By Sarah Lacy
On November 28, 2012
I’ve been hearing about the so-called Series A Crunch for at least six months, and in recent weeks, I’ve spoken with more than 20 venture capitalists, angel investors, incubator heads, lawyers, and other necessary cogs in the ecosystem trying to get some details about it.
Everyone — to a person — says it’s a real phenomenon. And everyone gives the exact same explanation of why it’s happening. But what it means for the Valley, and when this tidal wave of companies unable to raise more cash will hit the beach, remains frustratingly hard to quantify. Many worried investors have been asking me what I’m hearing as much as I’m asking them what they’re seeing.
We know this: As many as a thousand companies who’ve received seed rounds won’t be around in a year — maybe six months. There simply won’t be soft-landings and acqui-hires for all of them.
Essentially, we got here by entrepreneurs having too much of a good thing. The number of seed and angel investors has exploded in recent years, buoyed up by a number of factors.
They include a dramatic lowering of capital needed to start a company, substantially lowering the cash needed to become an angel. And because capital requirements are lower, entrepreneurs are holding onto more ownership, making it a lot easier to flip your company for less than, say, $30 million and become very rich. Angels begot quick wins that produced even more angels. Meanwhile, the rash of early liquidity and recent IPOs — unsatisfying as they were — gave liquidity to thousands of employees at large companies, and a subset of those made very real money.
Add to this regular angels becoming “super angels” — a much-mocked phrase for when someone goes from investing their own money to investing institutional funds. Essentially they became micro-VCs, still investing at the seed level but with much greater resources behind them. Incubators, too, helped flood the markets with even more startups, and AngelList played its part too. As All Things D reported yesterday incubators alone have yielded thousands of companies, created nearly 5,000 jobs, and raised $1.6 billion. Those numbers are likely conservative.
Because of all of this, traditional venture firms were getting edged out at earlier rounds. They decided to fight back. Firms like Accel and Greylock and Menlo Ventures announced discovery or seed funds, while other firms like Sequoia Capital and Andreessen Horowitz pioneered stealthy scout programs to give entrepreneurs their money, whether they knew it or not.
It seems everyone in this generation sought to emulate the Ron Conway-style of angel investing: Go wide and invest a little in a lot of things. A name like 500 Startups says it all.
At each turn, these market changes were heralded as wonderful developments for entrepreneurs. More cash equals more entrepreneurs who get to start companies. Many people in the ecosystem simply see no downside to that. Others have blamed the brutal hiring environment on everyone being able to start a company — whether they should or not — and argued that concentrating resources on fewer ideas would make the Valley a lot stronger.
But wherever you stand on that, there’s one very real consequence of this explosion in seed funding: There has not been a corresponding explosion in investors willing to lead the next round, the so-called Series A. In fact, if anything, there are fewer.
In the late 90s there was an explosion of capital at every level. This time around, there has been an explosion at the early stages, and the very late pre-IPO growth stages. But the Series A has remained the same. While Series A is what everyone is focusing on now, life doesn’t get much easier for those who survive. Finding a Series B will be even harder.
That means we’re getting a very different “nuclear winter” as a result of industry excesses this time around. And by most accounts, it’s a far more benign one, considering that potentially thousands of companies are — and will be — going out of business in droves over the next year.
You may never hear about these deaths, and their teams will get rapidly reabsorbed back into the system that’s still very hungry for talent and still seeding tons of new deals. By the math in that ATD post, each incubator grad only employs about three people on average. At most, we’ll see more stories like Erin Griffith’s this morning on the social travel space when eagle-eyed reporters follow up on a funding announcement they covered months ago, only to see a vague landing page about a much-needed vacation has taken the company’s place.
Companies we never really got to know are simply starting to fade away. Multiply that by literally a couple thousand, and that’s what 2013 is going to look like in Silicon Valley, and to a lesser degree some other startup ecosystems. “The numbers just don’t add up,” says Jon Callaghan of True Ventures. “There are a minimum of 2,000 companies per year getting funded and coming out if incubators, and there are only 750 VCs that call themselves ‘active.’ But when you look at who is doing at least two deals a quarter, the numbers fall to just 200 firms. Those firms are only going to do a few Series A deals a year.” When you look at the number of firms who invest at least $1 million a quarter for at least four straight quarters, the number drops further: To a paltry 97 firms.
The numbers I’ve heard from most everyone is that only about 20 percent of companies that have gotten a seed round in the last year will be able to raise a Series A. To put that in perspective, imagine a game of musical chairs with a hundred kids and just 20 seats. I recently went to a networking event for one of the seed funds that invested in PandoDaily, and I’ve never seen such worry on the faces of the entrepreneurs. They wondered as they looked around what lucky few of this crop the VC in question would actually back with a traditional venture round.
That much, we all agree on. But there’s no consensus on what it means for the Valley, and where we are in this crunch. Has it started? Will there be a big lump of companies running out of cash all at once? Or is this simply the new cycle of life in the Valley for the next few years? “It’s not a Series A crunch per se. It’s just getting easier to raise early rounds and harder to raise later rounds,” says Y Combinator’s Paul Graham over email, hewing to the latter view that this has merely become startup life in the Valley. “Investors will pay to see how an experiment turns out, but they are brutally unforgiving, if it doesn’t turn out well… What used to be an obelisk is now becoming a pyramid.”
Mike Maples of Floodgate Fund may have the most Darwinian take on it all — always a surprise delivered in his warm, folksy Andy Griffith-like Texas accent. “The tech industry creates roughly 10 awesome companies per year,” he says. “That’s independent of how much money VCs have or how many companies funded. There are 10 awesome companies a year, and they will get funded. It’s pretty simple.” He says if a company is going to be successful you can see it in 18 to 36 months. If you don’t, that company simply shouldn’t get to take up any more of the Valley’s rich resources — whether that’s talent or people. Sorry.
Hands down the people who are most concerned about this trend are the angel investors. And Maples would argue a lot of his peers have only themselves to blame — along with the venture industry at large.”The venture business in general is wildly undisciplined about throwing good money after bad,” he says. “There are so many companies in Silicon Valley that have raised $30 million and done absolutely nothing with it.”
On a micro level, failure is always painful. But at a macro level, widespread failure this early is far less painful than if it came at later stages. The stakes for everyone are lower. There is still enough froth in the Valley that entrepreneurs and their teams can easily get reabsorbed back into the system, or just head back to a place like YC for another try. The most resilient entrepreneurs embrace the experimental nature that Graham describes above. “I wouldn’t expect anyone except seed investors to complain about it,” Graham says. “Founders don’t think their problems are due to trends. And in fact, overall trends are a second-order effect for founders.”
Put another way: Maples is right. Great companies will thrive and find cash no matter what goes on in the outside world. They don’t have to worry. But the angels who’ve staked their funds on spreading bits of money all over the Valley are increasingly anxious that only 20 percent of their deals — in aggregate — will get the chance to keep going. That’s fine if you have a home run in that 20 percent. If all you have are a bunch of flips and acqui-hires, the picture isn’t pretty.
If the “great” companies will be okay, the ones these angels say they worry about are the “good” companies. Screw ‘em, say the Darwinists like Maples. Not so fast, say angels who’ve invested with the Ron Conway-like strategy. Maples — unsurprisingly — has little patience for that world view.
“The losing mentality is the mindset of playing a lot of hands of poker at the same time,” Maples says. “Investors should be saying, ‘What are all the things that need to be put in place to make this one of the 10 companies of the year?’”
Don’t even get Maples started on pivots. He helped coin the term, but it has been bastardized of late to mask failure. “Too many companies are one pivot away from something they can’t even articulate,” he says. “That’s just keeping the plates spinning.”
In off the record conversations, many angels have expressed the urgency of self-discipline. If they try to pass their dogs off to VCs, they ruin any credibility when advocating for an edge case company that may not yet have the traction but may have something intangible going for it.
Expect many more angels to back away from the category. Already we’ve seen “angels” like Chris Sacca, Ron Conway, and CrunchFund doing late stage and secondary cash-outs well before this crunch started. And noted New York angel Chris Dixon recently made the leap to the venture world.
He may be a canary in the coal mine for the industry. Most of these guys got into angel investing because that’s where the biggest gap was back in the mid-to-late 2000s. Now it’s glutted. “The real winners here are going to be the seed funds and early stage VCs that can write a $1 million to $2 million check,” says AngelList co-founder Naval Ravikant. “They’re buying into companies post-seed funding, with traction, at prices that aren’t significantly higher than angel prices.”
So when does this bizarre, quiet, slow-moving Armageddon hit? Out of the 20 or so people I spoke with for this story, only one told me there’s massive carnage happening right now. The rest said companies are mostly still hanging on. They’re cutting salaries and making the last tens of thousands — or if they’re lucky a hundred thousand — last.
Meanwhile, there’s been a surge in follow-on seed deals. Investors like First Round Capital and Jeff Clavier’s SoftTechVC all report doing way more of these than they have in the past. “It’s not the normal course of things, but you’re seeing a lot of companies raising second and third seed rounds,” First Round’s Josh Kopelman says. And not all of these have proven to be dogs. Some, like TaskRabbit, just needed a bit more time to get to that magical and vague term “traction.” “At some point, they won’t be able to raise a third or fourth extension,” Kopelman says.
Startups are scrappy, and many turn to AngelList when the money runs out. “We see a much larger number of companies coming in to fill out their bridges or to raise a second seed round,” says Ravikant of AngelList. “We tend not to feature those or be able to help much unless they have traction.” In other words: You’re increasingly on your own once that early cash runs out.
That’s the benefit of taking money from a microVC or super angel, say some entrepreneurs. They can stretch your seed round a bit further than an individual angel. Meanwhile, many of these angels are spending increased time looking for soft landings for these companies, hence the rash of acqui-hires in recent months. But there are nowhere near enough of those landings to go around.
These delays won’t last forever. Callaghan expects the meat of the crunch to hit in the first quarter of next year, but notes with a laugh he’s always a quarter or two early when it comes to predicting timing with any venture trend. Any shakeout moves more slowly than you’d expect. Entrepreneurs are survivors by nature.
If you are raising a seed round now, there are a few things you can do to protect yourself. There are still the same debates on whether or not you should take seed money from VCs. On the one hand, they are the guys who will be doing these rare Series As, so you may have a leg up on an entrepreneur they don’t know. But if you raise seed funds from a VC, and they chose not to invest your Series A, that can be a negative signal to anyone else who might be interested.
The tip that everyone agrees on is to avoid the so-called party rounds. These were rampant over the last year, and are when a collection of angels all put in a little. The hope was having more firms involved would help with hiring, raising more money, or anything else a first time entrepreneur might need. In reality, no one has much skin in the game. If you are going to have a flood of investors, make sure there’s a clear lead who believes in you and your vision. Otherwise, you’ll have to show massive traction to compete with all the other entrepreneurs who have that kind of advocate in their corners.
Many have hoped, too, that the convertible note dies off somewhere in this quiet, rolling carnage of once-good ideas. VCs have never liked them, arguing they misalign investors with entrepreneurs. Now they’re pointing out to companies that they are only advantageous to startups when things go well.
Lastly, seed-stage entrepreneurs who have pushed for the maximum valuation possible haven’t done themselves any favors. Unless they show significant traction, getting an up-round will be a challenge. Meanwhile, their seed investors aren’t particularly incentivized to get them a Series A that crams the previous valuation down.
In a Valley that’s always had an uneasy relationship with where luck ends and skill begins, a little historical perspective may help entrepreneurs weather the next six months. In the history of the Valley’s booms and busts, many of great entrepreneurs have failed and many idiots have succeeded. It’s the tax for living somewhere that so many people get the chance to try.