well-funded companies aren't "FNAC" startups. They're trying to completely transform some aspect of education by making it free or accessible online. The only problem with that strategy is that it's just as risky as offering a boring, derivative algebra app. Except here, there's a lot more money at stake.

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