Calling Bullshit On The Series A Crunch

Editor’s note: Guest contributor Paul Lee is a Partner at Lightbank Capital.  You can follow him @iPaulLee.

A lot has been written about the Series A Crunch.  The gist of the argument is that the number of seed financings have gone up (with the advent of incubators such as Y-Combinator, TechStars, and Excelerate, as well as a new generation of Super Angels, who may or may not be hanging out at Bin 38), but the number of Series A financings have remained relatively steady.  Ergo, the percentage of companies that can’t raise a Series A must be going up.

Rob Go, from Nextview Ventures, does a nice job explaining what’s happening from his perspective.  His theory is that this is somewhat cyclical, and that there will be a bit of a bloodbath but people should expect it and smart investors have been preparing for this day.

Dave McClure, that swashbuckler (Hi Dave!), is less diplomatic.

So what the hell is really going on?  While a lot has been written about the subject, I think the reality is the Series A Crunch is bullshit and people are misreading the signals here.

There is no Series A Crunch.  There is a huge supply of seed capital but a significantly larger percentage of angel-funded startups are not needing significant capital and thus not seeking Series A financing.

There are two factors driving this development—the supply and demand of venture capital.  First, the supply of venture capital has fundamentally changed.  Angels from the last generation of startups such as Google, PayPal, Facebook, and soon, Groupon, are starting to dabble in venture, doing investments of $50-$500K.

On the institutional side, total fundraising from Limited Partners (LP’s) in the asset class has gone up in the last year, but interestingly, fewer firms are actually receiving these funds.  You’re seeing the rich get richer.  LP’s are flocking to well known funds with great track records and the net result is that several mega funds have raised $1B+.

So what?

Well the reality is that $10 million exit on a seed investment (which may yield a $1-2 million return for the investor) is not going to mean squat for a billion dollar fund in terms of performance or impact on the firm’s ability to raise their next fund (this is classic ROI vs. Cash on Cash returns).

So how does that fund play in this space?  They sprinkle a few hundred thousand to as many of the small deals as possible for the option value (of getting to know the entrepreneur loosely) and if there’s traction, they bid early and aggressively (hence the run up on these valuations).  At the end of the day, to the venture firm, the most important thing is ownership in the deal.  If they have to pay a premium on the valuation, it’s not a big deal because they have a large fund that can absorb the extra money paid for the “hot” company.   The net net for seed stage deals however is that there is even more capital funding more companies and the takeaway for Series A deals is higher valuations (which require more investment for the target 20% ownership for the venture firm).

In addition to the trends on the supply side, the demand for venture capital has fundamentally changed.  We’re seeing a lot of two and three person startups that raise $500,000-$1 million in angel funding (for anywhere between 10-20% of the company). Back in the day, that would allow you to buy some servers and equipment, rent some space, and take you to the point of the initial iterations of a product.  With the advent of Amazon web services, communal working space, and an increased skill set of product development (at a younger age—we’re seeing founders as young as 18), today’s team’s are cranking out products that can start generating traction and even revenue.  Modular services such as Braintree, Twilio, and Recurly allow teams to bolt on functionality that would have taken months, if not years, to develop on their own.

As a result of these lowered costs and rapid development, you’re seeing businesses that have either scaled quickly to cash flow positive or to a point where they are $10 million acquisitions for larger players like Facebook, Google, and Groupon.  If the founders did one angel round and still own 80% of the business, the net payout would be $8 million to be split evenly between 2-3 founders. Certainly nice scratch.  If you think about that option versus the pain of going out to raise significant venture capital and getting diluted along the way, you can see why it would be an attractive alternative.

So what does all this mean?

It means that a larger than historical percentage of companies are getting seed funding (and we’ve been seeing companies that, in my opinion, shouldn’t be funded—but then again, I’ve been wrong a lot).  However, the assumption that a huge percentage of these companies are getting screwed since the same number of Series A deals are getting done is just flat out wrong. A significant percentage of these firms don’t need to raise a Series A.

The actionable advice I would give to founders is to think about what you want from your startup (and be real with yourself even if not reflected in your investment pitch).  Would you be happy with a small, yet attractive exit?  Or are you looking to build the next great business?

If the former, raise money from angels (who they are matters to a significant degree, but I’ll save that for a future post) and iterate and strive for a business that can sustain itself.

If the latter, think hard and choose wisely.  In particular, I would be careful about large 10-investor syndicates that include participation from large mega funds.  Realize that the seed investment is an “option” for these mega funds.  They may not be committed to the business in a real way (getting the partners’ time, advice, and network) until you can show meaningful traction.  Because it’s effectively an “option”, they are more apt to walk away from the investment if it is not going well and send a strong signal to the investment community.

In any event, it’s a great time to be a founder.  Take advantage of all the money out there to build your business.

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