There have been several great posts recently on the state of current investment activity in early stage venture capital, including Fred Wilson’s post warning of “storm clouds”, then Roger Ehrenberg’s post on the “feeding frenzy”, and Brad Feld’s post on “percentage of 2009 seed deals not raising a next round”. There is something to add to Brad’s post and that is that most seed deals will not raise a next round because there will be a lack in supply of VCs there to meet the demand. Here’s why.
We have seen two incredible shifts happen in venture capital over the last two years:
First is the dramatic rise of the seed funds, super-angel funds and accelerators/incubators all focused on professionally funding start-up companies. There were only a handful of seed funds several years ago whereas today there are literally dozens including First Round Capital, I/A Ventures, Blumberg Capital, Zelkova Ventures, SoftTech VC, 500 Start-ups, lowercase capital, etc. And some larger VC funds have truly developed seed programs (they used to say they would do seed deals, but in truth rarely if ever did them) including Foundry, DFJ, Charles River Ventures, Polaris, FirstMark etc. There are also accelerators/incubators like TechStars (we are an investor), AngelPad and Y Combinator, etc. And the angel market has come back strong, both as groups and individuals. Just check out Angel List for example.
Second is the dramatic decline of the overall quantity of later stage venture funds. This inevitable contraction actually came from Bubble 1.0 in the 1990s when both the quantity and size of funds exploded at an unnatural rate to take advantage of the quick IPO exit market. As venture funds are measured on a 10 year return horizon, once the bubble burst in March of 2000, many funds were living off prior exits while ignoring their own equivalent of burn rate and runway – their returns on investment and multiple of capital. Everyone in the venture industry knew the 10 year returns on average were deteriorating rapidly and would even turn negative at the 2008-2010 timeframe. As many of these funds over-invested in the next crop of companies anxiously awaiting the next IPO boom that never came, they themselves became sitting ducks for disgruntled LPs as the global economic crisis occurred.
We sat in our partner meeting post-Lehman Brothers market meltdown and hypothesized that as many as two-thirds of all venture funds might cease to exist. LPs would confront funds with the lack of returns and put them out of business overnight, or they would reduce the available capital to call exclusively for home run follow-on investments, or perhaps just let them finish out the fund with no hope of a next fund. Many in the industry can confirm these occurrences from the empty offices they encounter every day. Recently Ernst &Young reported a 47% plunge in active venture funds in the first six months of 2010 compared with the same 2009 period. Active in the report means one deal per quarter, which is not really very active. We suspect 47% is low and will grow significantly higher (even with the addition of so many very active seed funds).
So this is the problem. We have a record increase of seed stage investment activity from seed funds, super-angels, angels and accelerators/incubators. And much of what is funded by this seed fund rise are B2C oriented ventures which by their nature are capital intensive and require significant capital to stay alive through the user growth phase that often far outpaces revenue. And many of these “sexy” B2C “bright-shiny-object” seed deals have been bid up in valuation with little or no diligence in a seemingly “what’s hot” contest seeking to be named on the investor roster in TechCrunch. And yet we have a record decrease of later stage venture funds to invest in these companies when they seek larger capital.
Probably starting in the Spring or Summer of 2011 it is going to look like a high school dance with a very lopsided boy-girl ratio. On one side of the dance floor there will be a record high number of seed funded entrepreneurs with high B2C valuations, corresponding seed investor egos that bid them up, a need for additional capital to survive, angel/seed investors that cannot provide the necessary capital (many don’t plan for or do follow-on investments), and intense competition for larger capital from the oversupply of these deals. On the other side of the dance floor there is record low number of venture firms with larger-than-seed capital to invest. This will lead to an inevitable scenario where only the hottest girls will find a dance partner and the rest will go home in tears.
