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November 3, 2011

Too many start-ups or too few venture dollars?

"There’s too much venture money: it’s a bubble." "It’s so hard to raise VC capital these days." Depending upon one’s perspective, the early stage venture world is a vastly different place. From my seat I see several trends that are giving rise to this seeming disconnect, the outgrowth of which is frustration among both entrepreneurs and investors across the early-stage venture ecosystem:

  • Starting a company is easier and cheaper than ever before. The proliferation of incubators and the like have further reduced the friction. The barrier to creating a start-up is virtually nonexistent. 
  • There is an abundance of angel money to help seed these nascent businesses. This has contributed to many start-ups getting financing today that could not have raised money in previous eras.
  • It is not at all clear that more truly disruptive companies are being started due to the rise in aggregate start-up activity. There will be many commercially successful businesses that owe their lives to angel financing, but whether more companies hold the promise of massive scale warranting venture financing is a story yet to unfold.
  • Given the above, it follows that more companies that don’t merit venture financing are being created than ever before, leading to frustration on the part of entrepreneurs and angels (“There isn’t enough VC money to fund all the start-ups that need Series A capital”) as well as venture investors (“The signal/noise problem in my deal funnel is killing me”).

I think one of the hardest parts of being an entrepreneur is trying to honestly assess the magnitude of the opportunity being addressed and to finance the opportunity properly. For instance, there is absolutely nothing wrong with building a business that in all likelihood is a “small” outcome (let’s say an exit in the low tens of millions of dollars). In fact, our economy would benefit massively from the creation of tons of companies like these that serve as external innovation centers for larger, more bureaucratic enterprises. But to be clear, the investment math of these kinds of businesses generally don’t work for venture firms and as such, should be capitalized and operated in such a way that they don’t require venture backing. Deep-pocketed, professional angels (versus shallow-pocketed and inexperienced “dabblers”) and strategic investors are perfect for these kinds of businesses. They should also be run to generate revenues as soon as practicable to take the pressure off subsequent rounds of financing.

One of my early angel investments in a company called Global Bay Mobile Technologies was precisely this kind of company. Four of us invested $500,000 in the company back in mid-2005, and they were recently bought by VeriFone for a price that yielded a very attractive angel return (not to mention a home run for the founders!) but would have been a blah outcome if they had also taken in venture money. The team was super frugal, pushed for early revenues, switched from a time-consuming and capital-intensive enterprise sales model to a scalable, recurring revenue SaaS model and got the job done. Was this likely to be a multi-hundreds of millions outcome? No. The founders and the investors wanted to keep the exit bar low and to try and calibrate the financing to the business and exit opportunity. They founders were honest with themselves and we, the investors, were honest as well. Good company. Capital efficient. Overlapping founder/investor utility functions. Next…

The problem is, I frequently see disconnects between founders (“This business is going to change the world”) and venture investors (“Really? You are super smart and I love your enthusiasm but I respectfully disagree”) after a business has already been angel financed. The company has financed itself and calibrated its burn rate on the assumption that venture investment will invariably follow, and when it appears that this assumption was incorrect - doh! Unless you’ve got the right angels, it may be very hard to get additional financing out of your original syndicate. And if you’ve set up the business such that your structural burn rate leaves you between a rock and a hard place, there is generally only one answer left: fire sale/acqui-hire. And this is not what anyone was looking for going into this exciting, “world-changing” investment. This could have been prevented by spending less aggressively, getting to revenues earlier and selecting investors who have the mind-set and resources to support the company during its ugly teenage years (read: Years 2-3). And if, by chance, it really does appear that the company has the chance to be truly disruptive, smart and patient venture capital is always there to support a scale opportunity.

So what’s the answer to the question: too many start-ups or too few venture dollars? In my view, the answer is too many start-ups that are funded improperly and manage their burn incorrectly due to unrealistic expectations for the business. Plenty of venture dollars are out there for companies that have truly scale opportunities where one can structure a win/win between the venture investor and the founders. Now I understand that the very fiber of most founders is to be profoundly confident about their companies and their ability to be massive and disruptive. The problem is, this suspension of reality in the very earliest days meets with the brutal reality of investment math when money is running short and venture investment is not there to bridge the gap. So to the extent possible, founders should surround themselves with people who can inject a measure of reality and perspective into their thought processes. Because running hot and fast into the great financing unknown is likely to end in tears almost all the time. Be passionate. Think big. But by all means be smart. It is your company. If you choose to bet the ranch that’s cool, but don’t be surprised if the marshals come to repossess…

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